Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Pentair plc (NYSE:PNR) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. This is done using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not October 2018 then I highly recommend you check out the latest calculation for Pentair by following the link below.
Is PNR fairly valued?
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
|Levered FCF ($, Millions)||$443.86||$506.90||$526.95||$557.25||$496.00|
|Source||Analyst x5||Analyst x2||Analyst x2||Analyst x2||Est @ -10.99%|
|Present Value Discounted @ 10.68%||$401.04||$413.82||$388.69||$371.39||$298.68|
Present Value of 5-year Cash Flow (PVCF)= US$1.87b
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.9%. We discount this to today’s value at a cost of equity of 10.7%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$496.0m × (1 + 2.9%) ÷ (10.7% – 2.9%) = US$6.61b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$6.61b ÷ ( 1 + 10.7%)5 = US$3.98b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$5.85b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of $33.37. Compared to the current share price of $43.35, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
I’d like to point out 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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Pentair as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 10.7%, which is based on a levered beta of 1.096. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For PNR, there are three pertinent factors you should further research:
- Financial Health: Does PNR have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does PNR’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of PNR? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
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The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.