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Calculating The Intrinsic Value Of Analog Devices, Inc. (NASDAQ:ADI)

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Analog Devices fair value estimate is US$235

  • Analog Devices' US$214 share price indicates it is trading at similar levels as its fair value estimate

  • Our fair value estimate is 8.6% higher than Analog Devices' analyst price target of US$217

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Analog Devices, Inc. (NASDAQ:ADI) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

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See our latest analysis for Analog Devices

What's The Estimated Valuation?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF ($, Millions)

US$3.20b

US$4.12b

US$4.84b

US$5.68b

US$7.09b

US$8.03b

US$8.83b

US$9.51b

US$10.1b

US$10.6b

Growth Rate Estimate Source

Analyst x8

Analyst x7

Analyst x5

Analyst x2

Analyst x1

Est @ 13.26%

Est @ 10.00%

Est @ 7.71%

Est @ 6.11%

Est @ 4.99%

Present Value ($, Millions) Discounted @ 8.7%

US$2.9k

US$3.5k

US$3.8k

US$4.1k

US$4.7k

US$4.9k

US$4.9k

US$4.9k

US$4.7k

US$4.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$43b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.4%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$11b× (1 + 2.4%) ÷ (8.7%– 2.4%) = US$171b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$171b÷ ( 1 + 8.7%)10= US$74b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$117b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$214, the company appears about fair value at a 9.0% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
dcf

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Analog Devices as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.7%, which is based on a levered beta of 1.382. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Analog Devices

Strength

  • Debt is not viewed as a risk.

  • Dividends are covered by earnings and cash flows.

Weakness

  • Earnings declined over the past year.

  • Dividend is low compared to the top 25% of dividend payers in the Semiconductor market.

Opportunity

  • Annual earnings are forecast to grow for the next 3 years.

  • Current share price is below our estimate of fair value.

Threat

  • Annual earnings are forecast to grow slower than the American market.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Analog Devices, we've compiled three further elements you should further research:

  1. Financial Health: Does ADI have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

  2. Future Earnings: How does ADI's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

  3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.