Yahoo Finance An Intrinsic Calculation For Pivotal Systems Corporation (ASX:PVS) Suggests It's 50% Undervalued
Today we will run through one way of estimating the intrinsic value of Pivotal Systems Corporation (ASX:PVS) by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!
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 want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Check out our latest analysis for Pivotal Systems
Is Pivotal Systems fairly valued?
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. To start off with, we need to estimate the next ten years of cash flows. 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Levered FCF ($, Millions) | -US$2.10m | US$1.20m | US$1.84m | US$2.54m | US$3.22m | US$3.85m | US$4.39m | US$4.85m | US$5.23m | US$5.55m |
Growth Rate Estimate Source | Analyst x1 | Analyst x1 | Est @ 53.28% | Est @ 37.83% | Est @ 27.02% | Est @ 19.46% | Est @ 14.16% | Est @ 10.45% | Est @ 7.86% | Est @ 6.04% |
Present Value ($, Millions) Discounted @ 6.7% | -US$2.0 | US$1.1 | US$1.5 | US$2.0 | US$2.3 | US$2.6 | US$2.8 | US$2.9 | US$2.9 | US$2.9 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$18m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 6.7%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$5.5m× (1 + 1.8%) ÷ (6.7%– 1.8%) = US$114m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$114m÷ ( 1 + 6.7%)10= US$60m
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$78m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$0.3, the company appears quite undervalued 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.
The assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Pivotal 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 6.7%, which is based on a levered beta of 1.165. 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.
Moving On:
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Pivotal Systems, we've compiled three further aspects you should further examine:
Risks: You should be aware of the 4 warning signs for Pivotal Systems we've uncovered before considering an investment in the company.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PVS's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other High Quality Alternatives: Do you like a good all-rounder? 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 updates its DCF calculation for every Australian 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.
