Calculating The Fair Value Of VMware, Inc. (NYSE:VMW)

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Today we will run through one way of estimating the intrinsic value of VMware, Inc. (NYSE:VMW) by estimating the company’s future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.” data-reactid=”19″>Today we will run through one way of estimating the intrinsic value of VMware, Inc. (NYSE:VMW) by estimating the company’s future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.” data-reactid=”20″>Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content=" Check out our latest analysis for VMware ” data-reactid=”21″> Check out our latest analysis for VMware

The method

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 discount the value of these future cash flows to their estimated value in today’s dollars:

10-year free cash flow (FCF) forecast

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Present Value of 10-year Cash Flow (PVCF)= $30.41b” data-reactid=”28″>Present Value of 10-year Cash Flow (PVCF)= $30.41b

“Est” = FCF growth rate estimated by Simply Wall St

After calculating the present value of future cash flows in the intial 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 10-year government bond rate of 2.7%. We discount the terminal cash flows to today’s value at a cost of equity of 9.5%.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Terminal Value (TV) = FCF₂₀₂₉ × (1 + g) ÷ (r – g) = US$6.6b × (1 + 2.7%) ÷ (9.5% – 2.7%) = US$100b” data-reactid=”31″>Terminal Value (TV) = FCF₂₀₂₉ × (1 + g) ÷ (r – g) = US$6.6b × (1 + 2.7%) ÷ (9.5% – 2.7%) = US$100b

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Present Value of Terminal Value (PVTV) = TV / (1 + r)¹⁰ = $US$100b ÷ ( 1 + 9.5%)¹⁰ = $40.25b” data-reactid=”32″>Present Value of Terminal Value (PVTV) = TV / (1 + r)¹⁰ = $US$100b ÷ ( 1 + 9.5%)¹⁰ = $40.25b

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is $70.66b. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of $172.22. Compared to the current share price of $176.98, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.” data-reactid=”33″>The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is $70.66b. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of $172.22. Compared to the current share price of $176.98, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.

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Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 VMware 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 9.5%, which is based on a levered beta of 1.138. 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.