Calculating The Intrinsic Value Of Ambarella, Inc. (NASDAQ:AMBA)

Key Insights

• Ambarella's estimated fair value is US$77.08 based on 2 Stage Free Cash Flow to Equity
• Ambarella's US$63.15 share price indicates it is trading at similar levels as its fair value estimate
• Analyst price target for AMBA is US$73.63 which is 4.5% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Ambarella, Inc. (NASDAQ:AMBA) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Ambarella

The Method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	-US$4.97m	-US$34.6m	US$5.58m	US$34.0m	US$86.3m	US$135.2m	US$189.8m	US$244.7m	US$295.8m	US$341.1m
Growth Rate Estimate Source	Analyst x4	Analyst x5	Analyst x4	Analyst x1	Analyst x1	Est @ 56.69%	Est @ 40.35%	Est @ 28.91%	Est @ 20.90%	Est @ 15.30%
Present Value ($, Millions) Discounted @ 8.5%	-US$4.6	-US$29.3	US$4.4	US$24.5	US$57.3	US$82.8	US$107	US$127	US$142	US$151

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$661m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.5%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$341m× (1 + 2.2%) ÷ (8.5%– 2.2%) = US$5.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$5.5b÷ ( 1 + 8.5%)¹⁰= US$2.4b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$3.1b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$63.2, the company appears about fair value at a 18% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

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 these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Ambarella as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.5%, which is based on a levered beta of 1.261. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Ambarella

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Ambarella, we've put together three fundamental elements you should look at:

1. Risks: Every company has them, and we've spotted 2 warning signs for Ambarella you should know about.
2. Future Earnings: How does AMBA'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: Do you like a good all-rounder? 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 updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.