Oracle (NYSE:ORCL) is a large $225 billion market capitalization enterprise cloud software company that is a virtual cash cow. But so far, ORCL stock does not seem to reflect its huge profitability. I estimate that ORCL stock is worth at least 30% more than its April 14 price of $76.78.
Last year, Oracle generated more than $12.8 billion in free cash flow (FCF). This represented 32% of its $39.69 billion in revenue. That is a very high FCF margin.
So Oracle is very profitable on a cash-flow basis. But ORCL stock does not seem to reflect its huge FCF profits.
ORCL Stock Free Cash Flow, Earnings and Valuation
For example, the company’s $12.8 billion in FCF represents about 5% of its $225 billion market capitalization. This is a very high FCF yield. Most other large software companies have FCF yields at least half of that level.
ServiceNow (NYSE:NOW) produced $1.367 billion in FCF compared to its $107.65 billion market value, or an FCF yield of 1.27%. This is just 22% of the ORCL stock FCF yield. In effect, Oracle’s price should be more than three times higher in order for it to have a similar FCF yield.
Therefore, if ORCL stock traded at a 50% lower FCF yield, its valuation would be $12.8 billion divided by 2.895%, or $442.14 billion. That is well above its present $225 billion market value.
The same is true with Oracle’s price-to-earnings (P/E). Analysts expect Oracle to make $4.48 earnings per share (EPS) this year and $4.79 next. This puts the stock on a P/E multiple of 17.1 times 2021 earnings and 16 times 2022. But Oracle’s peers have much higher P/E multiples.
Consider that VMWare (NYSE:VMW) trades for 23 times this year’s forecast earnings and 20 times next year. That represents a 30% higher valuation metric on average between the two years.
So based on its FCF yield, ORCL stock should be double its April 14 price, and based on its P/E it should be 30% higher. This averages out to a 65% higher price, or $126.75 per share.
The company’s latest earnings release seems to bear out a higher valuation. Oracle produced 20% higher non-GAAP net income in its fiscal third quarter. Moreover, subscription revenue now accounts for 72% of Oracle’s total sales. This helps make its net income more predictable and recurring in nature.
A Matter of Earnings
Oracle uses its free cash flow to benefit its shareholders. The company pays a healthy dividend and has a 1.67% dividend yield.
Moreover, the company bought back $18 billion of its own shares last year. That represents 8.1% of market capitalization. In other words, it reduced the share count by 185.2 million shares or 6%. This is effectively a return of capital to shareholders.
The reason is that by buying back shares, the company can both increase its dividend per share for the same amount of money since there are fewer shares outstanding. In addition, its earnings per share increase since there are fewer shares outstanding.
But this only works if the price-to-earnings ratio increases. ORCL stock has not risen enough to raise its price-to-earnings ratio given its growth rate and its lower number of shares outstanding.
Measuring ORCL Gain
Let’s assume that it takes three years for the stock to reflect the 65% higher stock-price target. That means that the average annual gain in the stock will be 18.2% annually. This is a decent return for most investors. If it takes just two years, the average annual return will be 28.45%.
The total return will be even higher. Over three years, including the dividend yield, the stock will return 19.87%. Over two years, ORCL stock will have a total return of 30.1%. And this still does not include the effect of the company’s buybacks. That would add another 6% to the total yield.
Therefore, the total yield return will be 24.2% annually over three years (i.e., 18.2% plus 6% buyback yield), or 36.1% annually over two years. These are very good prospective ROIs for most investors.
On the date of publication, Mark R. Hake did not hold a long or short position in any of the securities in this article.
Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.
