Pegasystems Inc.'s (NASDAQ:PEGA) Intrinsic Value Is Potentially 20% Below Its Share Price

Key Insights

• The projected fair value for Pegasystems is US$55.45 based on 2 Stage Free Cash Flow to Equity
• Pegasystems is estimated to be 25% overvalued based on current share price of US$69.51
• The US$82.55 analyst price target for PEGA is 49% more than our estimate of fair value

In this article we are going to estimate the intrinsic value of Pegasystems Inc. (NASDAQ:PEGA) by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. 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 Pegasystems

The Calculation

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. 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) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF ($, Millions)	US$390.9m	US$397.5m	US$252.9m	US$277.0m	US$250.5m	US$235.6m	US$227.5m	US$223.8m	US$222.9m	US$223.9m
Growth Rate Estimate Source	Analyst x7	Analyst x4	Analyst x1	Analyst x1	Est @ -9.58%	Est @ -5.95%	Est @ -3.42%	Est @ -1.64%	Est @ -0.40%	Est @ 0.47%
Present Value ($, Millions) Discounted @ 6.8%	US$366	US$348	US$207	US$213	US$180	US$159	US$143	US$132	US$123	US$116

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$2.0b

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 (2.5%) 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 6.8%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = US$224m× (1 + 2.5%) ÷ (6.8%– 2.5%) = US$5.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$5.3b÷ ( 1 + 6.8%)¹⁰= US$2.7b

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$4.7b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$69.5, the company appears slightly overvalued at the time of writing. 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

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 6.8%, which is based on a levered beta of 1.048. 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

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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 lower than the current share price? For Pegasystems, we've compiled three relevant aspects you should explore:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Pegasystems , and understanding them 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 PEGA'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. 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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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.