Does the November share price for Unity Software Inc. (NYSE:U) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by taking the forecast future cash flows of the company and discounting them back to today’s value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Check out our latest analysis for Unity Software
The Method
We use what is known as a 2stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10year free cash flow (FCF) estimate
2023 
2024 
2025 
2026 
2027 
2028 
2029 
2030 
2031 
2032 

Levered FCF ($, Millions) 
US$74.4m 
US$10.7m 
US$280.0m 
US$415.0m 
US$521.4m 
US$618.0m 
US$701.8m 
US$772.6m 
US$831.8m 
US$881.3m 
Growth Rate Estimate Source 
Analyst x9 
Analyst x8 
Analyst x2 
Analyst x1 
Est @ 25.63% 
Est @ 18.53% 
Est @ 13.57% 
Est @ 10.09% 
Est @ 7.66% 
Est @ 5.95% 
Present Value ($, Millions) Discounted @ 7.8% 
US$69.0 
US$9.2 
US$224 
US$308 
US$359 
$394 
US$416 
US$425 
US$424 
US$417 
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10year Cash Flow (PVCF) = US$2.9b
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5year average of the 10year government bond yield of 2.0%. We discount the terminal cash flows to today’s value at a cost of equity of 7.8%.
Terminal Value (TV)= FCF_{2032} × (1 + g) (r – g) = US$881m× (1 + 2.0%) (7.8%– 2.0%) = US$16b
Present Value of Terminal Value (PVTV)= TV / (1 + r)^{10}= US$16b÷ ( 1 + 7.8%)^{10}= US$7.3b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$10b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$26.3, the company appears a touch undervalued at a 23% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.
The Assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Unity Software as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we’ve used 7.8%, which is based on a levered beta of 1,129. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Looking Ahead:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Unity Software, there are three relevant elements you should explore:

Risks: Take risks, for example – Unity Software has 4 warning signs we think you should be aware of.

Management:Have insiders been leaning up their shares to take advantage of the market’s sentiment for U’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

Other High Quality Alternatives: Do you like a good allrounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email the editorialteam(at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you longterm focused analysis driven by fundamental data. Note that our analysis may not factor in the latest pricesensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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