Adobe (NASDAQ:ADBE) is a popular application software company with powerful free cash flow (FCF) generating capability. In fact, it’s now clear that its FCF is so robust that we can project out the value of ADBE stock using its FCF yield.
The problem is, though, that ADBE stock is close to a full valuation. However, it’s still possible for the stock to rise between 22% and 35% more. That puts its value between $739 and $814 per share, compared to its Jul. 13 of $605.01. That gives it an average target price of $776.75, or about 28% higher.
The main reason behind this is that ADBE has already moved up quite significantly. For example, year-to-date (YTD), it’s up slightly over 21%. Plus, since the end of its first quarter, ADBE is up some 27% using the Jul. 13 price from $475.37. This is likely due to its overall superior Q1 performance.
ADBE Stock: Estimating the Free Cash Flow
On Jun. 17, Adobe reported a huge 23% gain in revenue year-over-year (YOY) to $3.84 billion for its fiscal Q2 ending Jun. 4. In addition, it made $1.893 billion in FCF. This means a whopping 49.4% of those sales ended up as free cash flow.
This FCF margin is very high, especially since most companies are lucky if they can get a 20% FCF margin. In effect, it means that about half of every dollar Adobe makes selling software ends up as pure cash profit (after all cash expenses, including capital expenditures, changes in working capital, all its normal SG&A expenses, taxes and cash payments have been taken out). This leaves 49.4% of those sales dollars “free” to be used to buy back shares or reduce debt, pay dividends, make acquisitions, or simply store as cash on its balance sheet.
We can use this to estimate Adobe’s FCF going forward. For example, analysts followed by Seeking Alpha forecast that sales for the year to Nov. 2021 will reach $15.67 billion and about $18 billion in 2022. Therefore, applying its 49.4% FCF margin to those numbers, we can estimate that FCF will hit $7.73 billion in 2021 and $8.87 billion in 2022.
As the table on the right shows, this implies that, by 2022, the $8.87 billion in FCF will have risen 67% over its 2020 level of $5.31 billion. That is a huge amount of growth and another reason ADBE stock could soon be moving higher.
Using FCF Yield to Value Adobe
Given that this FCF margin is so high, the market puts a high valuation on ADBE stock. For example, on Jul. 13, the market capitalization was $288.2 billion. So, if we divide its annual FCF by this market cap, we can derive its FCF yield.
Using the trailing twelve months (TTM) to Jun. 4, Adobe generated $6.595 billion in FCF. This can be seen on Yahoo! Finance, alongside TTM cash flow from operations (CFFO) of $6.978 billion. Dividing this $6.595 billion by Adobe’s market cap of $288.2 billion, the FCF yield is 2.29%.
This is a very high FCF yield. It also implies, as the table on the right shows, that the 2022 FCF estimate of $8.87 billion leads to a target market value of $387.7 billion. This is 34.5% over the recent market cap of $288.2 billion and also implies that ADBE stock could be worth $813.73 per share.
Where This Leaves the ADBE Stock Target
However, if we compare ADBE stock to some of its peers, we can see that it has one of the highest valuations. I did a cursory analysis and found that the range of FCF yields was between 3% to 5.4%. So, in order to be conservative, I decided to increase the FCF yield by 10%.
The table on the right shows that, using a 10%-increased yield (i.e., 2.52% instead of its TTM FCF yield of 2.29%), ADBE stock has a lower value of $739.76 per share.
So, if we raise the FCF yield in order to be more conservative, the target price falls. As a result, the average between these two is $776.75. That is a potential upside of about 28% over the Jul. 13 price of $605.01.
On the date of publication, Mark R. Hake did not hold (either directly or indirectly) any positions in any of the securities mentioned in the article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.