Estimating The Fair Value Of EPAM Systems, Inc. (NYSE:EPAM)

EPAM Systems, Inc. -3.63% Post

EPAM Systems, Inc.

EPAM

180.11

180.11

-3.63%

0.00% Post

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, EPAM Systems fair value estimate is US$296
  • Current share price of US$276 suggests EPAM Systems is potentially trading close to its fair value
  • Analyst price target for EPAM is US$318, which is 7.4% above our fair value estimate

In this article we are going to estimate the intrinsic value of EPAM Systems, Inc. (NYSE:EPAM) by taking the expected future cash flows and discounting them to their present 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 generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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 EPAM Systems

The Method

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2024 2025 2026 2027 2028 2029 2030 2031 2032 2033
Levered FCF ($, Millions) US$611.6m US$713.5m US$795.3m US$856.3m US$908.1m US$952.9m US$992.3m US$1.03b US$1.06b US$1.09b
Growth Rate Estimate Source Analyst x6 Analyst x6 Analyst x4 Est @ 7.67% Est @ 6.06% Est @ 4.93% Est @ 4.14% Est @ 3.58% Est @ 3.19% Est @ 2.92%
Present Value ($, Millions) Discounted @ 7.3% US$570 US$620 US$644 US$647 US$639 US$625 US$607 US$586 US$564 US$541

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$6.0b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$1.1b× (1 + 2.3%) ÷ (7.3%– 2.3%) = US$22b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$22b÷ ( 1 + 7.3%)10= US$11b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$17b. 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$276, the company appears about fair value at a 6.7% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
NYSE:EPAM Discounted Cash Flow March 28th 2024

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 EPAM Systems 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 7.3%, which is based on a levered beta of 1.084. 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.

SWOT Analysis for EPAM Systems

Strength
  • Debt is not viewed as a risk.
Weakness
  • Earnings declined over the past year.
Opportunity
  • Annual earnings are forecast to grow faster than the American market.
  • Good value based on P/E ratio and estimated fair value.
Threat
  • Revenue is forecast to grow slower than 20% per year.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For EPAM Systems, we've put together three fundamental elements you should explore:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with EPAM Systems , and understanding this should be part of your investment process.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for EPAM's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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.

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