Is there an opportunity with the 25% undervaluation of KLA Corporation (NASDAQ: KLAC)?
Today we are going to do a simple overview of a valuation method used to estimate the attractiveness of KLA Corporation (NASDAQ:KLAC) as an investment opportunity by taking expected future cash flows of the company and discounting them to the current value. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to do, although it may seem quite complex.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
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Is the UCK valued enough?
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF ($, millions) | $3.35 billion | $3.50 billion | US$3.42 billion | $3.39 billion | $3.39 billion | $3.41 billion | US$3.44 billion | $3.49 billion | US$3.54 billion | $3.59 billion |
Growth rate estimate Source | Analyst x4 | Analyst x2 | Analyst x2 | Is @ -0.86% | East @ -0.02% | Is at 0.57% | Is 0.98% | Is at 1.27% | Is at 1.47% | Is at 1.61% |
Present value (millions of dollars) discounted at 7.4% | $3,100 | $3,000 | $2.8,000 | $2,600 | $2,400 | $2,200 | $2,100 | $2,000 | $1,900 | $1.8,000 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $24 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 7.4%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = $3.6 billion × (1 + 1.9%) ÷ (7.4%–1.9%) = $68 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $68 billion ÷ (1 + 7.4%)^{ten}= $33 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $57 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US$303, the company looks slightly undervalued at a 25% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
Important 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 entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider 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 1.280. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Let’s move on :
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. 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 the company being undervalued or overvalued. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Can we understand why the company is trading at a discount to its intrinsic value? For KLA, we’ve put together three relevant things you should consider:
- Risks: For example, we found 1 warning sign for KLA that you must consider before investing here.
- Future earnings: How does KLAC’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs a daily updated cash flow assessment for each NASDAQGS stock. If you want to find the calculation for other stocks, search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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