I am going to run you through how I calculated the intrinsic value of Pure Storage, Inc. (NYSE:PSTG) by taking the expected future cash flows and discounting them to today’s value. I will be using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not December 2018 then I highly recommend you check out the latest calculation for Pure Storage by following the link below.
What’s the value?
I’m 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 perpetual stable growth rate. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.
5-year cash flow estimate
|Levered FCF ($, Millions)||$68.08||$131.03||$213.15||$249.39||$289.29|
|Source||Analyst x6||Analyst x8||Analyst x4||Est @ 17%, capped from 42.05%||Est @ 16%, capped from 42.05%|
|Present Value Discounted @ 11.16%||$61.25||$106.05||$155.20||$163.36||$170.48|
Present Value of 5-year Cash Flow (PVCF)= US$656m
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. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 11.2%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$289m × (1 + 2.9%) ÷ (11.2% – 2.9%) = US$3.6b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$3.6b ÷ ( 1 + 11.2%)5 = US$2.1b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is US$2.8b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $11.57. Compared to the current share price of $15.39, the stock is quite expensive and not available at a discount at this time.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Pure Storage 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 11.2%, which is based on a levered beta of 1.164. 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 PSTG, there are three important aspects you should further examine:
- Financial Health: Does PSTG 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 PSTG’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 PSTG? 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.