Estimating Fair Value: Intel in Focus

| About: Intel Corporation (INTC)

Intel (NASDAQ:INTC), the glorious winner of the microchip battle, is among the world's largest technology companies. California-based Intel produces and sells integrated circuits for computing and communications industries worldwide. It also offers microprocessor, communications, chip, chipset, wireless connectivity, NAND flash memory, and software products; handheld devices, and software development tools. As of June 10, the company had a market cap of $113.5 billion with a trailing P/E ratio of 10.1, and a forward P/E ratio 8.8. In the last 5 years, earnings per share increased by 7.5%. Annualized total return was in line with earnings growth. Intel returned 7.2%, annually. What is the fair value of Intel given the forecast estimates? Let's calculate it together, using a discounted earnings plus equity model.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs.

The methodology is based on discounting the present value of 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 + … + 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. The entire complexity of stock metrics is reduced to just 3 parameters. All we need is the current-period 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. Historically, the average return of DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

Since we are at the middle of the year, it will be more feasible to take the average of ttm EPS of $2.15 along with the mean estimate of $2.42 for the next year.

E0 = EPS = (2.15 + 2.42) / 2 = $2.286

Wall Street has diversified opinion on Intel's future. The bottom line is -9.2% growth, where the top line annualized growth estimate is 20.31%. Average five year growth forecast estimate is 11.3%.

The rest is as follows:

V0

E0

$2.29

V1

E0 (1+g)/(1+r)

$2.29

V2

E0((1+g)/(1+r))2

$2.30

V3

E0((1+g)/(1+r))3

$2.30

V4

E0((1+g)/(1+r))4

$2.31

V5

E0((1+g)/(1+r))5

$2.32

D

E0(1+g)5/[r(1+r)5]

$20.50

BV

Equals

$8.34

Fair Value

Equals

$34.30

Click to enlarge

I decided to add the book value per share so that we will distinguish between a low-debt and debt-loaded company. According to my 5 year discounted earnings plus equity model, the fair value estimate for Intel is $34.3 per share. As of June 10, Intel was trading at a dirt-cheap price of $21.38. Intel is undervalued by almost $13. While I do not expect this gap to be closed by this year, I think Intel will beat the market return for the next 5 years.

O – Metrix Confirmation

If the math above looks too complicated for you, try estimating the fair value using O-Metrix as such:

O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5

Dividend Yield: Higher is better.
EPS Growth: Higher is better.
P/E Ratio: Lower is better.

I multiplied the original formula mentioned by Jeremy Siegel by 5 to get a scale over 10. The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long term, such as 5 years. I am also continuously checking on specific sectors, and the formula works very well so far.

What is the O-Metrix Score of Intel?

  • Intel pays a nifty dividend yield of 3.86%. That is a huge bonus for the shareholders.
  • Growth estimate is the same as discounted earnings model, and is equal to 11.3%.
  • Since we are at the middle of the year, taking the average of ttm [10.1] and forward [8.8] P/E ratios will smooth the results. Thus, average P/E ratio to be used in the model is 9.45.

O-Metrix = [(3.86 + 11.3) / (9.45)] * 5 = 8

As of June 10, the average trailing P/E ratio of stocks tracked by finviz is 15.97, while the forward P/E ratio is 12.07. The EPS growth estimate for the next five years is 12.18%, and yield is 1.91%. The average market O-Metrix score is calculated as follows:

Market O-Metrix = [(1.91 + 12.18)/14.02]*5 = 5

Intel's O-Metrix score is 60% higher than the market average. Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. With a nifty dividend yield, Intel is in the A-Grade, high-return safety zone - (click chart to expand).

Summary

As of June 10, Intel was trading for $21.33, which is 60% lower than my fair value estimate. While I do not expect this gap to be closed in a short period of time, I think Intel will beat the market returns with a large margin. If the analyst estimates hold, and if Intel continues to reward shareholders with nifty dividends, an excess-market return above 10% is easily attainable. There is an immensely strong resistance at $20-$21 range. Therefore, I doubt shares will ever fall below that level. Unless something really bad happens, it will stay above that range. Thus, the downside is minimal, whereas there is a great upside potential in Intel.


Disclosure: I am long INTC.