Fair value estimate of KLA Corporation (NASDAQ: KLAC)
Today we’re going to walk through one way to estimate the intrinsic value of KLA Corporation (NASDAQ: KLAC) by taking the company’s expected future cash flows and discounting them to present value. We will therefore take advantage of the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
We would like to point out that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
Check out our latest analysis for KLA
The model
We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we need to get cash flow estimates for the next ten years. 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, and therefore the sum of these future cash flows is then discounted to present value:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF ($, million) | 2.00 billion USD | 2.36 billion USD | 2.54 billion USD | 2.67 billion USD | 2.79 billion USD | 2.89 billion USD | $ 2.98 billion | 3.06 billion USD | 3.14 billion USD | 3.21 billion USD |
Source of estimated growth rate | Analyst x4 | Analyst x4 | Analyst x2 | Is 5.28% | Is 4.29% | Is 3.6% | Is 3.12% | Is 2.78% | Is 2.54% | Is 2.38% |
Present value ($, millions) discounted at 7.4% | US $ 1.9K | US $ 2.0K | US $ 2.0K | US $ 2.0K | US $ 1.9K | US $ 1.9K | US $ 1.8K | US $ 1.7k | US $ 1.6k | US $ 1.6k |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 19 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} Ã— (1 + g) Ã· (r – g) = $ 3.2 billion Ã— (1 + 2.0%) Ã· (7.4% – 2.0%) = $ 60 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= 60 billion USD Ã· (1 + 7.4%)^{ten}= 29 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 $ 48 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 317, the company is around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
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 KLA 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 1.153. 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:
While important, the DCF calculation is just one of the many factors you need to assess for a business. It is not possible to obtain an infallible valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For KLA, we have compiled three important things that you need to evaluate:
- Risks: Take risks, for example – the UCK has 1 warning sign we think you should be aware of this.
- Management: Have insiders increased their shares to take advantage of market sentiment for KLAC’s future outlook? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality inventory to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, just search here.
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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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