A Look At The Fair Value Of SoundThinking, Inc. (NASDAQ:SSTI)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, SoundThinking fair value estimate is US$17.29

• SoundThinking's US$16.06 share price indicates it is trading at similar levels as its fair value estimate

• The US$26.29 analyst price target for SSTI is 52% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of SoundThinking, Inc. (NASDAQ:SSTI) by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for SoundThinking

Step By Step Through The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$15.7m	US$13.7m	US$12.6m	US$12.0m	US$11.6m	US$11.5m	US$11.4m	US$11.5m	US$11.6m	US$11.8m
Growth Rate Estimate Source	Analyst x2	Analyst x1	Est @ -8.18%	Est @ -5.04%	Est @ -2.84%	Est @ -1.30%	Est @ -0.22%	Est @ 0.53%	Est @ 1.06%	Est @ 1.43%
Present Value ($, Millions) Discounted @ 6.9%	US$14.7	US$12.0	US$10.3	US$9.1	US$8.3	US$7.7	US$7.2	US$6.7	US$6.4	US$6.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$88m

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 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 6.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$12m× (1 + 2.3%) ÷ (6.9%– 2.3%) = US$260m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$260m÷ ( 1 + 6.9%)¹⁰= US$133m

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$221m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$16.1, the company appears about fair value at a 7.1% 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.

dcf

The Assumptions

We would point out that 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 SoundThinking 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 6.9%, which is based on a levered beta of 1.010. 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 SoundThinking

Strength

• Debt is not viewed as a risk.

Weakness

• Shareholders have been diluted in the past year.

Opportunity

• Forecast to reduce losses next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

• Current share price is below our estimate of fair value.

Threat

• No apparent threats visible for SSTI.

Moving On:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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 SoundThinking, we've compiled three additional factors you should consider:

1. Risks: Case in point, we've spotted 2 warning signs for SoundThinking you should be aware of.

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

3. Other High Quality Alternatives: Do you like a good all-rounder? 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 NASDAQCM every day. If you want to find the calculation for other stocks just search here.

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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 long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.