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Are Investors Undervaluing Applied Materials, Inc. (NASDAQ:AMAT) By 23%?

Simply Wall St

How far off is Applied Materials, Inc. (NASDAQ:AMAT) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the foreast future cash flows of the company and discounting them back to today's value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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 want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Applied Materials

Crunching the numbers

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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) forecast

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

Levered FCF ($, Millions)

US$3.44b

US$3.43b

US$4.56b

US$5.06b

US$5.47b

US$5.81b

US$6.10b

US$6.34b

US$6.54b

US$6.73b

Growth Rate Estimate Source

Analyst x7

Analyst x6

Analyst x1

Est @ 10.89%

Est @ 8.14%

Est @ 6.22%

Est @ 4.88%

Est @ 3.94%

Est @ 3.28%

Est @ 2.82%

Present Value ($, Millions) Discounted @ 8.8%

US$3.2k

US$2.9k

US$3.5k

US$3.6k

US$3.6k

US$3.5k

US$3.4k

US$3.2k

US$3.1k

US$2.9k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$33b

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 10-year government bond rate of 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 8.8%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$6.7b× (1 + 1.7%) ÷ 8.8%– 1.7%) = US$97b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$97b÷ ( 1 + 8.8%)10= US$42b

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$75b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$62.9, the company appears a touch undervalued at a 23% 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.

NasdaqGS:AMAT Intrinsic value, January 19th 2020
NasdaqGS:AMAT Intrinsic value, January 19th 2020

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Applied Materials 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 8.8%, which is based on a levered beta of 1.293. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For Applied Materials, I've put together three relevant factors you should further research:

  1. 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.

  2. 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.

  3. 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. 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.