Which Model Should You Consider When Valuing Lam Research Corporation (NASDAQ:LRCX)?
Deciding if you should use a relative valuation model over an intrinsic valuation model can be a difficult choice for many investors. In the case of Lam Research Corporation’s (NASDAQ:LRCX), my discounted cash flow (DCF) model tells me that Lam Research Corporation’s (NASDAQ:LRCX) is undervalued by 46.42%; however, my relative valuation metrics tell me that Lam Research Corporation’s (NASDAQ:LRCX) is undervalued by 39.51%. Which model do I listen to and more importantly why?
Check out our latest analysis for Lam Research
A closer look at intrinsic valuation
Forecasting anything into the distant future is difficult and the same applies to forecasting free cash flows (FCFs) for businesses. This is why I’ve decided to use analyst FCF forecasts in my DCF to see what the consensus view is while also removing some subjectivity. If you’re unfamiliar with valuation, the assumption behind every DCF is that a firm’s true value is derived from the sum of all its future FCFs, which is why quality forecasts are important. To obtain the per share intrinsic value of LRCX, we must first discount the sum of LRCX’s future FCFs by 12%, which gives us an equity value of $US$41.5b, then 152.29k shares outstanding are divided through. This results in an intrinsic value of $272.63. Take a look at how I arrived at this intrinsic value here.,
Before we move on, let’s evaluate whether this number is accurate. Since it is generally impossible to forecast FCFs indefinitely, it is common for analysts to forecast for an explicit forecast horizon and then assume the company is mature by the end of that period and in a stable growth phase. Given LRCX’s final year growth is at a sustainable 3.57%, we can rest assured that the assumptions we have made regarding an appropriate forecast horizon for LRCX 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 LRCX, a viable proxy would be the overall Semiconductor industry itself. The calculations for relative valuation are quite simple. By multiplying LRCX’s earnings by the industry’s P/E ratio, we can obtain LRCX’s fair value of $203.79, which tells us that it is currently undervalued. However, should we believe this result?
One quick way of finding out is to see if LRCX shares a similar capital structure to the overall Semiconductor industry we are comparing it to. This is an important check since the P/E ratio, which we are using for our relative valuation, can be distorted by different capital structures. At 37.53, LRCX’s D/E ratio is significantly higher than the average firm in the Semiconductor industry, which has a D/E ratio of 55.47%. Given the discrepancy of LRCX’s D/E with the average Semiconductor firm, we could improve our analysis by using enterprise multiples like EV/Sales instead, which aren’t affected by different capital structures.
What Model Should I Listen To?
Neither model is perfect despite the robust financial theory behind them. Relative valuation is straightforward but prone to overall market mispricing. Meanwhile, intrinsic valuation is independent from market tendencies; however, is highly exposed to human error. Instead of listening to one model over another, I encourage you to calculate a weighted average target share price based off both, applying a higher weight to the valuation method you think is more appropriate.
Next Steps:
For LRCX, there are three essential factors you should further research:
Financial Health: Does LRCX 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 LRCX’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 LRCX? 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 for every stock on the NASDAQ every 6 hours. If you want to find the calculation for other stocks 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.
