Calculating The Fair Value Of Microchip Technology Incorporated (NASDAQ:MCHP)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Microchip Technology fair value estimate is US$97.50

• Current share price of US$91.36 suggests Microchip Technology is potentially trading close to its fair value

• Our fair value estimate is 4.1% higher than Microchip Technology's analyst price target of US$93.69

In this article we are going to estimate the intrinsic value of Microchip Technology Incorporated (NASDAQ:MCHP) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Microchip Technology

Crunching The Numbers

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$2.85b	US$1.57b	US$2.21b	US$2.62b	US$3.20b	US$3.64b	US$4.01b	US$4.33b	US$4.60b	US$4.84b
Growth Rate Estimate Source	Analyst x7	Analyst x7	Analyst x7	Analyst x2	Analyst x1	Est @ 13.68%	Est @ 10.29%	Est @ 7.92%	Est @ 6.26%	Est @ 5.09%
Present Value ($, Millions) Discounted @ 8.9%	US$2.6k	US$1.3k	US$1.7k	US$1.9k	US$2.1k	US$2.2k	US$2.2k	US$2.2k	US$2.1k	US$2.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$20b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.4%. We discount the terminal cash flows to today's value at a cost of equity of 8.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$4.8b× (1 + 2.4%) ÷ (8.9%– 2.4%) = US$76b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$76b÷ ( 1 + 8.9%)¹⁰= US$32b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$53b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$91.4, the company appears about fair value at a 6.3% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Microchip Technology 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 accounts for debt. In this calculation we've used 8.9%, which is based on a levered beta of 1.419. Beta is a measure of a stock's volatility, compared 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.

SWOT Analysis for Microchip Technology

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings and cashflows.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year is below its 5-year average.

• Dividend is low compared to the top 25% of dividend payers in the Semiconductor market.

Opportunity

• Current share price is below our estimate of fair value.

Threat

• Annual earnings are forecast to decline for the next 4 years.

Looking Ahead:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Microchip Technology, there are three additional items you should consider:

1. Risks: For example, we've discovered 3 warning signs for Microchip Technology (1 is a bit unpleasant!) that you should be aware of before investing here.

2. Future Earnings: How does MCHP'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: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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This article by Simply Wall St 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. Simply Wall St has no position in any stocks mentioned.