The intrinsic value of a company is based on its future free cash flow stream. After discounting a company's future free cash flow stream and summing each annual cash flow, one adds (or subtracts) the firm's net cash (or net debt) position to that sum. The result is equity value and compares directly to a firm's market capitalization (price). Dividing each of these measures by shares outstanding gets to intrinsic value per share and the company's share price, respectively. Comparing the company's intrinsic value to its share price determines whether a company is undervalued or overvalued. Let's do this process for Adobe (NASDAQ:ADBE).
Adobe Systems' Investment Considerations
• Adobe Systems' business quality (an evaluation of our ValueCreation and ValueRisk ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively. Adobe has one of the highest rated Economic Castles in our coverage universe.
• Adobe is one of the largest software companies in the world. The firm's flagship offering in its digital media business is Adobe Creative Cloud, which allows customers to download the latest version of Adobe Creative Suite products (like Photoshop). The firm also continues to focus on digital marketing solutions.
• Adobe Systems 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 28.5% in coming years. Total debt-to-EBITDA was 2 last year, while debt-to-book capitalization stood at 18.4%.
• Adobe continues to gain significant traction with respect to Creative Cloud subscriptions. Growing from just 195k in the third quarter of 2012, Adobe anticipates exponential growth in coming quarters and will round out fiscal 2014 with 2.8 million-plus paying subscribers. We love this recurring, subscription-based model.
• Adobe Marketing Cloud is quickly becoming a favorite of Chief Marketing Officers as digital marketing bookings continue to expand at a nice clip.
• Adobe registers a Valuentum Buying Index rating of a 6.
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 with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Adobe Systems' 3-year historical return on invested capital (without goodwill) is 201.6%, which is significantly above the estimate of its cost of capital of 10.6%. 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 gray 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. Adobe Systems' free cash flow margin has averaged about 34.3% 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 and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Adobe Systems, cash flow from operations decreased about 52% from levels registered two years ago, while capital expenditures fell about 10% over the same time period.
Our discounted cash flow model indicates that Adobe Systems' shares are worth between $52-$78 each. Shares are trading at roughly $63 each at the time of this writing.
All value is based on the future free cash flow stream. The future will always be unpredictable to a degree. The larger the unpredictability of a company's future free cash flow stream, the bigger the margin of safety around a company's fair value. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $65 per share represents a price-to-earnings (P/E) ratio of about 115.1 times last year's earnings and an implied EV/EBITDA multiple of about 41.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 13.3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.2%. Our model reflects a 5-year projected average operating margin of 28.3%, which is above Adobe Systems' trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 5.2% for the next 15 years and 3% in perpetuity. For Adobe Systems, we use a 10.6% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers - those who drive stock prices - pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Adobe to peers Microsoft (NASDAQ:MSFT) and Oracle (NYSE:ORCL).
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 $65 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 Adobe Systems. We think the firm is attractive below $52 per share (the green line), but quite expensive above $78 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 Adobe Systems' fair value at this point in time to be about $65 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 Adobe Systems' 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 also is subject to change over time should our views on the firm's future cash flow potential change. The expected fair value of $88 per share in Year 3 represents our existing fair value per share of $65 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
In the spirit of transparency, we show the latest study of the Valuentum Buying Index here. Past results are not a guarantee of future performance. Thank you for reading!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.