How Much Should VMware Inc’s (NYSE:VMW) Stock Be Trading At?
Deciding if you should use a relative valuation model over an intrinsic valuation model can be a difficult choice for many investors. For instance, while my relative valuation model tells me VMware Inc’s (NYSE:VMW) is overvalued by 80.34%, my discounted cash flow (DCF) model signals a 25.95% overvaluation instead. So, which model is more reliable and why?
View our latest analysis for VMware
A closer look at 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 VMW’s future FCFs by 11%, it’s equity value comes to $US$48.1b, then 408.73k shares outstanding are divided through. This results in an intrinsic value of $117.64. Take a look at how I arrived at this intrinsic value here.,
Before we move on, let’s evaluate whether this number is accurate. A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in VMW’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. At -11.79%, final year FCF growth is unsustainably low. If this assumption held true, VMW would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. Since these assumptions are far too extreme and unrealistic, one way of improving our DCF is to extend our forecast horizon by another few years until FCF growth moderates to a more sustainable rate. The downside is that forecasts are less reliable the further into the future they are.
Examining 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 VMW, a viable proxy would be the overall Software industry itself. To calculate the “true” value of VMW, we multiply VMW’s earnings by the industry’s P/E ratio to obtain a share price of $29.13, which means VMW is overvalued. But is this a dependable conclusion?
To check the robustness of our relative valuation, let’s take a look at if VMW shares a similar capital structure with the overall Software industry. 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 40.78, VMW’s D/E ratio is significantly higher than the average firm in the Software industry, which has a D/E ratio of 82.71%. Given the discrepancy of VMW’s D/E with the average Software firm, we could improve our analysis by using enterprise multiples like EV/Sales instead, which aren’t affected by different capital structures.
Which Model Is Superior?
Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. While intrinsic valuation is immune from market irrationality and mispricing, it is highly exposed to forecasting error. On the other hand, relative valuation is easy to calculate but affected by overall market mispricing. For example, relative valuation would not have been an effective tool to value a technology company at the height of the dotcom bubble in 2000. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
Next Steps:
For VMW, I’ve put together three fundamental aspects you should look at:
Financial Health: Does VMW 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 VMW’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 VMW? 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 NYSE 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.
