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Is There An Opportunity With Applied Optoelectronics Inc’s (NASDAQ:AAOI) 36.27% Undervaluation?

I am going to run you through how I calculated the intrinsic value of Applied Optoelectronics Inc (NASDAQ:AAOI) by projecting its future cash flows and then discounting them to today’s value. This is done using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in November 2018 so be sure check out the updated calculation by following the link below.

View our latest analysis for Applied Optoelectronics

Is AAOI fairly valued?

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 five years. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.

5-year cash flow forecast

2019 2020 2021 2022 2023
Levered FCF ($, Millions) $30.58 $36.38 $42.93 $50.23 $58.27
Source Analyst x1 Est @ 19%, capped from 32.76% Est @ 18%, capped from 32.76% Est @ 17%, capped from 32.76% Est @ 16%, capped from 32.76%
Present Value Discounted @ 10.71% $27.62 $29.69 $31.64 $33.44 $35.04

Present Value of 5-year Cash Flow (PVCF)= US$157m

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.9%. We discount this to today’s value at a cost of equity of 10.7%.

Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$58m × (1 + 2.9%) ÷ (10.7% – 2.9%) = US$773m

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$773m ÷ ( 1 + 10.7%)5 = US$465m

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is US$623m. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $31.6. Compared to the current share price of $20.14, the stock is quite good value at a 36% discount to what it is available for right now.

NasdaqGM:AAOI Intrinsic Value Export November 2nd 18

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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Applied Optoelectronics as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 10.7%, which is based on a levered beta of 1.1. This is derived from the Bottom-Up Beta method based on 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. What is the reason for the share price to differ from the intrinsic value? For AAOI, I’ve put together three fundamental aspects you should look at:

  1. Financial Health: Does AAOI 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 AAOI’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 AAOI? 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.