As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Intel's (INTC) case, we think the firm is worth north of $36 per share, a whopping 80% higher than where it is currently trading. This is one of the largest fair value discrepancies that we've seen within our coverage universe. Our full reports on Intel and hundreds of other companies are available on our website.
We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process 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. We think our methodology and broad coverage universe is largely responsible for the meaningful outperformance of the portfolio in our Best Ideas Newsletter.
Our Report on Intel
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With every company in our coverage universe, we rate them on 13 unique measures. To get started, we show Intel's below:
In addition to PC growth, the build-out of the cloud will continue to be a tailwind for Intel. Data center processor revenue was up 14% in the second quarter, and the business has nearly doubled since 2009. We think companies building clouds will continue to trust Intel to power these clouds, and we could see data center processors becoming an even bigger part of the company’s revenue mix going forward.
Intel 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. We expect the firm's return on invested capital (excluding goodwill) to expand to 58.7% from 51.9% during the next two years.
Intel 's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.
Intel 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 24.2% in coming years. Total debt-to-EBITDA was 0.1 last year, while debt-to-book capitalization stood at a mere 4.1%.
The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.
The firm sports a very nice dividend yield of 4.3%. We expect the firm to pay out about 36% of next year's earnings to shareholders as dividends.
We also think the market has been quick to write-off Intel as little more than a parts supplier. With the acquisition of McAffe for $7.68 billion in 2010, Intel also entered the profitable software security and solutions industry.
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 (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Intel's 3-year historical return on invested capital (without goodwill) is 42.9%, which is above the estimate of its cost of capital of 9.7%. 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
We think Intel is worth $36 per share, which represents a price-to-earnings (P/E) ratio of about 17.9 times last year's earnings and an implied EV/EBITDA multiple of about 9.5 times last year's EBITDA. We forecast a compound annual revenue growth rate of 8.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 4.4%.
Our model reflects a 5-year projected average operating margin of 32.6%, which is above Intel's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.5% for the next 15 years and 3% in perpetuity. For Intel, our model uses a 9.7% 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 $36 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 Intel. We think the firm is attractive below $27 per share (the green line), but quite expensive above $45 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 Intel's fair value at this point in time to be about $36 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 Intel '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 $44 per share in Year 3 represents our existing fair value per share of $36 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 Income Statement
Disclosure: Intel was included in our Best Ideas portfolio September 12, 2011.