Oracle: A Buy After Earnings Or A Value Trap?

Mar.20.14 | About: Oracle Corporation (ORCL)

Summary

After earnings, shares are trading at their fair value.

At 12 times forward earnings, shares are cheap, but not cheap enough given growth hurdles.

$35 is a better entry point for value investors.

Software giant Oracle (NASDAQ:ORCL) reported earnings earlier this week, slightly missing revenue and coming in short two cents on EPS. The knee-jerk reaction from investors was to sell and then sell some more, with shares trading down over 6% in the after-hours session. Yesterday, however, Oracle shares, after opening down ~$1.50, finished the day only marginally lower on heavy volume. In this article, we'll take a look at Oracle from a valuation perspective to see if Oracle, still trading near multi-year highs, still has some room to run.

To do this, I'll use a DCF-type model you can read more about here. Essentially, the model uses inputs such as earnings growth, dividends and a discount rate to compute a fair value for a company. For this exercise, I've used earnings estimates from Yahoo! Finance for 2014 and 2015. Thereafter, I assumed a lower growth rate of 7% per annum. I then assumed dividends would grow at 12% per annum and that the discount rate should be 9%. These are all open to interpretation and you could certainly make the case for higher or lower values for each.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.68

$2.93

$3.20

$3.42

$3.66

$3.92

x(1+Forecasted earnings growth)

9.30%

9.20%

7.00%

7.00%

7.00%

7.00%

=Forecasted earnings per share

$2.93

$3.20

$3.42

$3.66

$3.92

$4.19

Equity Book Value Forecasts

Equity book value at beginning of year

$9.67

$12.12

$14.78

$17.60

$20.59

$23.75

Earnings per share

$2.93

$3.20

$3.42

$3.66

$3.92

$4.19

-Dividends per share

$0.48

$0.54

$0.60

$0.67

$0.76

$0.85

=Equity book value at EOY

$9.67

$12.12

$14.78

$17.60

$20.59

$23.75

$27.10

Abnormal earnings

Equity book value at begin of year

$9.67

$12.12

$14.78

$17.60

$20.59

$23.75

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

$0.87

$1.09

$1.33

$1.58

$1.85

$2.14

Forecasted EPS

$2.93

$3.20

$3.42

$3.66

$3.92

$4.19

-Normal earnings

$0.87

$1.09

$1.33

$1.58

$1.85

$2.14

=Abnormal earnings

$2.06

$2.11

$2.09

$2.08

$2.07

$2.06

Valuation

Future abnormal earnings

$2.06

$2.11

$2.09

$2.08

$2.07

$2.06

x discount factor(0.09)

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

$1.89

$1.77

$1.62

$1.47

$1.34

$1.23

Abnormal earnings in year +6

$2.06

Assumed long-term growth rate

3.00%

Value of terminal year

$34.25

Estimated share price

Sum of discounted AE over horizon

$8.09

+PV of terminal year AE

$20.42

=PV of all AE

$28.52

+Current equity book value

$9.67

=Estimated current share price

$38.19

Click to enlarge

Using these inputs the model computes a fair value for Oracle shares of $38.19. You'll notice that this price is not so different from Oracle's closing price of $38.55 so we'll attack this discussion from that angle. First, it is important to understand what the model is implying. The estimated fair value is just that, a fair value, and not a price target. The model is saying that using a discount rate of 9% with this set of inputs means that Oracle is fairly valued right now. So what are the implications of that?

The most obvious implication is that if you think the discount rate should be lower, Oracle shares are a good buy right now. However, 9% is a fairly conservative discount rate so unless you are just that sure of Oracle's future, I'd suggest the discount rate should be higher, if anything. Like I said, the discount rate is very subjective and using 9% is what I felt was right given some kind of risk premium and the fact that Oracle is a huge, mature company with no bankruptcy or liquidity event risk and that its customers largely have significant switching costs.

The second implication of my model here is that if you think Oracle will be able to grow earnings more quickly than what I've shown, shares will outperform because the fair value is something higher than $38.19 right now. Yahoo! shows earnings estimates in the out years to be 10.5% growth yearly whereas I've used 7%. I did this because 10.5% growth for years on end is typically more difficult for a $175 billion company like Oracle. Granted, the company does have some growth avenues such as cloud software subscriptions and its ever-expanding list of acquisitions, but that is a tall task simply given the size of its operation and the switch from up-front licensing fees to a subscription model.

In essence, what I'm saying here is that I think Oracle is probably pretty fairly valued at $38+ right now. Given that acquisitions are expensive by their very nature and that Oracle is still undergoing a shift in how it operates and how it obtains revenue from its clients, I would want more value present before buying. Just because I don't want to be long at $38 doesn't mean there isn't value in Oracle shares; it simply means that for me, I think you want to wait until the odds are stacked more in your favor. For instance, using my model with an earnings growth rate of only 5% in the out years produces a fair value of just over $35. What that suggests is that if Oracle shares trade down into the $35 range, only 5% earnings growth is being priced in over the medium term, representing a fairly easy bar to beat. This is where I'd be interested in Oracle shares as the company is still a world leader in its field and that isn't likely to change soon. I just don't want to step in when the odds of earnings beats are as low as they are now, with shares pricing in 7%+ earnings growth. Oracle is a good buy, just not at this price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.