Are Investors Undervaluing Pegasystems Inc. (NASDAQ:PEGA) By 48%?

Pegasystems Inc. +0.44% Pre

Pegasystems Inc.

PEGA

58.72

58.72

+0.44%

0.00% Pre

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Pegasystems fair value estimate is US$94.13
  • Pegasystems is estimated to be 48% undervalued based on current share price of US$48.86
  • The US$53.92 analyst price target for PEGA is 43% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Pegasystems Inc. (NASDAQ:PEGA) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using 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 would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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.

See our latest analysis for Pegasystems

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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2024 2025 2026 2027 2028 2029 2030 2031 2032 2033
Levered FCF ($, Millions) US$254.7m US$77.6m US$259.0m US$356.0m US$409.5m US$455.3m US$494.0m US$526.6m US$554.5m US$578.8m
Growth Rate Estimate Source Analyst x7 Analyst x6 Analyst x1 Analyst x1 Est @ 15.03% Est @ 11.18% Est @ 8.50% Est @ 6.61% Est @ 5.29% Est @ 4.37%
Present Value ($, Millions) Discounted @ 7.6% US$237 US$67.0 US$208 US$266 US$284 US$294 US$297 US$294 US$288 US$279

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$2.5b

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 (2.2%) 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 7.6%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$579m× (1 + 2.2%) ÷ (7.6%– 2.2%) = US$11b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$11b÷ ( 1 + 7.6%)10= US$5.4b

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$7.9b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$48.9, the company appears quite undervalued at a 48% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
NasdaqGS:PEGA Discounted Cash Flow December 30th 2023

Important Assumptions

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 these inputs, I recommend redoing the calculations yourself and playing with them. 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 7.6%, which is based on a levered beta of 1.067. 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 well covered by earnings and cashflows.
Weakness
  • Dividend is low compared to the top 25% of dividend payers in the Software market.
Opportunity
  • Expected to breakeven next year.
  • Has sufficient cash runway for more than 3 years based on current free cash flows.
  • Good value based on P/S ratio and estimated fair value.
Threat
  • No apparent threats visible for PEGA.

Moving On:

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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Pegasystems, we've put together three fundamental factors you should consider:

  1. Financial Health: Does PEGA 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.
  2. 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.
  3. 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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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