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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 company is fairly valued at $16 per share, slightly higher than where it is currently trading. Our report on Applied Materials and hundreds of other companies can be found here.

For some background, we think a comprehensive analysis of a company'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 VBI, Valuentum Buying Index (click here for an in-depth, narrated presentation of our methodology), 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 'faily valued' DCF assessment, its neutral relative valuation versus peers, and its bullish techinicals. Applied Materials is comparable to peers Cree CREE,
KLA-Tencor (NASDAQ:KLAC), and United Mirco (NYSE:UMC), which all have a VBI score of 6. Novellus (NASDAQ:NVLS) falls below its peers scoring a VBI of 5.

Our Report on Applied Materials

(click to enlarge images)

Investment Considerations

Investment Highlights

Applied Materials earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The company has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the company's return on invested capital (excluding goodwill) to expand to 67% from 66% during the next two years.

The company looks fairly valued at this time. We expect it to trade within our fair value estimate range for the time being. If its share price fell below $11, we'd take a closer look.

Applied Materials has an excellent combination of strong free cash flow generation and low financial leverage. We expect the free cash flow margin to average about 14.1% in coming years. Total debt-to-EBITDA was 0.8 last year, while debt-to-book capitalization stood at 18.1%.

The company's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.

The company sports a very nice dividend yield of 2.6%. We expect it to pay out about 42% of next year's earnings to shareholders as dividends.

Economic Profit Analysis

The best measure of a company'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 company's economic profit spread. Applied Materials 's 3-year historical return on invested capital (without goodwill) is 43.2%, which is above the estimate of its cost of capital of 10.9%. As such, we assign 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

Companies that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Applied Materials 's free cash flow margin has averaged about 13% during the past 3 years. As such, we think the company'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 www.valuentum.com. At Applied Materials, cash flow from operations increased about 629% from levels registered two years ago, while capital expenditures fell about 16% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Applied Materials 's shares are worth between $11 and $21 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 $16 per share represents a price-to-earnings (P/E) ratio of about 11 times last year's earnings and an implied EV/EBITDA multiple of about 6.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 9%. Our model reflects a 5-year projected average operating margin of 19.9%, 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 2.9% for the next 15 years and 3% in perpetuity. For Applied Materials, we use a 10.9% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each company on the basis of the present value of all future free cash flows. Although we estimate the company's fair value at about $16 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 were 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 company is attractive below $11 per share (the green line), but quite expensive above $21 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 company, in our opinion.

Future Path of Fair Value

We estimate Applied Materials' fair value at this point in time to be about $16 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 current share price with the path of Applied Materials' 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 company's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the company's future cash flow potential change. The expected fair value of $21 per share in Year 3 represents our existing fair value per share of $16 increased at an annual rate of the company'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

Source: Applied Materials Is Trading Within Our Fair Value Range