Does the November share price for Analog Devices, Inc. (NASDAQ:ADI) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by taking the expected future cash flows and discounting them to today’s value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. 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 would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
Check out the opportunities and risks within the US Semiconductor industry.
Is Analog Devices Fairly Valued?
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 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
|Leveraged FCF ($, Millions)||US$4.68b||US$5.05b||US$5.83b||US$6.09b||US$6.29b||US$6.48b||US$6.65b||US$6.81b||US$6.97b||US$7.12b|
|Growth Rate Estimate Source||Analyst x9||Analyst x6||Analyst x1||Analyst x1||Est @ 3.36%||Est @ 2.95%||Est @ 2.66%||Est @ 2.45%||Est @ 2.31%||Est @ 2.21%|
|Present Value ($, Millions) Discounted @ 8.3%||US$4.3k||US$4.3k||US$4.6k||US$4.4k||US$4.2k||US$4.0k||US$3.8k||US$3.6k||US$3.4k||US$3.2k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$40b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.0%) 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 8.3%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$7.1b× (1 + 2.0%) ÷ (8.3%– 2.0%) = US$116b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$116b÷ ( 1 + 8.3%)10= US$52b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$92b. In the final step we divide the equity value by the number of outstanding shares. Compared to the current share price of US$162, the company appears about fair value at a 9.7% discount to where the stock price currently trades. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
We would point out that 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 results, 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 Analog Devices 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 8.3%, which is based on a levered beta of 1.225. 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.
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. For Analog Devices, there are three essential factors you should further examine:
- Risks: For example, we’ve discovered 3 warning signs for Analog Devices that you should be aware of before investing here.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for ADI’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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!
SP. 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.
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Find out whether Analog Devices is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
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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 into account 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.