Is Applied Optoelectronics, Inc. (NASDAQ:AAOI) Worth US$1.8 Based On Its Intrinsic Value?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Applied Optoelectronics fair value estimate is US$1.36

• Applied Optoelectronics' US$1.82 share price signals that it might be 34% overvalued

• The US$5.25 analyst price target for AAOI is 287% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Applied Optoelectronics, Inc. (NASDAQ:AAOI) by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Applied Optoelectronics

Is Applied Optoelectronics Fairly Valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$1.78m	US$2.60m	US$3.45m	US$4.26m	US$4.99m	US$5.61m	US$6.14m	US$6.58m	US$6.96m	US$7.28m
Growth Rate Estimate Source	Analyst x1	Est @ 45.77%	Est @ 32.66%	Est @ 23.48%	Est @ 17.06%	Est @ 12.56%	Est @ 9.41%	Est @ 7.21%	Est @ 5.67%	Est @ 4.59%
Present Value ($, Millions) Discounted @ 14%	US$1.6	US$2.0	US$2.3	US$2.5	US$2.6	US$2.6	US$2.5	US$2.3	US$2.1	US$2.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$22m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 14%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$7.3m× (1 + 2.1%) ÷ (14%– 2.1%) = US$63m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$63m÷ ( 1 + 14%)¹⁰= US$17m

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$39m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$1.8, the company appears potentially overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Applied Optoelectronics 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 14%, which is based on a levered beta of 2.000. 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 Applied Optoelectronics

Strength

• Debt is well covered by earnings.

Weakness

• Shareholders have been diluted in the past year.

Opportunity

• Forecast to reduce losses next year.

• Good value based on P/S ratio compared to estimated Fair P/S ratio.

Threat

• Debt is not well covered by operating cash flow.

• Has less than 3 years of cash runway based on current free cash flow.

• Not expected to become profitable over the next 3 years.

Next Steps:

Although the valuation of a company is important, it is only one of many factors that you need to assess 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. What is the reason for the share price exceeding the intrinsic value? For Applied Optoelectronics, we've compiled three relevant aspects you should further examine:

1. Risks: To that end, you should be aware of the 4 warning signs we've spotted with Applied Optoelectronics .

2. Future Earnings: How does AAOI'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGM every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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