Identifying Mispricing Opportunities For Applied Materials Inc (NASDAQ:AMAT) Based On Two Models
Knowing which valuation model to use for financial analysis can be incredibly confusing for even the most seasoned of investors. In the case of Applied Materials Inc’s (NASDAQ:AMAT), my discounted cash flow (DCF) model tells me that Applied Materials Inc’s (NASDAQ:AMAT) is undervalued by 30.31%; however, my relative valuation metrics tell me that Applied Materials Inc’s (NASDAQ:AMAT) is undervalued by 69.11%. Which model do I listen to and more importantly why?
Check out our latest analysis for Applied Materials
Deep-dive into intrinsic valuation
Since forecasting future free cash flows (FCFs) accurately into the future is often difficult and a highly subjective task, I’ve used analysts’ FCF forecasts as a starting point for my DCF. For those less familiar with valuation, the assumption behind the DCF is that a firm’s intrinsic value is equal to the sum of all its future FCFs, which is why quality forecasts are a high priority. After discounting the sum of AMAT’s future FCFs by 12%, it’s equity value comes to $US$50b, then 982.99k shares outstanding are divided through. This results in an intrinsic value of $50.49. Take a look at how I arrived at this intrinsic value here.,
Before we accept this value and move on, let’s take a look at how reliable it is. A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in AMAT’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. Given AMAT’s final year growth is at a sustainable 3.37%, we can rest assured that the assumptions we have made regarding an appropriate forecast horizon for AMAT are reasonable, and therefore our conclusions are significantly more dependable.
A closer look at relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to AMAT, a viable proxy would be the overall Semiconductor industry itself. To calculate the “true” value of AMAT, we multiply AMAT’s earnings by the industry’s P/E ratio to obtain a share price of $59.51, which means AMAT is undervalued. But is this a dependable conclusion?
One quick way of finding out is to see if AMAT shares a similar capital structure to the overall Semiconductor industry we are comparing it to. This is especially important since we are using the P/E ratio, which is ineffective when comparing two entities with dramatically differing capital structures. At 77.63, AMAT’s D/E ratio is significantly higher than the average firm in the Semiconductor industry, which has a D/E ratio of 51.23%. In this case, rather than using a price multiple like P/E, we could resolve this issue by using an enterprise multiple like EV/EBITDA, which is immune from being influenced by differing capital structures.
Which Model Is Superior?
Neither model is perfect despite the robust financial theory behind them. Relative valuation is computationally simple but exposed to market irrationality, which undermines its usefulness. Conversely, intrinsic valuation is immune from these factors but heavily affected by human forecasting errors. Given the pros and cons that I have laid out, I encourage you to derive a valuation by calculating a weighted average share price by using both models.
Next Steps:
For AMAT, I’ve compiled three key factors you should further examine:
Financial Health: Does AMAT 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.
Future Earnings: How does AMAT’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: Are there other high quality stocks you could be holding instead of AMAT? 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 does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.
