The intrinsic value of Pegasystems Inc. (NASDAQ: PEGA) is potentially 98% higher than its share price
Today we’re going to review one way to estimate the intrinsic value of Pegasystems Inc. (NASDAQ: PEGA) by taking expected future cash flows and discounting them to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!
We generally think of a business’s value as the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. If you still have burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
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Is Pegasystems just valued?
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. In the first step, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF ($, Millions)||US $ 46.5 million||US $ 129.1 million||US $ 261.7 million||US $ 473.5 million||US $ 669.4 million||US $ 821.3 million||US $ 956.7 million||US $ 1.07 billion||US $ 1.17 billion||US $ 1.25 billion|
|Source of estimated growth rate||Analyst x5||Analyst x5||Analyst x3||Analyst x2||Analyst x2||Est @ 22.69%||East @ 16.48%||Is at 12.13%||Est @ 9.09%||Est @ 6.96%|
|Present value (in millions of dollars) discounted at 6.5%||US $ 43.7||114 USD||$ 216||$ 368||US $ 488||US $ 562||US $ 614||$ 647||US $ 662||US $ 665|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 4.4 billion
It is now a matter of calculating the Terminal Value, which takes into account all future cash flows after this ten-year period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 6.5%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US $ 1.3 billion × (1 + 2.0%) ÷ (6.5% – 2.0%) = US $ 28 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 28 billion ÷ (1 + 6.5%)ten= US $ 15 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $ 19 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 120, the company appears to be quite undervalued with a 50% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
We draw your attention to the fact that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Pegasystems 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 takes debt into account. In this calculation, we used 6.5%, which is based on a leveraged beta of 0.962. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and ideally, it won’t be the only piece of analysis you will look at for a business. DCF models are not the alpha and omega of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Can we understand why the company trades at a discount to its intrinsic value? For Pegasystems, we have compiled three more things you should review:
- Risks: You should be aware of the 2 warning signs for Pegasystems (1 doesn’t suit us too much!) We found out before considering an investment in the company.
- Future benefits: How does PEGA’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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