By Cagdas Ozcan
Qualcomm (NASDAQ:QCOM) is currently operating in an extremely attractive market. This chip manufacturer is supplying chips to some of the biggest smartphone manufacturers in the world. The smartphone market is currently experiencing a boom, and the growth is not expected to slow down in the near future. As a result, there is going to be a substantial demand for Qualcomm products in the future. While this growth is expected to slow down in the future, we still think that the stock is undervalued. Therefore, we decided to determine the fair value of the company using our fair value model. Results of the model and assumptions are discussed below.
As of the time of writing this article, QCOM stock was trading at around $65.50, with a 52week range of $53.09  $68.87. It has a market cap of about $112.4 billion. The trailing twelvemonth P/E ratio of 19.7 is above the forward P/E ratio of 13.7. P/B, P/S, and P/CF ratios stand at 3.2, 5.6, and 18.6, respectively. The operating margin is 30.4% while the net profit margin is 32.3%.
Qualcomm has a 4star rating from Morningstar. Out of ten analysts covering the stock, five have a buy recommendation and one has a sell recommendation. On the other hand, most of the analysts have positive ratings, and three analysts are neutral about the stock. Average fiveyear annualized growth forecast is 15%.
We can estimate Qualcomm's fair value using discounted earnings plus equity model as follows.
Discounted Earnings plus Equity Model
This model is primarily used for estimating the returns from longterm projects. It is also frequently used to price fairvalued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + â€¦ + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the currentperiod earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.
Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.
In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year. The average EPS for Qualcomm is $3.84.
While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average fiveyear growth forecast is 15%. Book value per share is $20.75.
Fair Value Estimator  
V0 
E_{0} 
$3.84 
V1 
E_{0} (1+g)/(1+r) 
$3.98 
V2 
E_{0}((1+g)/(1+r))^{2} 
$4.12 
V3 
E_{0}((1+g)/(1+r))^{3} 
$4.27 
V4 
E_{0}((1+g)/(1+r))^{4} 
$4.42 
V5 
E_{0}((1+g)/(1+r))^{5} 
$4.58 
D 
E_{0}(1+g)^{5}/[r(1+r)^{5}] 
$41.67 
BV 
Equals 
$20.75 
Fair Value Range 
Lower Boundary 
$66.89 
Upper Boundary 
$87.64 

Potential 
33.80% 
(You can download FED+ Fair Value Estimator, here.)
I decided to add the book value per share so that we can distinguish between a lowdebt and debtloaded company. The lower boundary does not include the book value. According to my 5year discountedearningsplusbookvalue model, the fairvalue range for Qualcomm is between $66.89 and $87.64 per share. At a price of about $65.50, Qualcomm is trading below the lower boundary of its fair value range. The stock still has up to 34% upside potential to reach its fair value maximum.
From a technical perspective, Qualcomm is currently moving in a steady upward trend. The stock returned about 6% in this year so far. However, according to our fair value model, the stock is still trading at a substantial discount to its fair value. Qualcomm is operating in an extremely attractive industry. The market is growing at a fast pace, which should allow the company to grow in the years to come. Taking into account the growth potential of Qualcomm, we believe that the stock offers a great opportunity to make healthy profits in the long term. It should be kept in mind that our model predicts the longterm potential of the stock, and our fair value is based on the longterm earnings growth rate of the firm. While the stock might have its ups and downs, it has substantial potential in the long term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: EfsInvestment is a team of analysts. This article was written by Cagdas Ozcan, one of our equity researchers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.