Are Investors Undervaluing Ribbon Communications Inc. (NASDAQ:RBBN) By 46%?

Simply Wall St.
25 Oct 2024

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Ribbon Communications fair value estimate is US$6.84
  • Current share price of US$3.71 suggests Ribbon Communications is potentially 46% undervalued
  • Analyst price target for RBBN is US$5.70 which is 17% below our fair value estimate

How far off is Ribbon Communications Inc. (NASDAQ:RBBN) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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. 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 Ribbon Communications

The Method

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) forecast

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF ($, Millions) US$43.1m US$50.3m US$55.6m US$60.2m US$64.1m US$67.5m US$70.5m US$73.2m US$75.7m US$78.2m
Growth Rate Estimate Source Analyst x2 Analyst x1 Est @ 10.64% Est @ 8.20% Est @ 6.49% Est @ 5.29% Est @ 4.45% Est @ 3.87% Est @ 3.46% Est @ 3.17%
Present Value ($, Millions) Discounted @ 7.5% US$40.1 US$43.5 US$44.7 US$45.0 US$44.6 US$43.7 US$42.4 US$41.0 US$39.4 US$37.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$422m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.5%. We discount the terminal cash flows to today's value at a cost of equity of 7.5%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$78m× (1 + 2.5%) ÷ (7.5%– 2.5%) = US$1.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$1.6b÷ ( 1 + 7.5%)10= US$772m

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$1.2b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$3.7, the company appears quite undervalued at a 46% 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.

NasdaqGS:RBBN Discounted Cash Flow October 25th 2024

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Ribbon Communications 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 7.5%, which is based on a levered beta of 1.219. 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 Ribbon Communications

Strength
  • No major strengths identified for RBBN.
Weakness
  • Interest payments on debt are not well covered.
Opportunity
  • Has sufficient cash runway for more than 3 years based on current free cash flows.
  • Good value based on P/S ratio and estimated fair value.
    Have RBBN insiders been buying lately?
Threat
  • Debt is not well covered by operating cash flow.
  • Not expected to become profitable over the next 3 years.
    Is RBBN well equipped to handle threats?

Moving On:

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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" 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. What is the reason for the share price sitting below the intrinsic value? For Ribbon Communications, we've put together three additional elements you should explore:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Ribbon Communications , and understanding it 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 RBBN'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. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (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 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.

Disclaimer: Investing carries risk. This is not financial advice. The above content should not be regarded as an offer, recommendation, or solicitation on acquiring or disposing of any financial products, any associated discussions, comments, or posts by author or other users should not be considered as such either. It is solely for general information purpose only, which does not consider your own investment objectives, financial situations or needs. TTM assumes no responsibility or warranty for the accuracy and completeness of the information, investors should do their own research and may seek professional advice before investing.

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