Pegasystems Inc.'s (NASDAQ:PEGA) Intrinsic Value Is Potentially 43% Above Its Share Price

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Pegasystems fair value estimate is US$138
• Current share price of US$95.96 suggests Pegasystems is potentially 30% undervalued
• The US$93.70 analyst price target for PEGA is 32% less than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Pegasystems Inc. (NASDAQ:PEGA) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Pegasystems

Is Pegasystems Fairly Valued?

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 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 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$396.6m	US$454.9m	US$498.6m	US$536.0m	US$568.4m	US$596.9m	US$622.6m	US$646.2m	US$668.4m	US$689.8m
Growth Rate Estimate Source	Analyst x5	Analyst x3	Est @ 9.61%	Est @ 7.51%	Est @ 6.04%	Est @ 5.02%	Est @ 4.30%	Est @ 3.79%	Est @ 3.44%	Est @ 3.20%
Present Value ($, Millions) Discounted @ 7.1%	US$370	US$397	US$406	US$407	US$403	US$395	US$385	US$373	US$360	US$347

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$3.8b

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. 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 2.6%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = US$690m× (1 + 2.6%) ÷ (7.1%– 2.6%) = US$16b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$16b÷ ( 1 + 7.1%)¹⁰= US$8.0b

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$12b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$96.0, the company appears quite undervalued at a 30% 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.

The 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. 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 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 7.1%, 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 Pegasystems

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Pegasystems, we've put together three pertinent elements you should further research:

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