This article details how to construct an unlevered discounted cash flow (DCF) analysis for IAC/InterActiveCorp (NasdaqGS: IAC) by using finbox.io’s five-year valuation model. Note that unlevered free cash flow refers to the cash a business generates before paying any providers of capital such as debt and equity holders.
The basic philosophy behind a DCF analysis is that the intrinsic value of a company is equal to the future cash flows of that company, discounted back to present value. The general formula is provided below. The intrinsic value is considered the actual value or “true value” of an asset based on an individual’s underlying expectations and assumptions.
Cash flows into the firm in the form of revenue as the company sells its products and services, and cash flows out as it pays its cash operating expenses such as salaries or taxes (taxes are part of the definition for cash operating expenses for purposes of defining free cash flow, even though taxes aren’t generally considered a part of operating income). With the leftover cash, the firm will make short-term net investments in working capital (an example would be inventory and receivables) and longer-term investments in property, plant and equipment. The cash that remains is available to pay out to the firm’s investors: bondholders and common shareholders.
I will take you through my own expectations for InterActiveCorp as well as explain how I arrived at certain assumptions. The full analysis was completed on Tuesday, January 16. An updated analysis using real-time data can be viewed in your web browser at finbox.io’s InterActiveCorp DCF analysis page. The steps involved in the valuation are:
1. Forecast Free Cash Flows
Create a revenue forecast
Forecast EBITDA profit margin
Forecast depreciation & amortization expenses
Select a pro-forma tax rate
Plan/estimate capital expenditures
Forecast net working capital investment
Calculate free cash flow
2. Select a discount rate
3. Estimate a terminal value
4. Calculate the equity value
Step 1: Forecast Free Cash Flows
I found it helpful to analyze each of IAC’s operating segments before forecasting the total company’s free cash flows.
This segment provides dating products, which enables a user to establish a profile and review other people’s profiles in 38 languages. 39% of the company’s total sales derive from this group while EBITDA makes up a larger portion (72%) as of December 2016.
This segment offers a variety of consumer services in categories ranging from simple home repairs to larger home remodeling projects. This segment is responsible for 16% of the company’s total sales and 9% of EBITDA as of December 2016.
This segment develops various desktop applications that offer users the ability to access search services. As of December 2016, 19% of the company’s total revenues derive from this group while EBITDA makes up a larger portion (24%).
This segment publishes digital content through About.com, Dictionary.com, Investopedia, The Daily Beast, and Ask.com. This segment is responsible for 13% of the company’s total sales and is cash flow negative (-1% of EBITDA as of December 2016).
Video and Other
This segment operates a video sharing platform and tools to share, distribute, and monetize content online. As of December 2016, 13% of the company’s total revenues derive from this group and also operates at a loss (-4% of EBITDA).
Match Group and ANGI Homeservices not only make up more than 80% of IAC’s total EBITDA, they are also the two fastest growing segments. Match Group’s sales have grown at 15% on average over the last 3 years while ANGI Homeservices top line has grown at 28% on average.
Create A Revenue Forecast
When available, the finbox.io’s pre-built models use analyst forecasts as the starting assumptions. To forecast revenue, analysts gather data about the company, its customers and the state of the industry. I typically review the analysts’ forecast and modify the growth rates based on historical performance, news and other insights gathered from competitors. Note that if a company only has a small number of analysts giving projections, the consensus forecast tends to not be as reliable as companies that have several analysts’ estimates. Another check for reliability is to analyze the range of estimates. If the range is really wide, it may be less accurate.
Analysts covering the stock often compare the company to a peer group that includes GoDaddy (NYSE: GDDY), eBay (NasdaqGS: EBAY), Twitter, (NYSE: TWTR) and Yelp (NYSE: YELP).
The company’s projected 5-year revenue CAGR of 9.6% is above EBAY (5.8%) and TWTR (5.8%) but below GDDY (12.8%) and YELP (14.3%).
As highlighted below, InterActiveCorp’s revenue growth has ranged from -2.8% to 36.0% over the last five fiscal years.
Going forward, analysts forecast that InterActiveCorp’s total revenue will reach $4,960 million by fiscal year 2021 representing a five-year CAGR of 9.6%.
In my model, I conservatively adjusted the growth figures lower in 2018 and 2019 since total company growth hasn’t been above 8% since 2012. Reading through investor presentations, earnings announcements and other SEC filings helped me get comfortable with my revenue forecast, which is shown below.
Forecast InterActiveCorp’s EBITDA Profit Margin
The next step is to forecast the company’s earnings before interest, taxes, depreciation and amortization (EBITDA). Note that EBITDA is a commonly used metric in valuation models because it provides a cleaner picture of overall profitability, especially when benchmarking against comparable companies. This is because it ignores non-operating costs that can be affected by certain items such as a company’s financing decisions or political jurisdictions. For more detail, see InterActiveCorp’s EBITDA definition.
EBITDA margin is calculated by dividing EBITDA by revenue. The higher the EBITDA margin, the smaller the firm’s operating expenses are in relation to its revenue, which may ultimately lead to higher profit. Lower operating expenses for a given level of revenue can be a sign of internal economies of scale.
The charts below compare InterActiveCorp’s LTM EBITDA margin to the same peer group. The company’s EBITDA margin of 10.1% is only above YELP (7.2%) and below GDDY (12.0%), EBAY (31.2%), TWTR (11.8%).
InterActiveCorp’s EBITDA margin has ranged from 12.3% to 18.0% over the last five fiscal years. Wall Street analysts are forecasting that InterActiveCorp’s EBITDA margin will reach 30.3% by fiscal year 2021, representing an increase of 20.2% from its LTM EBITDA margin of 10.1%. That’s a large jump!
Again, I conservatively bring Wall Street’s EBITDA margins down each year in my forecast shown below. However, I do project that EBITDA margin expands to 20% by fiscal year 2021 as Match Group’s 33% margins continue to represent more InterActiveCorp’s total EBITDA.
Forecast Depreciation & Amortization Expenses
Depreciation and amortization (D&A) are usually embedded in cost of goods sold (COGS) or selling general and administrative expenses (SG&A) on the income statement. The model subtracts D&A to estimate NOPAT but eventually adds it back in the build-up to free cash flow because it’s a non-cash expense. Including it as an expense in the calculation of NOPAT allows the model to capture the tax benefits associated with D&A. While depreciation is a non-cash expense, the firm reduces its tax bill by expensing it, so the free cash flow available is increased by the tax savings.
I’ve kept D&A at 6.2% of revenues throughout the projection period, which is in line with its past performance.
Select a Pro Forma Tax Rate
Companies are required to pay a portion of their profits to the governments in the countries in which they operate. A firm’s effective tax rate is calculated from the reported income statement by dividing taxes by operating income before taxes. The marginal tax rate is the rate owed on the company’s last dollar of taxable income. A company’s effective and marginal tax rate is not always the same due to accounting standards related to tax credits, tax deferrals and net operating losses (NOLs) carried forward. However, historical effective tax rates are useful for estimating a company’s marginal tax rate, which is what I use in the model.
InterActiveCorp along with many other companies report their effective tax rates in their quarterly and annual reports. The company’s effective tax rate and my selected assumption are highlighted below.
Note that President Trump signed a massive GOP tax bill into law right before Christmas bringing the corporate tax rate down from 35% to 21%. Therefore, historical tax rates are not indicative of what will be paid by companies going forward.
State and local taxes vary by jurisdiction so I selected a higher 23% tax rate in my model.
Spending on plant, property, and equipment (PP&E), which is often referred to as capital expenditures allows a firm to continue to operate as well as grow its operations. The amount that InterActiveCorp has spent (as a percentage of revenue) has ranged from 1.8% to 2.7% over the last five fiscal years.
I kept my capital expenditure projections in line with historical performance.
Forecast Net Working Capital Investment
As a company grows, it typically needs to tie up more cash in working capital to manage its day-to-day operations effectively. The model accounts for the impact of this investment by first estimating InterActiveCorp’s net working capital (NWC) as a percentage of revenue and then deducting year-over-year increases from free cash flow.
It is important to note that net working capital typically fluctuates more year over year than other DCF assumptions and is generally more difficult to project with as much confidence. InterActiveCorp has historically required -8.5% of revenue on average for net working capital, but this figure has been as high as -7.2% and as low as -9.4%. The company’s latest fiscal-year NWC margin of -8.6% is in the ballpark, so I kept it at that level in the forecast shown in the figure below.
Calculate Free Cash Flow
With all required forecasts in place, the next step is to calculate projected free cash flow as shown below.
Step 2: Select InterActiveCorp’s Discount Rate
The next step is to select a discount rate to calculate the present value of the forecasted free cash flows. I used finbox.io’s Weighted Average Cost of Capital (WACC) model to help arrive at an estimate. Generally, a company’s assets are financed by either debt (debt is after tax in the formula) or equity. WACC is the average return expected by these capital providers, each weighted by respective usage. The WACC is the required return on the firm’s assets.
It’s important to note that the WACC is the appropriate discount rate to use because this analysis calculates the free cash flow available to InterActiveCorp’s bondholders and common shareholders. On the other hand, the cost of equity would be the appropriate discount rate if we were calculating cash flows available only to InterActiveCorp’s common shareholders (i.e., dividend discount model, equity DCF). This is commonly referred to as the difference between free cash flow to equity (FCFE) and free cash flow to the firm (FCFF). By using the WACC to discount FCFF, we are calculating total firm value. If we discounted FCFE at the required return on equity, we would end up with equity value of the firm. Equity value of the firm is simply total firm value minus the market value of debt.
I determined a reasonable WACC estimate for InterActiveCorp to be 8.5% at the midpoint. An updated cost of capital analysis using real-time data can be found at finbox.io’s InterActiveCorp WACC Model Page. The DCF model then does the heavy lifting of calculating the discount factors by applying the mid-year convention technique.
Step 3: Estimate InterActiveCorp’s Terminal Value
Since it is not reasonable to expect that InterActiveCorp will cease its operations at the end of the five-year forecast period, we must estimate the company’s continuing value, or terminal value. Terminal value is an important part of the DCF model because it accounts for the largest percentage of the calculated present value of the firm. If you were to exclude the terminal value, you would be excluding all the future cash flow past the horizon period. Using finbox.io, users can choose a five-year or 10-year horizon period to forecast future free cash flow.
The most generally accepted techniques to calculate a terminal value are by applying the Gordon growth approach, using an EBITDA exit multiple and using a revenue exit multiple. This analysis applies the Gordon growth formula:
As the formula suggests, we need to estimate a “perpetuity” growth rate at which we expect InterActiveCorp’s free cash flows to grow forever. Most analysts suggest that a reasonable rate is typically between the historical inflation rate of 2% to 3% and the historical GDP growth rate of 4% to 5%.
InterActiveCorp’s free cash flows are still growing at 8% at the end of the projection period, so I’ve selected a perpetuity growth rate of 4% (at the midpoint).
An EBITDA multiple is calculated by dividing enterprise value by EBITDA. Similarly, the terminal EBITDA multiple implied from a DCF analysis is calculated by dividing the terminal value by the terminal year’s projected EBITDA. Comparing the terminal EBITDA multiple implied from the selected growth rate to benchmark multiples can serve as a useful check.
InterActiveCorp’s implied EBITDA multiple of 16.4x seems reasonable when compared to the sector LTM EBITDA multiple of 16.3x.
Step 4: Calculate InterActiveCorp’s Equity Value
The enterprise value previously calculated is a measure of the company’s total value. An equity waterfall is a term often used by valuation firms, referring to the trickle-down process of computing a company’s equity value from its enterprise value. Note that in the event of a bankruptcy, debt holders will be paid in full before anything is distributed to common shareholders. Therefore, we must subtract debt and other financial obligations to determine a firm’s equity value. The general formula for calculating equity value is illustrated in the figure below.
The model uses the formula shown above to calculate equity value and divides the result by the shares outstanding to compute intrinsic value per share as shown at the bottom of the figure below.
The assumptions I used in the model imply an intrinsic value per share range of $130.31 to $199.40 for InterActiveCorp.
InterActiveCorp’s stock price currently trades at $134.70 as of Tuesday, January 16, 16.7% below the midpoint value of $157.19.
Conclusion: InterActiveCorp Has Upside Potential
A DCF analysis can seem complex at first, but it’s worth adding to your investment analysis toolbox since it provides the clearest view of company value. I’ll end with this quote by renowned economist John Maynard Keynes:
“It is better to be roughly right than precisely wrong.”
Instead of focusing on the getting each of the assumptions exactly right, take Keynes’ advice on being roughly right. Select different assumptions deemed reasonable to get a sense for key drivers of value. Apply multiple scenarios (e.g., base case, downside case etc.) to get comfortable with the upside and downside potential of the company.
This is not a buy or sell recommendation on any security mentioned. image source: IAC