Ambarella, Inc. (NASDAQ:AMBA)’s intrinsic value may be 47% above its share price

Key findings

• The estimated fair value of Ambarella is $83.67 based on 2-step free cash flow to equity
• Ambarella’s share price of $57.03 suggests the company may be undervalued by 32%
• The analyst price target for AMBA is $72.29, 14% below our fair value estimate.

In this article, we will estimate the intrinsic value of Ambarella, Inc. (NASDAQ:AMBA) by taking the expected future cash flows and discounting them to their present value. To do this, we will use the Discounted Cash Flow (DCF) model. It doesn’t actually take too much to do, even though it may seem quite complex.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without its flaws. If you still have some burning questions about this type of valuation, take a look at Simply Wall St’s analysis model.

Check out our latest analysis for Ambarella

What is the estimated value?

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) = 831 million 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 8.5%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = $347 million × (1 + 2.4%) ÷ (8.5% – 2.4%) = $5.8 billion

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 5.8 billion US dollars ÷ (1 + 8.5%)¹⁰= 2.6 billion US dollars

The total value or equity value is then the sum of the present value of future cash flows, which in this case is $3.4 billion. The final step is to divide the equity value by the number of shares outstanding. Relative to the current share price of $57.0, the company appears quite undervalued at a 32% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it is better to consider this as a rough estimate that is not accurate to the last cent.

The assumptions

The key inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don’t agree with these results, try the calculation yourself and play with the assumptions. The DCF also doesn’t take into account the potential cyclicality of an industry or a company’s future capital needs and therefore doesn’t provide a complete picture of a company’s potential performance. Since we consider Ambarella 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 takes debt into account. In this calculation, we used 8.5%, which is based on a leveraged beta of 1.320. 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 Ambarella

Looking ahead:

Although the DCF calculation is important, ideally it should not be the only analysis you look at for a company. It is not possible to get a foolproof valuation using a DCF model. You should rather apply different cases and assumptions and see how they affect the valuation of the company. For example, slightly adjusting the terminal value growth rate can change the overall result dramatically. Can we find out why the company is trading at a discount to intrinsic value? For Ambarella, there are three key factors you should investigate further:

1. Risks: For this purpose, you should consult the 3 warning signs we discovered Ambarella.
2. management:Have insiders increased their shares to capitalize on market sentiment regarding AMBA’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 runs a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks, just search here.

Do you have feedback on this article? Are you concerned about the content? Get in touch directly from us. Alternatively, send an email to editorial-team (at) simplywallst.com.

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.

Do you have feedback on this article? Are you interested in the content? Contact us directly. Alternatively, send an email to [email protected]