Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Politics : Idea Of The Day -- Ignore unavailable to you. Want to Upgrade?

To: IQBAL LATIF who wrote (29646)	11/10/1999 4:15:00 AM
From: IQBAL LATIF	Read Replies (3) \| Respond to of 50167

SUNW is it expensive.. by Tom Byrne 11/9/99 on individual investor.. Two weeks ago I wrote a column extolling the virtues of Net Present Value (NPV) analysis, a method consisting of three steps: a period of forecasted cash flows, usually three to five years, a terminal growth rate after the company reaches maturity, and a discounting factor that consists of the risk-free rate of return on 30-year Treasury bonds plus an equity risk premium, plus an adjustment for individual company risk. The discounting factor essentially adds up to a company?s cost of capital, therefore in PV analysis, you will hear the terms discount rate and cost of capital used interchangeably. I employ NPV analysis when I?m looking at stocks and I favor it over any other valuation method. It may be easy to manipulate net earnings, but relatively speaking, it?s almost impossible to manipulate operating earnings or free cash flow, which is why I rely so heavily on NPV analysis. Like this Article? At the conclusion of my column two weeks ago, I asked for readers to submit stocks in the Bull Session forum that they wanted me to scrutinize using my specific type of NPV analysis. The most common request came for Sun Microsystems (NASDAQ: SUNW - Quotes, News, Boards). Sun?s stock is up 143% for the year and investors want to know if the stock is still a good value. Monday, the stock closed at $111.81, up $2.25 for the day. Midway through Tuesday?s session, the shares are trading at $112.25, up $0.25 for the day. From the perspective of traditional valuation measures, Sun?s stock seems egregiously overvalued. Shares are trading for 86 times trailing earnings, 8.1 times sales, 17.7 times book value and 54 times free cash flow. Compare this to the S&P 500, which is trading at 36 times trailing earnings, 5.9 times sales, 9.4 times book value and 46 times free cash flow. So how does Sun look from an NPV analysis vantage point? Practically like it?s on the discount rack. After running an NPV analysis on Sun, the shares appear to be anywhere from 50% to 200% undervalued based on the company?s ability to generate cash flow. Here?s how it works. Sun generated $1.6 billion in EBITDA (earnings before interest, taxes, depreciation and amortization) for the year ended June 1999. The company generated $2.5 billion in positive cash flow from operations. During the last three years, EBITDA growth has averaged 25% and cash flow growth has averaged a whopping 51%. In my NPV analytical test for these two measures, I assumed Sun could sustain the same growth for the next four years. Although the historical rate of return for stocks this century is between 11% and 12%, I assumed a discount rate of 15% because Sun is a fast-growing technology stock and investors should demand a higher rate of return for technology stocks. On an EBITDA basis, assuming 25% growth, Sun will generate a sum of $12.1 billion over the next four years. Discounting that back to the present using the 15% discount rate yields a net present value of $8.3 billion, or $10.68 per share. Applying a very modest multiple of 15 times EBITDA (or operating earnings) leaves a fair value of $160 for Sun?s stock. Given its current price, Sun is trading 28% below its fair value on an EBITDA basis. Looking at cash flow from operations, assuming 60% growth (Sun?s cash flow growth has been accelerating and it hit 65% last year), Sun will generate $37.3 billion in positive cash flow over the next four years. Discounting that back to the present using the 15% discount rate yields a net present value of $24.6 billion, or $31.63 per share. Applying a very modest multiple of 10 times cash flow (remember Sun is currently trading at 54 times free cash flow) leaves a fair value of $316 for Sun?s stock. Sun is currently trading 64% below its fair value on a cash flow basis. Using the reciprocal of 64%, Sun?s stock would have to increase 175% from its current level in order to hit fair value of $316. This is why I use NPV analysis and why I look at more than one form of cash flow. At a minimum, NPV analysis shows us that Sun?s stock is worth $160. At a maximum, it is worth $316. Somewhere between those two numbers lies Sun?s true fair value, which is well above its current stock price. Bottom Line: If you rely primarily upon traditional valuation measures like P/E ratio, you wouldn?t touch Sun?s stock. But NPV analysis tells us the stock is still a bargain, so load up.