A look at the intrinsic value of Semtech Corporation (NASDAQ: SMTC)
Does the May Semtech Corporation (NASDAQ: SMTC) share price reflect what it is really worth? Today we will estimate the intrinsic value of the security by taking expected future cash flows and discounting them to their present value. One way to do this is to use the Discounted Cash Flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
There are many ways that businesses can be valued, so we would like to stress that a DCF is not perfect for all situations. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.
The calculation
We are going to use a two-step DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or the last reported value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) forecast
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF ($, million) | 105.4 million USD | $ 164.0 million | $ 192.3 million | USD 213.1 million | $ 230.6 million | 245.1 million USD | $ 257.5 million | $ 268.1 million | $ 277.4 million | 285.8 million USD |
Source of estimated growth rate | Analyst x1 | Analyst x1 | Analyst x1 | Is 10.83% | Is 8.18% | Is 6.32% | Is 5.02% | Is 4.11% | Is 3.48% | Is 3.03% |
Present value ($, millions) discounted at 7.4% | US $ 98.1 | 142 USD | US $ 155 | 160 USD | US $ 161 | US $ 159 | US $ 156 | US $ 151 | US $ 145 | US $ 139 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 1.5 billion USD
Now we need to calculate the terminal value, which takes into account all future cash flows after that ten year period. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 7.4%.
Terminal value (TV)= FCF_{2030} × (1 + g) ÷ (r – g) = $ 286 million × (1 + 2.0%) ÷ (7.4% – 2.0%) = $ 5.3 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $ 5.3 billion ÷ (1 + 7.4%)^{ten}= 2.6 billion USD
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is US $ 4.1 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 63.0, the company appears to be around fair value at the time of writing. Remember though, this is only a rough estimate, and like any complex formula – garbage in, garbage out.
NasdaqGS: SMTC Discounted Cash Flow May 7, 2021
The hypotheses
We draw your attention to the fact that the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. If you don’t agree with these results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Semtech 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 takes debt into account. In this calculation, we used 7.4%, which is based on a leveraged beta of 1.156. Beta is a measure of the volatility of a stock, relative 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.
Next steps:
Valuation is only one side of the coin in terms of building your investment thesis, and ideally it won’t be the only analysis you look at for a business. The DCF model is not a perfect inventory valuation tool. Preferably, you would apply different cases and assumptions and see how they would impact the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Semtech, we’ve put together three basic things you should research further:
- Risks: For example, we discovered 2 warning signs for Semtech which you should be aware of before investing here.
- Management: Insiders have increased their shares to take advantage of market sentiment for the future outlook for TCMS? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other strong companies: Low debt, high return on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.
This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in any of the stocks mentioned.
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