Adobe: Why It May Be Time To Take Some Profits

Summary

• Adobe has exceeded our price targets and the valuation now appears to be a little stretched.
• The higher valuation puts the company at a higher risk for drawdowns if discount rates rise or earnings disappoint even slightly.
• We are not necessarily bearish, and would rate it a hold for buy-and-hold investors. However, for more active investors, it may be time to take some profits.

David Tran/iStock Editorial via Getty Images

Adobe (NASDAQ:ADBE) is a fantastic company with strong competitive advantages which we covered in our previous articles:

1. Adobe Stock: Here's Why It Is Undervalued Despite High Valuation Multiples
2. Despite Inflation Fears, Adobe's Valuation Has Increased

Our first article went into more detail about Adobe's operations and advantages and we recommend having a read if you are unfamiliar with it. Since our first article, Adobe has returned investors 31.78% compared to the S&P 500's return of 13.17%. Since our second article, Adobe has returned 20.90% versus 4.95% from the S&P 500.

In this article, we will be updating our valuation model for the company since our previous price targets have been exceeded.

Valuation

We will value Adobe using a DCF as we did in our previous articles.

Assumptions:

• A fundamental revenue growth rate of 18.75% that we calculated in our first article using the company's reinvestment rate and revenue to invested capital
• Marginal tax rate: 21%
• Cost of debt: 2.4% (1.90% after-tax)
• 2-year weekly beta: 0.8
• Equity risk premium (S&P Global): 4.7%
• Risk-free rate: 1.34%
• Cost of Equity: 5.10%
• Weighted average cost of capital: 5.05%
• Terminal growth rate: 2%
• 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

As you can see, Adobe is trading above our estimated fair value when using a conservative 5-year DCF model. The main driver that has impacted the change in valuation from $570 in our previous article to $603 is the risk-free rate which has lowered the discount rate.

However, we assume a 2% terminal growth rate which could very well be a little low for a company that has a very wide moat. Under current market conditions, bumping the terminal growth rate to 2.5% would boost the valuation to $710.

Risks

The main risk to Adobe at the moment would be a rise in discount rates. This would happen if either the risk-free rate or the equity risk premium were to rise. Since discount rates are always changing, we have created the sensitivity analysis below to demonstrate the valuation at different rates:

Source: Author

As you can see, a slight increase in discount rates may have a material impact on Adobe's valuation. At the moment, it appears that discount rates are more likely to begin trending upwards in the medium term rather than downwards. This is due to the increasing expectations that the Federal Reserve will begin to taper bond purchases.

Final Thoughts

Although we love Adobe, we believe that the potential upside may not offset the potential downside risk that could be triggered by a possible increase in discount rates. In addition, a higher valuation makes the stock more vulnerable to earnings disappointments, even if they are minimal. We are not necessarily bearish, and would rate it a hold for buy-and-hold investors. However, for more active investors, it may be time to take some profits.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.