With the recent fall in Autodesk's (NASDAQ:ADSK) price, let's see if the firm is set to deliver alpha from here.
Investors know that to generate alpha, one must constantly seek out new opportunities and new ways of looking at the same things. Alpha can be created by capitalizing on public information that other investors can't easily process (think footnotes of an 8-k), building a better mousetrap (think a better valuation model), achieving a better understanding of how the market works (an in-depth understanding of the company and its drivers), or exploiting structural impediments of the market (think cross-methodological work and post-earnings drift).
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Autodesk's Investment Considerations
Autodesk 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 144.8% from 87.7% during the next two years.
We want to capture alpha, and the higher the rating on our Valuentum Buying Index (our stock selection methodology), the higher probability a company will deliver alpha in our Best Ideas portfolio. Autodesk looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $28 (see our valuation assumptions below), we'd take a closer look at the company. Autodesk currently registers a 6 on our Valuentum Buying Index, which is respectable, but not as good as other firms that register a 9 or a 10 on our index.
We think earnings and free cash flow drive the valuations of stocks. Autodesk 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 21.5% in coming years, and the firm had no debt as of last quarter.
Autodesk'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.
Economic Profit Analysis
We think 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 (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Autodesk's 3-year historical return on invested capital (without goodwill) is 76.4%, which is above the estimate of its cost of capital of 10.8%. 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
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Autodesk's free cash flow margin has averaged about 20.5% during the past 3 years. As such, we think the firm'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. It differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Autodesk, cash flow from operations increased about 132% from levels registered two years ago, while capital expenditures expanded about 62% over the same time period.
Our discounted cash flow model indicates that Autodesk's shares are worth between $28.00 - $46.00 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 $37 per share represents a price-to-earnings (P/E) ratio of about 30.3 times last year's earnings, and an implied EV/EBITDA multiple of about 15.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -1.5%. Our model reflects a 5-year projected average operating margin of 25.8%, which is above Autodesk's trailing 3-year average. Beyond year five, we assume free cash flow will grow at an annual rate of 2.7% for the next 15 years and 3% in perpetuity. For Autodesk, we use a 10.8% 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 Autodesk's fair value at about $37 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 Autodesk. We think the firm is attractive below $28 per share (the green line), but quite expensive above $46 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 Autodesk's fair value at this point in time to be about $37 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 Autodesk'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 Three 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 $50 per share in Year Three represents our existing fair value per share of $37 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 Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Apple (NASDAQ:AAPL) is included in our Best Ideas portfolio.