An Intrinsic Calculation For Pure Storage, Inc. (NYSE:PSTG) Suggests It's 38% Undervalued

Key Insights

• Pure Storage's estimated fair value is US$38.58 based on 2 Stage Free Cash Flow to Equity

• Current share price of US$24.05 suggests Pure Storage is potentially 38% undervalued

• The US$35.65 analyst price target for PSTG is 7.6% less than our estimate of fair value

Does the March share price for Pure Storage, Inc. (NYSE:PSTG) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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. 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.

View our latest analysis for Pure Storage

Step By Step Through The Calculation

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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$486.7m	US$452.7m	US$695.4m	US$799.0m	US$887.3m	US$961.5m	US$1.02b	US$1.08b	US$1.12b	US$1.16b
Growth Rate Estimate Source	Analyst x5	Analyst x4	Analyst x5	Est @ 14.90%	Est @ 11.05%	Est @ 8.36%	Est @ 6.47%	Est @ 5.15%	Est @ 4.23%	Est @ 3.58%
Present Value ($, Millions) Discounted @ 9.4%	US$445	US$378	US$531	US$558	US$566	US$561	US$546	US$525	US$500	US$473

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.1b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 9.4%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$1.2b× (1 + 2.1%) ÷ (9.4%– 2.1%) = US$16b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$16b÷ ( 1 + 9.4%)¹⁰= US$6.6b

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. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$24.1, the company appears quite undervalued at a 38% 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

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 Pure Storage 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 9.4%, which is based on a levered beta of 1.234. 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 Pure Storage

Strength

• Debt is not viewed as a risk.

Weakness

• Shareholders have been diluted in the past year.

Opportunity

• Annual earnings are forecast to grow faster than the American market.

• Trading below our estimate of fair value by more than 20%.

Threat

• Revenue is forecast to grow slower than 20% per year.

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Pure Storage, we've put together three fundamental aspects you should assess:

1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Pure Storage .

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PSTG'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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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