Nvidia (NVDA) is a leading designer of graphics chips used in PC's, game consoles, and handheld devices. Products include the GeForce line of GPU's, the Tesla line for High Performance Computing, and the Tegra line of mobile processors.
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Nvidia stock has fallen nearly 50% since the beginning of 2011, currently trading at $13.39. Let's look at the recent financial performance:
| (In Million $) | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|---|---|---|---|---|
| Revenue | $4,097 | $3,424 | $3,326 | $3,543 | $3,997 |
| Operating Cash Flow | $1,270 | $249 | $487 | $675 | $909 |
| Capital Expenditure | $-188 | $-408 | $-78 | $-98 | $-139 |
| Free Cash Flow | $1,082 | $-159 | $410 | $577 | $770 |
Nvidia had a rough two-year stretch in fiscal 2009-2010, which ended in January of 2010, but since then has been growing both revenue and free cash flow.
Owner Earnings
Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:
These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges ... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume ... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.
I'll calculate Owner earnings by taking the Net Income and adding back various non-cash items, such as depreciation, and then subtracting the 5-year average Capital Expenditures. I'll also add interest payments adjusted for taxes since interest is tax deductible.
| (In Million $) | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|---|---|---|---|---|
| Net income | $797 | $-31 | $-68 | $253 | $581 |
| Depreciation & amortization | $133 | $185 | $196 | $186 | $204 |
| Investment/asset impairment charges | $0 | $9 | $0 | $0 | $0 |
| Stock based compensation | $0 | $162 | $242 | $100 | $136 |
| Other non-cash items | $79 | $-22 | $1 | $-14 | $-34 |
| Interest Payments | $0 | $0 | $3 | $3 | $3 |
| Avg Capital Expenditure | $-182 | $-182 | $-182 | $-182 | $-182 |
| Owner Earnings | $828 | $124 | $193 | $347 | $708 |
Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine Nvidia's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.
| (In Million $) | 2008 | 2009 | 2010 | 2011 | 2012 |
|---|---|---|---|---|---|
| Owner Earnings | $828 | $124 | $193 | $347 | $708 |
| Invested Capital | $3,747 | $3,350 | $3,585 | $4,495 | $5,552 |
| CROIC | 22.11% | 3.71% | 5.39% | 7.73% | 12.76% |
CROIC was low in fiscal 2009 and 2010, but has recovered to 12.76% in fiscal 2012. This means that given, say, $1 million of invested capital (retained earnings for example) the company will generate $127,600 in cash on that investment. Here's the most recent balance sheet.
| Cash and Cash Equivalents | $3,129 |
|---|---|
| Investments | $10 |
| Debt | $21 |
| Pension Obligations | $0 |
| Minority Interest | $0 |
| Net Cash (Debt) | $3,118 |
| Diluted Float | 613 |
| Cash/Share | $5.08 |
Nvidia has essentially no debt and over $3 billion in cash, translating into over $5 of cash per share. This cash represents 38% of Nvidia's market capitalization.
Valuation
I use a discounted cash flow analysis to estimate the fair value of a company. I will use a discount rate of both 12% and 15% and use the results to define a fair value range. You can read about my views on discount rates here. I will set the initial owner earnings growth rate to 6% and let that rate decay over 20 years to a perpetual rate of 3% as per the growth table below.
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| % | 6% | 5.85% | 5.7% | 5.55% | 5.4% | 5.25% | 5.1% | 4.95% | 4.8% | 4.65% |
| Year | 11 | 12 | 13 | 14 | 15 | 16 | 17 | 18 | 19 | 20 |
| % | 4.5% | 4.35% | 4.2% | 4.05% | 3.9% | 3.75% | 3.6% | 3.45% | 3.3% | 3% |
For reference the average analyst estimate for the five-year earnings growth rate is 15%. This seems overly optimistic, and my growth rates are much more conservative. Using the above parameters I arrive at a fair value range of $16.89-$21.16. With Nvidia currently trading at $13.39, the market price offers a discount to the lower bound of my fair value range. Buy targets for various margins of safety below the lower bound are displayed below.
| Margin of Safety | Buy Target |
|---|---|
| 10% | $15.20 |
| 15% | $14.36 |
| 20% | $13.51 |
| 25% | $12.67 |
Conclusion
Nvidia is currently trading at about a 20% discount to the lower bound of my fair value range. Even with growth estimates far below that of analysts the stock appears to be dramatically undervalued. Going forward, Nvidia faces heavy competition in both the GPU space, with Advanced Micro Devices' (AMD) competing Radeon line of graphics cards, and in the mobile processor space, with Qualcomm (QCOM), Intel (INTC), and Texas Instruments (TXN) all in direct competition. But given the ample margin of safety, Nvidia looks like a bargain at today's prices.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in NVDA over the next 72 hours.
