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 = E_{0} + E_{1 }/(1+r) + E_{2 }/(1+r)^{2} + E_{3}/(1+r)^{3} + E_{4}/(1+r)^{4} + E_{5}/(1+r)^{5 } + Disposal Value
V = E_{0} + E_{0 }(1+g)/(1+r) + E_{0}(1+g)^{2}/(1+r)^{2} + … + E_{0}(1+g)^{5}/(1+r)^{5} + E_{0}(1+g)^{5}/[r(1+r)^{5}]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E_{0}(1+g)^{5}/[r(1+r)^{5}] = E_{5} / 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 | E_{0 } | $2.29 |
V1 | E_{0 }(1+g)/(1+r) | $2.29 |
V2 | E_{0}((1+g)/(1+r))^{2} | $2.30 |
V3 | E_{0}((1+g)/(1+r))^{3} | $2.30 |
V4 | E_{0}((1+g)/(1+r))^{4} | $2.31 |
V5 | E_{0}((1+g)/(1+r))^{5} | $2.32 |
D | E_{0}(1+g)^{5}/[r(1+r)^{5}] | $20.50 |
BV | Equals | $8.34 |
Fair Value | Equals | $34.30 |
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.