Estimating The Intrinsic Value Of Cadence Design Systems, Inc. (NASDAQ:CDNS)
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Cadence Design Systems, Inc. (NASDAQ:CDNS) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Check out our latest analysis for Cadence Design Systems
The Model
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. To start off with, we need to estimate the next ten years of cash flows. 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 discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Levered FCF ($, Millions) | US$1.31b | US$1.50b | US$1.67b | US$1.94b | US$2.12b | US$2.28b | US$2.40b | US$2.51b | US$2.61b | US$2.69b |
Growth Rate Estimate Source | Analyst x7 | Analyst x5 | Analyst x4 | Analyst x2 | Est @ 9.54% | Est @ 7.27% | Est @ 5.68% | Est @ 4.57% | Est @ 3.79% | Est @ 3.25% |
Present Value ($, Millions) Discounted @ 7.5% | US$1.2k | US$1.3k | US$1.3k | US$1.4k | US$1.5k | US$1.5k | US$1.4k | US$1.4k | US$1.4k | US$1.3k |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$14b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.5%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$2.7b× (1 + 2.0%) ÷ (7.5%– 2.0%) = US$50b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$50b÷ ( 1 + 7.5%)10= US$24b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$38b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$162, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
The Assumptions
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 Cadence Design Systems 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 7.5%, which is based on a levered beta of 0.993. 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 Cadence Design Systems
Strength
Earnings growth over the past year exceeded the industry.
Debt is not viewed as a risk.
Weakness
Earnings growth over the past year is below its 5-year average.
Expensive based on P/E ratio and estimated fair value.
Opportunity
Annual earnings are forecast to grow faster than the American market.
Threat
Revenue is forecast to grow slower than 20% per year.
Moving On:
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Cadence Design Systems, we've compiled three important aspects you should explore:
Risks: We feel that you should assess the 1 warning sign for Cadence Design Systems we've flagged before making an investment in the company.
Future Earnings: How does CDNS'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.
Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock 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.
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