Crunching the numbers
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. Where possible I use analyst estimates, but when these aren’t available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. The sum of these cash flows is then discounted to today’s value.
5-year cash flow forecast
|Levered FCF ($, Millions)||$212.00||$203.00||$229.26||$258.93||$292.42|
|Source||Analyst x1||Analyst x1||Extrapolated @ (12.94%)||Extrapolated @ (12.94%)||Extrapolated @ (12.94%)|
|Present Value Discounted @ 10.51%||$191.84||$166.23||$169.89||$173.63||$177.44|
Present Value of 5-year Cash Flow (PVCF)= US$879.03m
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 10.5%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$292.42m × (1 + 2.9%) ÷ (10.5% – 2.9%) = US$3.98b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$3.98b ÷ ( 1 + 10.5%)5 = US$2.42b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$3.30b. 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 $25.5. Relative to the current share price of $34.45, the stock is rather overvalued and not available at a discount at this time.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Integrated Device Technology 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 10.5%, which is based on a levered beta of 1.072. 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.
Whilst important, DCF calculation 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 IDTI, I’ve put together three important aspects you should further research:
- Financial Health: Does IDTI 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 IDTI’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 IDTI? 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.