Is PDF Solutions, Inc. (NASDAQ:PDFS) Trading At A 45% Discount?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, PDF Solutions fair value estimate is US$66.79

• PDF Solutions is estimated to be 45% undervalued based on current share price of US$36.70

• The US$46.50 analyst price target for PDFS is 30% less than our estimate of fair value

How far off is PDF Solutions, Inc. (NASDAQ:PDFS) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for PDF Solutions

The Model

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. 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.

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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$47.8m	US$73.2m	US$100.9m	US$128.2m	US$153.4m	US$175.5m	US$194.3m	US$210.1m	US$223.5m	US$234.8m
Growth Rate Estimate Source	Analyst x1	Est @ 53.12%	Est @ 37.83%	Est @ 27.13%	Est @ 19.63%	Est @ 14.39%	Est @ 10.72%	Est @ 8.15%	Est @ 6.35%	Est @ 5.09%
Present Value ($, Millions) Discounted @ 8.6%	US$44.0	US$62.1	US$78.8	US$92.2	US$102	US$107	US$109	US$109	US$106	US$103

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$913m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (2.2%) 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 8.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$235m× (1 + 2.2%) ÷ (8.6%– 2.2%) = US$3.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$3.7b÷ ( 1 + 8.6%)¹⁰= US$1.6b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$2.5b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$36.7, the company appears quite good value at a 45% 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

Important Assumptions

Now 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 PDF Solutions 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 8.6%, which is based on a levered beta of 1.288. 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 PDF Solutions

Strength

• Currently debt free.

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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for 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?" 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 PDF Solutions, there are three relevant aspects you should consider:

1. Risks: You should be aware of the 1 warning sign for PDF Solutions we've uncovered before considering an investment in the company.

2. Future Earnings: How does PDFS'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 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.

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.