An Intrinsic Calculation For Pegasystems Inc. (NASDAQ:PEGA) Suggests It's 36% Undervalued

Key Insights

• The projected fair value for Pegasystems is US$87.23 based on 2 Stage Free Cash Flow to Equity
• Pegasystems is estimated to be 36% undervalued based on current share price of US$56.06
• Our fair value estimate is 18% higher than Pegasystems' analyst price target of US$73.91

In this article we are going to estimate the intrinsic value of Pegasystems Inc. (NASDAQ:PEGA) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

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Is Pegasystems Fairly Valued?

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. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF ($, Millions)	US$564.1m	US$657.8m	US$729.3m	US$791.9m	US$847.2m	US$896.9m	US$942.6m	US$985.3m	US$1.03b	US$1.07b
Growth Rate Estimate Source	Analyst x6	Analyst x2	Est @ 10.86%	Est @ 8.58%	Est @ 6.99%	Est @ 5.87%	Est @ 5.09%	Est @ 4.54%	Est @ 4.15%	Est @ 3.89%
Present Value ($, Millions) Discounted @ 8.4%	US$520	US$559	US$572	US$573	US$565	US$552	US$534	US$515	US$495	US$474

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.4b

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 3.3%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = US$1.1b× (1 + 3.3%) ÷ (8.4%– 3.3%) = US$21b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$21b÷ ( 1 + 8.4%)¹⁰= US$9.4b

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$15b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$56.1, the company appears quite good value at a 36% 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.

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. 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 8.4%, which is based on a levered beta of 1.122. 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.

See our latest analysis for Pegasystems

SWOT Analysis for Pegasystems

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" 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. Can we work out why the company is trading at a discount to intrinsic value? For Pegasystems, we've put together three important aspects you should explore:

1. Financial Health: Does PEGA have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future Earnings: How does PEGA'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. 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.