Are Investors Undervaluing Pegasystems Inc. (NASDAQ:PEGA) By 48%?
Key Insights
Using the 2 Stage Free Cash Flow to Equity, Pegasystems fair value estimate is US$125
Pegasystems' US$65.60 share price signals that it might be 48% undervalued
Our fair value estimate is 76% higher than Pegasystems' analyst price target of US$71.09
How far off is Pegasystems Inc. (NASDAQ:PEGA) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
See our latest analysis for Pegasystems
The Method
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$344.3m | US$318.6m | US$90.9m | US$396.8m | US$477.3m | US$537.1m | US$587.9m | US$630.8m | US$667.4m | US$699.1m |
Growth Rate Estimate Source | Analyst x6 | Analyst x8 | Analyst x3 | Analyst x1 | Analyst x1 | Est @ 12.52% | Est @ 9.45% | Est @ 7.30% | Est @ 5.80% | Est @ 4.75% |
Present Value ($, Millions) Discounted @ 7.1% | US$321 | US$278 | US$73.9 | US$301 | US$338 | US$355 | US$363 | US$364 | US$359 | US$351 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$3.1b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.1%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$699m× (1 + 2.3%) ÷ (7.1%– 2.3%) = US$15b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$15b÷ ( 1 + 7.1%)10= US$7.4b
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$11b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$65.6, the company appears quite undervalued at a 48% 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.
The Assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 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 accounts for debt. In this calculation we've used 7.1%, which is based on a levered beta of 1.053. 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 Pegasystems
Strength
Debt is not viewed as a risk.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Software market.
Opportunity
Annual revenue is forecast to grow faster than the American market.
Trading below our estimate of fair value by more than 20%.
Threat
Annual earnings are forecast to grow slower than the American market.
Looking Ahead:
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Pegasystems, there are three important factors you should look at:
Risks: Take risks, for example - Pegasystems has 2 warning signs we think you should be aware of.
Future Earnings: How does PEGA'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 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.
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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.
