Is Pacific Biosciences of California, Inc. (NASDAQ:PACB) Worth US$8.8 Based On Its Intrinsic Value?

Key Insights

• The projected fair value for Pacific Biosciences of California is US$6.55 based on 2 Stage Free Cash Flow to Equity
• Current share price of US$8.77 suggests Pacific Biosciences of California is potentially 34% overvalued
• Our fair value estimate is 85% higher than Pacific Biosciences of California's analyst price target of US$12.13

Today we will run through one way of estimating the intrinsic value of Pacific Biosciences of California, Inc. (NASDAQ:PACB) by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Pacific Biosciences of California

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. To begin with, we have to get estimates of 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.

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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	-US$276.0m	-US$222.6m	-US$160.5m	-US$50.8m	US$67.5m	US$104.9m	US$146.2m	US$187.4m	US$225.5m	US$259.1m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x3	Analyst x2	Analyst x2	Est @ 55.38%	Est @ 39.38%	Est @ 28.19%	Est @ 20.35%	Est @ 14.87%
Present Value ($, Millions) Discounted @ 8.5%	-US$254	-US$189	-US$126	-US$36.6	US$44.8	US$64.2	US$82.4	US$97.3	US$108	US$114

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = -US$95m

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 8.5%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$259m× (1 + 2.1%) ÷ (8.5%– 2.1%) = US$4.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$4.1b÷ ( 1 + 8.5%)¹⁰= US$1.8b

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$1.7b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$8.8, the company appears reasonably expensive at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Important Assumptions

Now 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 8.5%, which is based on a levered beta of 1.088. 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

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a premium to intrinsic value? For Pacific Biosciences of California, we've put together three further factors you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Pacific Biosciences of California , and understanding these should be part of your investment process.
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 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 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.