A Look At The Fair Value Of Penske Automotive Group, Inc. (NYSE:PAG)

By
Simply Wall St
Published
November 28, 2021
NYSE:PAG
Source: Shutterstock

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Penske Automotive Group, Inc. (NYSE:PAG) 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. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Penske Automotive Group

What's the estimated valuation?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.

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

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$135.4m US$477.1m US$724.6m US$768.7m US$802.6m US$832.0m US$858.3m US$882.3m US$904.7m US$926.2m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x1 Analyst x1 Est @ 4.4% Est @ 3.67% Est @ 3.16% Est @ 2.8% Est @ 2.55% Est @ 2.37%
Present Value ($, Millions) Discounted @ 9.2% US$124 US$400 US$556 US$540 US$516 US$490 US$462 US$435 US$408 US$383

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$4.3b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 9.2%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$926m× (1 + 2.0%) ÷ (9.2%– 2.0%) = US$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$13b÷ ( 1 + 9.2%)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$9.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$102, the company appears about fair value at a 17% 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.

dcf
NYSE:PAG Discounted Cash Flow November 29th 2021

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Penske Automotive Group 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 9.2%, which is based on a levered beta of 1.662. 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. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. For Penske Automotive Group, we've compiled three important factors you should explore:

  1. Risks: For instance, we've identified 3 warning signs for Penske Automotive Group (1 is a bit concerning) you should be aware of.
  2. Future Earnings: How does PAG'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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