Estimating The Intrinsic Value Of Analog Devices Inc (NASDAQ:ADI)

Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Analog Devices Inc (NASDAQ:ADI) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. I will use the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not October 2018 then I highly recommend you check out the latest calculation for Analog Devices by following the link below.

Check out our latest analysis for Analog Devices

The model

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. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.

5-year cash flow estimate

2019 2020 2021 2022 2023
Levered FCF ($, Millions) $2.27k $2.38k $2.81k $3.28k $3.81k
Source Analyst x10 Analyst x3 Est @ 18%, capped from 18.54% Est @ 17%, capped from 18.54% Est @ 16%, capped from 18.54%
Present Value Discounted @ 12.38% $2.02k $1.88k $1.98k $2.06k $2.13k

Present Value of 5-year Cash Flow (PVCF)= US$10.1b

The second stage is also known as Terminal Value, this is the business’s cash flow after 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 12.4%.

Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$3.8b × (1 + 2.9%) ÷ (12.4% – 2.9%) = US$41.6b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$41.6b ÷ ( 1 + 12.4%)5 = US$23.2b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$33.3b. 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 $89.5. Relative to the current share price of $80.41, the stock is about right, perhaps slightly undervalued at a 10% discount to what it is available for right now.

NasdaqGS:ADI Intrinsic Value Export October 31st 18
NasdaqGS:ADI Intrinsic Value Export October 31st 18

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Analog Devices 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 12.4%, which is based on a levered beta of 1.338. 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:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. For ADI, I’ve compiled three essential factors you should look at:

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

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.