The Afterpay Touch Group Ltd (ASX: APT) share price has flown into the stratosphere over the past 24 months, and companies like Zip Co Ltd (ASX: Z1P) and Splitit Ltd (ASX: SPT) are being swept up in its wake.

About Afterpay

Afterpay Touch is the owner of the popular “buy now, pay later” app. As of early 2019, Afterpay had over 3.5 million registered users worldwide, making it one of Australia’s true technology success stories.

Valuation

In recent months I’ve heard a lot of commentary from people saying things like, ‘Afterpay shares are far too expensive because they have a price-sales ratio of more than 45x’ or ‘Afterpay’s valuation (market capitalisation) is nearly $6 billion and Splitit’s is $300 million, therefore Afterpay is expensive’.

The reality is, these two measures are about as good as a finger lick in the wind. It’s a first-level thinker’s analysis of value when a company has risen fast.

What investors should really be focusing on is the cash flow potential of the business longer term.

Unfortunately, the business’ current free cash flow is nothing to write home about (click here to learn what FCF means). Therefore, you will have to forecast free cash flow based on the business’ internal economics, risks, market opportunity and competition from the likes of Affirm and others.

For example, you could start by forecasting the number of Afterpay users per geography, then gross margin per user (and/or a normalised default rate), less expenses and financing costs. Then you would calculate free cash flow like any other business valuation.

I think this exercise would be quite revealing because it would show you how the economic engine inside Afterpay actually works (there are very good bits and some ugly parts). Click here to take our tutorials on discounted cash flow (DCF) analysis.

If that sounds too hard you could value the business on its flywheel of LTV-to-CAC.

Indeed, given its infancy as a business, you might start with something much more simple than a DCF. You might value it using, say, a ratio of customer acquisition cost (CAC) and lifetime value (LTV) to determine what each Afterpay user is worth and forecast into the future. You might even run an IRR and exit multiple for, say, five years’ time. This is a common technique among technology investors.

Summary

According to The Wall Street Journal, analysts have their valuations set around $24 for Afterpay shares. That’s below the current share price. However, I’ve said it time and again that using other analysts’ targets is a dangerous exercise because they’re often wrong.

If you were to do your own analysis of Afterpay you may find that your value is considerably different from those of the analysts, which is ok. But regardless of what value you come up with, by valuing the shares yourself you will have learned a lot about what makes the business ‘tick’ and how its current share price can be justified.

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Disclaimer: Any information contained in this article is limited to general financial/investment advice only. The information has not taken into account your specific needs, goals or objectives, so please consider consulting a licenced and trusted adviser before acting on the information. Please read The Rask Group’s Financial Services Guide (FSG) for more information. This article is authorised by Owen Raszkiewicz of The Rask Group, which is a corporate authorised representative No. 1264179 of Strawman Pty Ltd (ACN: 610 908 211) (AFSL: 501 223).

At the time publishing, Owen does not have a financial interest in any of the companies mentioned.