Estimated fair value of Pilbara Minerals Limited (ASX:PLS)
Does the March share price for Pilbara Minerals Limited (ASX:PLS) reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by estimating the future cash flows of the company and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
See our latest analysis for Pilbara Minerals
We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF (A$, Millions)||A$607.5 million||A$940.9 million||A$545.1 million||A$419.0 million||A$376.4 million||A$351.6 million||A$337.3 million||A$329.5 million||A$326.0 million||A$325.3 million|
|Growth rate estimate Source||Analyst x2||Analyst x2||Analyst x2||Analyst x1||East @ -10.17%||Is @ -6.58%||East @ -4.07%||Is @ -2.31%||Is @ -1.07%||Is @ -0.21%|
|Present value (A$, millions) discounted at 6.4%||AU$571||AU$832||AU$453||AU$328||AU$277||AU$243||AU$219||AU$201||AU$187||AU$176|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = 3.5 billion Australian dollars
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.8%. We discount terminal cash flows to present value at a cost of equity of 6.4%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = AU$325 million × (1 + 1.8%) ÷ (6.4%–1.8%) = AU$7.3 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= AU$7.3b÷ ( 1 + 6.4%)ten= AU$3.9 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is A$7.4 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of AU$2.9, the company appears around fair value at the time of writing. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Pilbara Minerals 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 takes debt into account. In this calculation, we used 6.4%, which is based on a leveraged beta of 1.074. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Let’s move on :
Valuation is only one side of the coin in terms of crafting your investment thesis, and it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. For Pilbara Minerals, we’ve rounded up three essentials you should consider:
- Risks: Every business has them, and we’ve spotted 4 warning signs for Pilbara Minerals you should know.
- Future earnings: How does the growth rate of PLS compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks, search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.