Adobe (NASDAQ:ADBE) is a fantastic company with strong competitive advantages which we covered in our previous articles:
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.
We will value Adobe using a DCF as we did in our previous articles.
Adobe's margins and debt-to-EBITDA ratio have been fairly stable the last 5 years and have averaged the following:
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.
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:
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.
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.
This article was written by
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.