Tuesday, November 13, 2007

Adobe (ADBE) Valuation

It is always fun to put your independent value on a stock and compare it to the current selling price. More than just fun, it is the way smart investors make money. Today I'll be looking at Adobe Systems Incorporated (ADBE). I have never owned Adobe stock though I have followed it for a while. What Adobe reports in its quarterly analyst conferences (see my Adobe summaries) does give insight into some of the stocks I do own and the health of the technology sector in general.

Adobe is on a different fiscal year than most companies. Its third fiscal 2007 quarter ended August 31, 2007, and it released the results for the quarter and held the analyst conference on September 17, 2007. That means the current quarter will end November 30th, which is soon, and the conference will be in mid-December.

Revenues for fiscal Q3 were $852 million, up 14% from Q2 and up 41% from year-earlier. Net income was $205 million, up 35% sequentially and up 117% from year-earlier.

So if you like to draw straight lines, you might guess that in fiscal 2008 Q3 will generate some well over $400 million in net income, and in 2009 $600 million. Of course you can also use the same percentage increase each year, which gives well over $800 million.

Multiply those numbers out by 4 to get annual net income, and you get $1.6 billion in 2008 and either $2.4 billion or $3.2 billion in 2009. Adobe looks like a gold mine. Therefore, the bulls would argue, it deserves a stock price that gives a high price-to-earnings (PE) ratio, if you base it on past earnings.

Right this moment Adobe is having a bad day. It is priced at $39.72 and its resulting market capitalization (number of shares x price) is $23.4 billion. Its Nasdaq page gives it a trailing PE of 27.4.

Trailing earnings, the total of the past 4 reported quarters, are lower for a growing company than what you get if you multiply the recent, highest quarter by 4. Hoping that the future is always onward and upward, or at least flat, take the annual rate based on 4 x $205 million or $820 million. Divide that into today's market capitalization and you get - 28.5. So invert 28.5 for the rate of return of earnings on what you pay for a share of stock. The result is 3.5%.

You can do better than 3.5% on a CD. But suppose we look further out, using the most optimistic assumption based on recent data. Suppose fiscal 2009 net income is really $3.2 billion. What then. Why, at todays price and market capitalization, the PE ratio would be an ultra-low 7.3 and the earnings on your hard-saved dollar would be 13.7%. That does look like a gold mine.

Which is why valuing stock is such an art. If there is a recession or depression, Adobe won't be seeing $3.2 billion in net income in 2009. If some other company brings out a new product that cuts heavily into one of Adobe's lines, growth could slow down. On the other hand if all the new designers in India and China decide they need Adobe's software and actually pay for copies instead of pirating it, the $3.2 billion mark could be passed easily.

I prefer to go on conservative assumptions. Adobe has had periods of rapid growth and of slow growth in the past. This year new versions of old products were introduced, and that tends to give a burst of speed. If I had to choose a number rather than a range of numbers, I would actually do more research, but for this blog I'd say expect about 20% growth in revenues in Q3 fiscal 2008 over Q3 fiscal 2007.

A useful benchmark is that a PE of 20 is a return of 5%. Me, I like some of those earnings returned in dividends, which may seem old-fashioned but which tends to preserve stock prices in general market downturns.

If I were actually thinking of buying or selling Adobe I would do a lot more research and number play. But this is just an exercise, or a screening that I would do to many stocks before choosing one or more to invest in.

I'd saw that a PE of 30 is in the ballpark for Adobe. So today it is somewhat undervalued by my standards. That, I believe, is mainly because the market as a whole has been weak lately. I believe most tech stocks, excluding Apple, Google, and a few other high-flyers, are at least slightly undervalued right now. That is based on my macroeconomic assumption that the risk of an actual recession in 2008-2009 is low, the risk of a depression is near zero, and in fact the most likely scenario is slow growth in Q1 of 2008, then some acceleration in 2008 as people begin to build and buy houses again.

Truthfully, the best bargains right now are probably in real estate, not the stock market. However, an ordinary investor can get much better diversity in the stock market. For an ordinary investor buying a single piece of real estate is putting a lot on a single roll of the dice, as many ex-flipper found out this year.

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