Adobe (NASDAQ:ADBE) is the type of free cash flow (FCF) powerhouse company that I love to analyze since ADBE stock is likely to move much higher. This is based 0n the company’s consistently high FCF margins which seem to be sustainable. Moreover, the market is willing to value the stock appropriately based on its huge FCF production.
As a result, ADBE stock has skyrocketed this year. On Dec. 31, it was trading at $500.12., but by Oct. 25, it was at $646.97 per share, up 29.4% year-to-date (YTD). In fact, recently ADBE stock peaked at $665.11 on Sept. 16. This was after having reached a low of $421.20 on March 8.
However, now there is every reason that the stock will keep moving significantly higher. This is based on its recent fiscal third-quarter earnings.
Adobe’s Huge Free Cash Flow
On Sept. 23, the diversified software company produced excellent earnings for the fiscal Q3 for the quarter ending Sept. 3. Moreover, the company showed that its FCF hit $1.32 billion.
That works out to a FCF margin of 33.5% of its $3.93 billion in revenue for the quarter. That revenue was up 22% over the past year.
Moreover, Adobe’s 9 month sales were up 23.6% to $11.67 billion. But, even more important, the FCF margin for the past 9 months was $4.915 billion. This can be seen on page 9 of Adobe’s 10-Q filing of Sept. 29.
It shows that there was $5.164 billion in operating cash flow from which $249 million in capex spending is deducted to reach $4.915 billion in FCF. As a result, the 9 month FCF margin was 42.1% (i.e., $4.915 billion / $11.675 billion). That is even higher than the 3 month 33.5% FCF margin.
On average that works out to 40% for the full year ending November 2021 using Adobe’s own sales forecast for Q4.
Using FCF Yield to Value Adobe Stock
Moreover, we can use this to forecast the coming’s years FCF. For example, in two years, analysts forecast that revenue could hit $20.86 billion by the year ending November 2023. If we apply a 40% FCF margin to that number it equals $8.344 billion.
Using a 2% FCF yield to value the stock, this results in a target market value of $417 billion. This is seen by dividing $8.344 billion in forecast FCF by 2%.
The result, $417 billion, represents a 35.9% gain over today’s market value of $307 billion. This represents a stock price of $879.23 per share (i.e., $1359 x today’s price of $646.97).
Why did I use a 2% FCF yield to value ADBE stock? This is implied FCF yield today. For example, assuming Adobe makes a 40% FCF margin on sales of $15.76 billion, as forecast by analysts surveyed by Seeking Alpha, then FCF in 2021 will be $6.304 billion. That works out to 2% of the $307 billion market value today.
What to Do With ADBE Stock
The bottom line is that in 2 years the company will make $8.3 billion in FCF and that will make the stock market value worth $417 billion. That represents a price of $879.23 for ADBE stock. This is a 36% gain over today’s price.
That is a pretty good return for most investors. For example, even it takes one and half years for that to occur, the average annual compound return is 22.7% on an annualized basis. That is also a very good ROI.
Moreover, the stock return is likely to be much higher than this given that Adobe is now buying back large amounts of shares. For example, last quarter the company spent $1 billion in share repurchases, up from $500 million a year ago. This also can be seen in the cash flow report on page 5 of the company’s earnings release.
Annually that represents $4 billion of buybacks over the next year, or 1.3% of its $307 billion market value. That increases the annualized return to 24% (i.e., 22.7% +1.3%). Again this is very good ROI for most investors.
On the date of publication, Mark R. Hake did not hold any positions (either directly or indirectly) in any of the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.