Is Pacific Biosciences of California, Inc. (NASDAQ:PACB) Trading At A 32% Discount?

Key Insights

• The projected fair value for Pacific Biosciences of California is US$19.96 based on 2 Stage Free Cash Flow to Equity
• Current share price of US$13.50 suggests Pacific Biosciences of California is potentially 32% undervalued
• Our fair value estimate is 36% higher than Pacific Biosciences of California's analyst price target of US$14.73

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Pacific Biosciences of California, Inc. (NASDAQ:PACB) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Pacific Biosciences of California

The Calculation

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 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 ($, Millions)	-US$223.7m	-US$157.5m	-US$20.1m	US$107.2m	US$174.6m	US$252.6m	US$333.2m	US$409.7m	US$478.1m	US$537.0m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x3	Analyst x2	Est @ 62.89%	Est @ 44.66%	Est @ 31.89%	Est @ 22.96%	Est @ 16.70%	Est @ 12.33%
Present Value ($, Millions) Discounted @ 8.2%	-US$207	-US$135	-US$15.9	US$78.2	US$118	US$157	US$192	US$218	US$235	US$244

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$886m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 (2.1%) 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 8.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$537m× (1 + 2.1%) ÷ (8.2%– 2.1%) = US$9.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$9.0b÷ ( 1 + 8.2%)¹⁰= US$4.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$5.0b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$13.5, the company appears quite undervalued at a 32% 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.

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. 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 Pacific Biosciences of California 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 8.2%, which is based on a levered beta of 1.024. 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 Pacific Biosciences of California

Looking Ahead:

Although the valuation of a company is important, 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Pacific Biosciences of California, there are three important aspects you should look at:

1. Risks: Take risks, for example - Pacific Biosciences of California has 2 warning signs we think you should be aware of.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PACB's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS 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.