Calculating The Fair Value Of Pro-Pac Packaging Limited (ASX:PPG)

Key Insights

• Pro-Pac Packaging's estimated fair value is AU$0.24 based on 2 Stage Free Cash Flow to Equity

• Pro-Pac Packaging's AU$0.28 share price indicates it is trading at similar levels as its fair value estimate

• Industry average of 772% suggests Pro-Pac Packaging's peers are currently trading at a higher premium to fair value

In this article we are going to estimate the intrinsic value of Pro-Pac Packaging Limited (ASX:PPG) by taking the expected future cash flows and discounting them to their present 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Pro-Pac Packaging

The Method

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.

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 (A$, Millions)	-AU$6.41m	-AU$3.61m	AU$801.1k	AU$1.25m	AU$1.75m	AU$2.25m	AU$2.71m	AU$3.12m	AU$3.47m	AU$3.76m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ 55.96%	Est @ 39.82%	Est @ 28.52%	Est @ 20.61%	Est @ 15.08%	Est @ 11.20%	Est @ 8.49%
Present Value (A$, Millions) Discounted @ 7.0%	-AU$6.0	-AU$3.2	AU$0.7	AU$1.0	AU$1.2	AU$1.5	AU$1.7	AU$1.8	AU$1.9	AU$1.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$2.5m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$3.8m× (1 + 2.2%) ÷ (7.0%– 2.2%) = AU$80m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$80m÷ ( 1 + 7.0%)¹⁰= AU$41m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$43m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$0.3, the company appears around fair value at the time of writing. 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.

dcf

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 Pro-Pac Packaging 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 7.0%, which is based on a levered beta of 1.041. 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 Pro-Pac Packaging

Strength

• Debt is well covered by earnings.

Weakness

• No major weaknesses identified for PPG.

Opportunity

• Forecast to reduce losses next year.

• Good value based on P/S ratio compared to estimated Fair P/S ratio.

Threat

• Debt is not well covered by operating cash flow.

• Has less than 3 years of cash runway based on current free cash flow.

Moving On:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Pro-Pac Packaging, there are three additional elements you should explore:

1. Risks: As an example, we've found 1 warning sign for Pro-Pac Packaging that you need to consider before investing here.

2. Future Earnings: How does PPG'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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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.