Does VMware Inc (NYSE:VMW) Look Attractive Based On These Two Valuation Methods?

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 VMware Inc's (NYSE:VMW), my discounted cash flow (DCF) model tells me that VMware Inc's (NYSE:VMW) is overvalued by 19.45%; however, my relative valuation metrics tell me that VMware Inc's (NYSE:VMW) is overvalued by 79.71%. So, which model is more reliable and why?

View our latest analysis for VMware

Examining intrinsic valuation

Since forecasting future free cash flows (FCFs) accurately into the future is often difficult and a highly subjective task, I’ve used analysts' FCF forecasts as a starting point for my DCF. For those less familiar with valuation, the assumption behind the DCF is that a firm’s intrinsic value is equal to the sum of all its future FCFs, which is why quality forecasts are a high priority. After discounting the sum of VMW’s future FCFs by 11%, it’s equity value comes to $US$48.1b, then 408.73k shares outstanding are divided through. This results in an intrinsic value of $117.59. Take a look at how I arrived at this intrinsic value here.,

But how accurate is this figure? A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in VMW’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. VMW’s final year FCF growth rate of -11.79%, is too low. If this assumption held true, VMW 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%. The downside is that forecasts are less reliable the further into the future they are.

A closer look at 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 VMW, a viable proxy would be the overall Software industry itself. The calculations for relative valuation are quite simple. By multiplying VMW’s earnings by the industry’s P/E ratio, we can obtain VMW’s fair value of $28.5, which tells us that it is overvalued. However, should we believe this result?

To check the robustness of our relative valuation, let’s take a look at if VMW shares a similar capital structure with the overall Software industry. This is especially important since we are using the P/E ratio, which is ineffective when comparing two entities with dramatically differing capital structures. At 40.78, VMW’s D/E ratio is significantly higher than the average firm in the Software industry, which has a D/E ratio of 83.44%. Given the discrepancy of VMW’s D/E with the average Software firm, we could improve our analysis by using enterprise multiples like EV/Sales instead, which aren’t affected by different capital structures.

Which Model Is Superior?

Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. 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. Instead of listening to one model over another, I encourage you to calculate a weighted average target share price based off both, applying a higher weight to the valuation method you think is more appropriate.

Next Steps:

For VMW, there are three important aspects you should further examine:

1. Financial Health: Does VMW 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 VMW'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 VMW? 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 NYSE every 6 hours. If you want to find the calculation for other stocks just search here.

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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.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article 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.