Is there an opportunity with the 23% undervaluation of Lam Research Corporation (NASDAQ: LRCX)?
Today we are going to do a simple walkthrough of a valuation method used to estimate the attractiveness of Lam Research Corporation (NASDAQ:LRCX) as an investment opportunity by taking expected future cash flows and discounting them to their current value. One way to do this is to use the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St Analysis Template.
The method
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. In the first step, we need to estimate the company’s cash flow over 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) | $5.97 billion | $4.70 billion | $5.07 billion | $4.79 billion | $4.64 billion | $4.56 billion | $4.53 billion | US$4.54 billion | US$4.57 billion | $4.62 billion |
Growth rate estimate Source | Analyst x7 | Analyst x6 | Analyst x4 | East @ -5.44% | Is @ -3.23% | Is @ -1.68% | Is @ -0.59% | Is at 0.17% | Is at 0.7% | Is at 1.07% |
Present value (millions of dollars) discounted at 7.2% | $5,600 | $4,100 | $4,100 | $3,600 | $3,300 | $3,000 | $2.8,000 | $2,600 | $2,400 | $2,300 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $34 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 7.2%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = $4.6 billion × (1 + 1.9%) ÷ (7.2%–1.9%) = $90 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $90 billion ÷ (1 + 7.2%)^{ten}= $45 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $79 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$439, the company looks slightly undervalued at a 23% 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
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the 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 Lam Research 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 7.2%, which is based on a leveraged beta of 1.240. 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. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” If a company grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is the stock price below intrinsic value? For Lam Research, we’ve compiled three essentials you should look into:
- Risks: You should be aware of the 3 warning signs for Lam Research (1 is potentially serious!) that we discovered before considering an investment in the company.
- Future earnings: How does LRCX’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 else you might be missing!
PS. Simply Wall St updates its DCF calculation daily for every US stock, so if you want to find the intrinsic value of any other stock, 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.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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