As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Applied Materials' (NASDAQ:AMAT) case, we think the firm is worth $69 per share, about in line with where it is trading. But let's see if this current valuation makes sense.
For those that don't know us, we're the firm that lets the numbers tell the story. We love straight talk, and we put more weight in numbers than anything else. We think numbers tell the whole story -- analysts can have different motives, management can commit fraud, authors can be biased, the board can be incompetent, but the numbers -- well, they don't mislead.
As such, we think a comprehensive analysis of a firm's discounted cash-flow valuation is the best way to identify the most attractive stocks. We think there may be some investors that may not know what a fully-populated discounted cash-flow model is, but here's a brief snapshot of the income statement that we develop for all the companies in our coverage universe. We have corresponding fully-populated balance sheets and cash-flow statements, too. We make the model for your use here.
Our methodology culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Applied Materials posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. On a relative value basis, we compare Applied Materials to peers Cree (NASDAQ:CREE), KLA-Tencor (NASDAQ:KLAC), and Lam Research (NASDAQ:LRCX).
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score (from ideas included in the Best Ideas portfolio). The table below reveals how companies with the respective scores when added to the portfolio performed subsequently (until the measurement date or until the security was removed). The sorting mechanism inherent to the Valuentum Buying Index is rather remarkable, and we think it is a helpful tool for any investor.
Our Report on Applied Materials
• Applied Materials earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 51.5% during the past three years.
• Applied may be the world's largest supplier of semiconductor equipment, LCD fabrication equipment to the flat panel display industry and photovoltaic manufacturing systems to the solar industry, but substantial competition exists in all areas of its
• Applied Materials has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 13.3% in coming years. Total debt-to-EBITDA was 1.4 last year, while debt-to-book capitalization stood at 21.2%.
• The semiconductor industry has been increasingly driven by consumer demand for lower-cost electronic products with increased capability. The rapid pace of technological change can quickly diminish the value of Applied Materials' current technologies.
• The firm sports a very nice dividend yield of 2.1%. We expect the firm to pay out about 68% of next year's earnings to shareholders as dividends.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Applied Materials's 3-year historical return on invested capital (without goodwill) is 51.5%, which is above the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Applied Materials' free cash flow margin has averaged about 18.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Applied Materials, cash flow from operations increased about 7% from levels registered two years ago, while capital expenditures fell about 4% over the same time period.
Our discounted cash flow model indicates that Applied Materials's shares are worth between $14.00 - $23.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $18 per share represents a price-to-earnings (P/E) ratio of about 210.9 times last year's earnings and an implied EV/EBITDA multiple of about 16.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 20.3%. Our model reflects a 5-year projected average operating margin of 23.7%, which is above Applied Materials's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4% for the next 15 years and 3% in perpetuity. For Applied Materials, we use a 10.3% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $18 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Applied Materials. We think the firm is attractive below $14 per share (the green line), but quite expensive above $23 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Applied Materials' fair value at this point in time to be about $18 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Applied Materials's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $23 per share in Year 3 represents our existing fair value per share of $18 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
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.