Despite Inflation Fears, Adobe's Valuation Has Increased
Summary
- In our previous article, we placed a $530 intrinsic value on Adobe.
- Since then, the price of Adobe has exceeded our target, and we estimate its intrinsic value has increased.
- Valuation is valid only while discount rates remain low.
- Adobe's business is inflation resistant due to its market dominance.
Back in February, we wrote an article about Adobe (NASDAQ:NASDAQ:ADBE) and placed a price target of $530. This was right before inflation fears became mainstream. After a wild few months, the share price has now met and exceeded $530. As a result, we wanted to do a follow-up on the company.
In our previous article, we went through the company's industry position and its large moat over competitors in detail. In addition, we highlighted what we believed to be growth catalysts. Nothing has changed in those regards and you can check out our detailed explanations if interested.
As a refresher for those who may have read the previous article, the points we made about Adobe's market dominance can be summarized as follows:
- Creative software is difficult to learn and people are unwilling to learn how to use a new one once mastering Adobe's products.
- Job postings specifically state knowledge of Adobe products as a requirement.
- In turn, schools teach courses on how to use Adobe products since that's what is required when applying for jobs.
- These factors result in very high switching costs for companies especially if they are large and have tight deadlines.
Despite free alternatives to Adobe which are very similar, companies are unwilling to make the switch, even as Adobe has continued to hike its prices over the year. This competitive advantage shows up in the company's profit margins, which were also discussed in our previous article.
Inflation Fears
Lately, the biggest concern facing investors is whether or not inflation will be transitory or if the Federal Reserve will lose control and be forced to jack up rates. A lot of companies are facing shortages and increasing material costs which will result in companies either taking the hit to their margins or passing the costs to the consumers.
As a result, the best companies to own in this type of environment are those with high margins or considerable pricing power with consumers. Adobe happens to have both. We've already established that customers are unwilling to switch to alternatives and will pay whatever Adobe wants them to pay.
However, since the company sells software, it doesn't have to worry about incurring costs associated with things such as raw materials or shipping. It might be impacted by wage inflation or the energy costs to light their buildings or marketing expenses. Nonetheless, we don't believe these will cause a material increase in expenses as far as margins go.
As a result, they might be able to get away with a small increase in their prices. That is of course if they weren't already planning on increasing their prices anyway.
Valuation
The main thing we wanted to touch on in this article is the company's valuation. We wanted to update our valuation to see how inflation fears and market conditions have impacted the value.
Our preferred method of valuation is the discounted cash flow model. We like it because it's dynamic and changes the company value as market conditions change. This includes changes in risk-free rates affected by factors such as inflation and Fed policies. Other factors it incorporates are changes in equity risk premiums and the cost of borrowing.
The downside is that it can be sensitive to changes in discount rates. This is especially true for companies that don't plan to generate cash in the short to medium term. It also requires some degree of monitoring because you need to update discount rates whenever there is a material change in market conditions.
We understand that this is not everyone's cup of tea, but it works very well for us and much more appropriate for a high-margin, cash flow machine such as Adobe.
Assumptions:
- A fundamental revenue growth rate of 18.75% that we calculated in our previous article using the company's reinvestment rate and revenue to invested capital
- Marginal tax rate: 28%
- Cost of debt: 2.4% (1.73% after-tax)
- 2-year weekly beta: 0.81
- Equity risk premium (S&P Global): 4.7%
- Risk-free rate: 1.46%
- Cost of Equity: 5.27%
- Weighted average cost of capital: 5.21%
- Half-year convention used
Adobe's margins and debt-to-EBITDA ratio have been fairly stable the last 5 years and have averaged the following:
- EBITDA margin: 34.5%
- Debt to EBITDA: 1.0x
- Free cash flow margin (adj. to remove stock-based compensation): 31.49%
Source: Author
It's important to note what the main driver of the valuation increase is. The decrease in the equity risk premium (5.2% to 4.7%) was more than enough to offset the increase in risk-free rates to drive the valuation up to $571 per share.
The valuation is likely to be conservative because we assume that Adobe will only grow at 2% after 5 years which seems highly unlikely given its market dominance and the high cost of switching from its products. Adobe should be able to easily sustain double-digit growth during the next decade.
Nonetheless, if inflation proves to not be transitory and discount rates accelerate upwards, the valuation would take a hit. If the WACC increases to only 6%, Adobe's valuation will fall to $450 per share on our 5-year DCF as demonstrated below:
Source: Author
Final thoughts
Although the company's share price may appear expensive when using valuation multiples, the discounted cash flow model says otherwise. This is especially true if you consider that our growth estimates are conservative. Whether you agree with the DCF method or not, it at least provides an explanation as to why the market is pricing Adobe the way it is.
We agree when people say the market is inflated because of low discount rates. However, discount rates move markets and stocks will move upwards while the rates are low. Using WACC as a discount rate allows us to listen to what the market is telling us the discount rates should be. As a personal preference, we prefer to adjust our valuations and portfolio holdings as market conditions change instead of waiting around on the sideline for a correction.
This approach works well for us, but requires continuous monitoring and may not be suited for everyone's individual investing style. But financial theory aside, Adobe continues to be a powerhouse business with a massive moat that should be able to continue seeing double-digit revenue growth for a long time.
This article was written by
Disclosure: I am/we are long ADBE. 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.