Do investors undervalue Pilbara Minerals Limited (ASX: PLS) by 36%?

Does the January price of Pilbara Minerals Limited (ASX: PLS) stock reflect what it is really worth? Today, we’re going to estimate the intrinsic value of the stock by estimating the company’s future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Patterns like these may seem beyond a layman’s comprehension, but they are easy enough to follow.

We would like to point out that there are many ways to assess a business, and like DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a little more about intrinsic value should have a read of the Simply Wall St.

Discover our latest analyzes for Pilbara Minerals

Is Pilbara Minerals valued?

We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous Free Cash Flow (FCF) from the last estimate or last published value. We assume that companies with decreasing free cash flow will slow down their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the following 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 the present value:

10-year free cash flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = AU $ 1.1b

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 step. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to present value at a cost of equity of 8.0%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = AU $ 450 million × (1 + 2.0%) ÷ (8.0% – 2.0%) = AU $ 7.6 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= AU $ 7.6b ÷ (1 + 8.0%)^ten= AU $ 3.5b

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is A $ 4.7 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of AU $ 1.1, the company appears to be quite undervalued with a 36% discount from the current share price. Remember though, this is only a rough estimate, and like any complex formula – garbage in, garbage out.

Important assumptions

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the math yourself and play around with it. 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 full picture of a company’s potential performance. Since we view 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 into account debt. In this calculation, we used 8.0%, which is based on a leveraged beta of 1.149. Beta is a measure of the volatility of a stock, relative 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.

Looking forward:

While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. It is not possible to obtain an infallible valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Can we understand why the company is trading at a discount to its intrinsic value? For Pilbara Minerals, we’ve put together three more things you should explore:

1. Risks: You should be aware of the 4 warning signs for Pilbara Minerals (1 is worrying!) Which we discovered before considering an investment in the company.
2. Management: Have Insiders Raised Their Shares To Take Advantage Of Market Sentiment For PLS Future Prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
3. Other strong companies: Low debt, high return on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each ASX share. If you want to find the calculation for other actions, just search here.

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This Simply Wall St article is general in nature. It is not a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in any of the stocks mentioned.
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