A Look At The Fair Value Of Microchip Technology Incorporated (NASDAQ:MCHP)
Key Insights
Using the 2 Stage Free Cash Flow to Equity, Microchip Technology fair value estimate is US$82.15
Current share price of US$87.65 suggests Microchip Technology is potentially trading close to its fair value
The US$92.43 analyst price target for MCHP is 13% more than our estimate of fair value
How far off is Microchip Technology Incorporated (NASDAQ:MCHP) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
View our latest analysis for Microchip Technology
Crunching The Numbers
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$2.85b | US$1.61b | US$2.27b | US$3.03b | US$3.20b | US$3.34b | US$3.46b | US$3.57b | US$3.68b | US$3.78b |
Growth Rate Estimate Source | Analyst x8 | Analyst x8 | Analyst x8 | Analyst x1 | Analyst x1 | Est @ 4.25% | Est @ 3.66% | Est @ 3.25% | Est @ 2.96% | Est @ 2.76% |
Present Value ($, Millions) Discounted @ 8.8% | US$2.6k | US$1.4k | US$1.8k | US$2.2k | US$2.1k | US$2.0k | US$1.9k | US$1.8k | US$1.7k | US$1.6k |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$19b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.8%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$3.8b× (1 + 2.3%) ÷ (8.8%– 2.3%) = US$59b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$59b÷ ( 1 + 8.8%)10= US$25b
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$44b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$87.7, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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 Microchip Technology 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 1.423. 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 Microchip Technology
Strength
Earnings growth over the past year exceeded the industry.
Debt is well covered by earnings and cashflows.
Dividends are covered by earnings and cash flows.
Weakness
Earnings growth over the past year is below its 5-year average.
Dividend is low compared to the top 25% of dividend payers in the Semiconductor market.
Expensive based on P/E ratio and estimated fair value.
Opportunity
MCHP's financial characteristics indicate limited near-term opportunities for shareholders.
Threat
Annual earnings are forecast to decline for the next 3 years.
Looking Ahead:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Microchip Technology, we've compiled three essential items you should further examine:
Risks: We feel that you should assess the 3 warning signs for Microchip Technology (1 is concerning!) we've flagged before making an investment in the company.
Future Earnings: How does MCHP'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.
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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.
