Estimating the fair value of Arista Networks, Inc. (NYSE:ANET)

Key findings

• The estimated fair value of Arista Networks is $361 based on the 2-step free cash flow to equity
• With a share price of $348, Arista Networks appears to be trading close to its estimated fair value
• Analysts’ price target for ANET is $327, 9.2% below our fair value estimate.

How far is Arista Networks, Inc. (NYSE:ANET) from its intrinsic value? Using the most recent financial data, we will check whether the stock is fairly valued by projecting its future cash flows and then discounting them to today’s value. The Discounted Cash Flow (DCF) model is the tool we will use to do this. Don’t be put off by the technical jargon, the math behind it is actually quite simple.

Companies can be valued in many ways, so we would like to point out that a DCF is not perfect for every situation. If you want to learn more about intrinsic value, you should take a look at Simply Wall St’s analysis model.

Check out our latest analysis for Arista Networks

Processing the numbers

We use what is called a 2-stage model, which simply means that we have two different growth periods for the company’s cash flows. Generally speaking, the first stage is one of higher growth, and the second stage is one of lower growth. In the first stage, we need to estimate the company’s cash flows for 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 that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate, over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today. Therefore, the sum of these future cash flows is discounted to today’s value:

10-year free cash flow (FCF) forecast

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 33 billion US dollars

We now need to calculate the terminal value that takes into account all future cash flows after this ten-year period. For various reasons, a very conservative growth rate is used that cannot exceed a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.4%) to estimate future growth. In the same way as with the 10-year “growth” period, we discount future cash flows to today’s value, using a cost of equity of 6.6%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = 6.3 billion US dollars × (1 + 2.4%) ÷ (6.6% – 2.4%) = 152 billion US dollars

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 152 billion US dollars ÷ (1 + 6.6%)¹⁰= 80 billion US dollars

Total value is the sum of the next ten years’ cash flows plus the discounted terminal value, which gives the total value of equity, which in this case is $113 billion. To get the intrinsic value per share, we divide that by the total number of shares outstanding. Compared to the current share price of $348, the company seems roughly fairly valued at a 3.5% discount to the current share price. However, keep in mind that this is only an approximate valuation and as with any complex formula, where there’s garbage in, there’s garbage out.

The assumptions

The key inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. Part of investing is making your own assessment of a company’s future performance, so try the calculation yourself and check your own assumptions. DCF also does not take into account the potential cyclicality of an industry or a company’s future capital needs, and therefore does not provide a complete picture of a company’s potential performance. Since we are viewing Arista Networks as prospective 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 takes debt into account. In this calculation, we used 6.6%, which is based on a leveraged beta of 0.915. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies, with a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for Arista Networks

Go on:

Valuation is only one side of the coin in building your investment thesis and just one of many factors you need to evaluate for a company. The DCF model is not a perfect tool for stock valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to an undervaluation or overvaluation of the company. If a company grows differently or its cost of equity or risk-free rate changes significantly, the outcome can be very different. For Arista Networks, we’ve put together three key points to examine:

1. Risks: For example, we found 1 warning signal for Arista Networks that you should know.
2. management:Have insiders increased their shares to capitalize on market sentiment regarding ANET’s future prospects? Read our management and board analysis with insights into CEO compensation and governance factors.
3. Other high-quality alternatives: Like a good all-rounder? Explore our interactive list of high-quality stocks to get a sense of what else you might be missing out on!

PS The Simply Wall St app does a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks, just search here.

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This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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