Dropbox (NASDAQ:DBX) is up 13.85% this year as of Oct. 12, but just 7% in the past year. Nevertheless, Dropbox stock looks like good value here, especially since it generates steady free cash flow (FCF).
Dropbox makes money from annual subscriptions to its data storage business, mostly from small business and enterprise clients. As such, it is a steady revenue and FCF earner.
Moreover, earnings and FCF should grow at least 16% next year. That means the stock will be up at least that much and possibly higher.
Growing Revenue and FCF
In the past quarter ending June 30, Dropbox generated $120 million in FCF. Revenue was $467.4 million so that means its FCF margin is very high at 25.6%.
Most companies would love to have that high a ratio for their net income margin or even their gross income margin, much less an FCF margin. This shows that Dropbox has a powerful business model.
For example, a year ago the company generated $95 million in FCF on revenue of $401.5 million. That means two things. First, this past quarter its FCF grew by $25 million over the past year, or up 26%.
And second, its FCF margin was just 23.7% last year, but in Q2 2020 it rose to 25.6%. In other words, the company is getting more efficient at producing FCF as its revenue and FCF grows.
Moreover, Dropbox’s management forecasts that they expect to reach $1 billion in annual FCF by 2024. They are at about the halfway mark right now. For example, its Q2 FCF of $120 million works out to an annual FCF run rate of $480 million.
We can project the level of growth that they foresee in the next four years ending 2024. FCF will have to rise by $520 million, or 208%. That works out to a compound annual growth rate of 20.1% each year.
In other words, if Dropbox stock follows its FCF growth, it could rise by at least 20% per year over the next 4 years.
What’s Next With Dropbox Stock
If the DBX FCF yield does better over the next four years, the stock could rise by more than 20% per year. The FCF yield is the annualized FCF divided by the stock’s market value. So as the FCF goes lower, the value of the stock goes higher. In other words, we want the FCF yield to be lower in four years from now.
For example, right now the Dropbox FCF yield is 5.69% (i.e., $480 million Q2 run-rate FCF divided by its market capitalization of $8.63 billion). Therefore, it seems reasonable to assume that the FCF yield might fall by (i.e., increase in value) by 20% annually over the next four years.
That would mean that it would fall to 2.33% by 2024. You derive this by taking 80% of each year’s FCF yield over the next four years. In other words, 80% to the power of 4 (40.96%) times 5.96% is 2.33%.
Therefore, in four years assuming $1 billion in annual FCF, the market might value this by dividing it by 2.33% (instead of 5.69% as it does today). That would give the stock a market value of $42.92 billion. That represents a price that is 5 times higher than today’s price.
Estimating the ROI
So now you see the power of the FCF yield valuation metric. Instead of just rising by 208%, the market cap could rise by 4 times (i.e., the gain is 4 times the present price).
Moreover, even if the FCF yield fell by half of that amount to just 4.00%, Dropbox stock would rise to a market value of $25 billion (i.e., $1 billion divided by 4 is $25 billion). That means the stock would rise from $8.43 billion to $25 billion, or 2.966 times the present price.
Thus, the target price in four years will be $59.40 in four years (i.e. 2.966 times $20.03 Oct. 12). What kind of ROI will that represent?
Over four years, the compound annual growth rate for a stock that rises from $20.03 to $59.40 is 31.2% per year. Therefore, making an estimated 32% every year for four years with Dropbox stock is a very good ROI for most investors.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.