Palo Alto Networks' estimated fair value is US$537 based on 2 Stage Free Cash Flow to Equity
Current share price of US$344 suggests Palo Alto Networks is potentially 36% undervalued
Our fair value estimate is 41% higher than Palo Alto Networks' analyst price target of US$380
How far off is Palo Alto Networks, Inc. (NASDAQ:PANW) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Crunching The Numbers
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF ($, Millions)
US$3.44b
US$4.00b
US$4.55b
US$5.32b
US$6.65b
US$7.49b
US$8.21b
US$8.82b
US$9.35b
US$9.81b
Growth Rate Estimate Source
Analyst x27
Analyst x22
Analyst x7
Analyst x3
Analyst x3
Est @ 12.63%
Est @ 9.59%
Est @ 7.46%
Est @ 5.98%
Est @ 4.93%
Present Value ($, Millions) Discounted @ 6.6%
US$3.2k
US$3.5k
US$3.8k
US$4.1k
US$4.8k
US$5.1k
US$5.2k
US$5.3k
US$5.2k
US$5.2k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$45b
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 2.5%. We discount the terminal cash flows to today's value at a cost of equity of 6.6%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$244b÷ ( 1 + 6.6%)10= US$128b
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$174b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$344, the company appears quite good value at a 36% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
NasdaqGS:PANW Discounted Cash Flow September 6th 2024
The Assumptions
Now 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 evaluation of a company's future performance, so try the calculation yourself and check your own 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 Palo Alto Networks 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 6.6%, which is based on a levered beta of 1.000. 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 Palo Alto Networks
Strength
Earnings growth over the past year exceeded the industry.
Debt is not viewed as a risk.
Balance sheet summary for PANW.
Weakness
Shareholders have been diluted in the past year.
Opportunity
Annual revenue is forecast to grow faster than the American market.
Trading below our estimate of fair value by more than 20%.
Threat
Annual earnings are forecast to decline for the next 3 years.
What else are analysts forecasting for PANW?
Moving On:
Valuation is only one side of the coin in terms of building 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'd apply different cases and assumptions and see how they would impact the company's valuation. 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. What is the reason for the share price sitting below the intrinsic value? For Palo Alto Networks, we've compiled three further aspects you should assess:
Risks: You should be aware of the 3 warning signs for Palo Alto Networks (1 is potentially serious!) we've uncovered before considering an investment in the company.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PANW's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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.
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.