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Choosing the right financial tool to evaluate a company can be a daunting task, especially when different models are giving you drastically different conclusions. In the case of Arrow Electronics, Inc.’s (NYSE:ARW), my discounted cash flow (DCF) model tells me that Arrow Electronics, Inc.’s (NYSE:ARW) is undervalued by 5.53%; however, my relative valuation metrics tell me that Arrow Electronics, Inc.’s (NYSE:ARW) is undervalued by 13.2%. So, which valuation methodology should I listen to and why?
Examining intrinsic valuation
The DCF model follows the principle that a firm’s “true” value today is equal to the sum of all its the future free cash flows (FCF) it will make in the future (to infinity). Since the hardest part of constructing a DCF is forecasting this, I’ve decided to use the average expected FCF forecasted by broker analysts in my model. Calculating the per share intrinsic value of ARW involves two key steps. First, I discount the sum of ARW’s future FCFs at 13%, which gives us an equity value of $US$7.4b, then 84.92k shares outstanding are divided through. This results in an intrinsic value of $86.79. Check out the source of my 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 ARW’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. ARW’s final year FCF growth rate of -2.22%, is too low. If this assumption held true, ARW would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. To improve our DCF analysis, we could extend the terminal year until FCF growth moderates to a more sustainable level around 1% to 5%. However, the trade-off is that there are less analyst forecasts the further in the future we go.
Deep-dive into 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 ARW, a viable proxy would be the overall Electronic industry itself. To calculate the “true” value of ARW, we multiply ARW’s earnings by the industry’s P/E ratio to obtain a share price of $92.81, which means ARW is undervalued. But is this a dependable conclusion?
One quick way of finding out is to see if ARW shares a similar capital structure to the overall Electronic 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. ARW’s D/E ratio of 64.84% is closely aligned with the average firm in the Electronic industry, which has a D/E of 68.65%. This means that investors can have the freedom of using price multiples like the P/E ratio in addition to enterprise multiples should they wish to bolster their relative valuation analysis.
What Model Should I Listen To?
Both are somewhat weakened by assumptions we have used to fill in the gaps. 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. 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.
For ARW, I’ve put together three important aspects you should look at:
- Financial Health: Does ARW 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 ARW’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 ARW? 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 does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.