Pason Systems Inc. (TSE:PSI) Shares Could Be 50% Below Their Intrinsic Value Estimate

Key Insights

• Pason Systems' estimated fair value is CA$29.00 based on 2 Stage Free Cash Flow to Equity

• Current share price of CA$14.50 suggests Pason Systems is potentially 50% undervalued

• Our fair value estimate is 66% higher than Pason Systems' analyst price target of CA$17.50

How far off is Pason Systems Inc. (TSE:PSI) 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. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Pason Systems

The Model

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$104.3m	CA$132.2m	CA$146.4m	CA$158.3m	CA$168.2m	CA$176.5m	CA$183.7m	CA$189.9m	CA$195.6m	CA$200.8m
Growth Rate Estimate Source	Analyst x4	Analyst x2	Est @ 10.77%	Est @ 8.12%	Est @ 6.26%	Est @ 4.96%	Est @ 4.05%	Est @ 3.42%	Est @ 2.97%	Est @ 2.66%
Present Value (CA$, Millions) Discounted @ 8.8%	CA$95.8	CA$112	CA$114	CA$113	CA$110	CA$106	CA$102	CA$96.7	CA$91.5	CA$86.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.0b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.9%) 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 8.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$201m× (1 + 1.9%) ÷ (8.8%– 1.9%) = CA$3.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$3.0b÷ ( 1 + 8.8%)¹⁰= CA$1.3b

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 CA$2.3b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$14.5, the company appears quite good value at a 50% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

We would point out that 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 Pason Systems 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 8.8%, which is based on a levered beta of 1.375. 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 Pason Systems

Strength

• Earnings growth over the past year exceeded its 5-year average.

• Currently debt free.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year underperformed the Energy Services industry.

• Dividend is low compared to the top 25% of dividend payers in the Energy Services market.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Trading below our estimate of fair value by more than 20%.

Threat

• Annual earnings are forecast to grow slower than the Canadian market.

Looking Ahead:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value higher than the current share price? For Pason Systems, we've put together three additional factors you should explore:

1. Risks: Case in point, we've spotted 2 warning signs for Pason Systems you should be aware of, and 1 of them can't be ignored.

2. Future Earnings: How does PSI'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.

3. 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX every day. If you want to find the calculation for other stocks 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.