Packaging Corporation of America (NYSE:PKG) Shares Could Be 38% Below Their Intrinsic Value Estimate

Simply Wall St · 11/26 10:35

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Packaging Corporation of America fair value estimate is US$398
  • Current share price of US$247 suggests Packaging Corporation of America is potentially 38% undervalued
  • Analyst price target for PKG is US$214 which is 46% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Packaging Corporation of America (NYSE:PKG) by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Packaging Corporation of America

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 begin with, we have to get estimates of 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF ($, Millions) US$972.9m US$1.14b US$1.14b US$1.22b US$1.28b US$1.33b US$1.38b US$1.43b US$1.48b US$1.52b
Growth Rate Estimate Source Analyst x5 Analyst x5 Analyst x1 Analyst x1 Est @ 5.05% Est @ 4.32% Est @ 3.81% Est @ 3.45% Est @ 3.20% Est @ 3.03%
Present Value ($, Millions) Discounted @ 6.0% US$918 US$1.0k US$956 US$964 US$956 US$941 US$922 US$900 US$877 US$853

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$9.3b

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 2.6%. We discount the terminal cash flows to today's value at a cost of equity of 6.0%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$1.5b× (1 + 2.6%) ÷ (6.0%– 2.6%) = US$47b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$47b÷ ( 1 + 6.0%)10= US$26b

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$36b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$247, the company appears quite undervalued at a 38% 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.

dcf
NYSE:PKG Discounted Cash Flow November 26th 2024

Important 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 Packaging Corporation of America 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 6.0%, which is based on a levered beta of 0.810. 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 Packaging Corporation of America

Strength
  • Debt is not viewed as a risk.
  • Dividends are covered by earnings and cash flows.
Weakness
  • Earnings declined over the past year.
  • Dividend is low compared to the top 25% of dividend payers in the Packaging market.
Opportunity
  • Annual earnings are forecast to grow for the next 3 years.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Annual earnings are forecast to grow slower than the American market.

Looking Ahead:

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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Packaging Corporation of America, we've compiled three additional aspects you should explore:

  1. Risks: You should be aware of the 1 warning sign for Packaging Corporation of America we've uncovered before considering an investment in the company.
  2. Future Earnings: How does PKG'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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.