Oracle (NYSE:ORCL) stock looks even more undervalued than it did in April. At the time, I said this cloud software company was worth at least 30% more than its April 14 price of $76.78. That put the value of ORCL stock at about $100 per share. Today, with its Q4 free cash flow (FCF) up 19% year-over-year (YOY), expect to see ORCL stock rise 34.5% to $118 per share.
Oracle is a cash-flow powerhouse. But so far, ORCL stock does not seem to reflect its huge cash-generating abilities.
Here is how I estimated its target value: I used its historical FCF margins to forecast its FCF going forward. Then, I applied that figure to a credible FCF yield metric to obtain its target value.
Estimating Oracle’s FCF and FCF Margins
On June 15, the company released its fiscal Q4 and full-year earnings statement for the period ending May 31. It showed that revenue grew 8%, mainly from activities pertaining to its cloud services and licenses. Its net income was up 11% on a non-GAAP basis for the fiscal year.
FCF was $13.752 billion, up 18.8% from $11.575 billion the year before. I like to use FCF as a measure of a company’s profitability. It cuts through all the nonsense and accounting figures that companies use to camouflage their performance. FCF is what a company uses to pay its dividends, cut debt and buy back stock. Without FCF, none of these can happen easily.
In the 2021 fiscal year, the company produced a high FCF margin. Its Q4 FCF was 100% of net income and represents 34% of its $40.479 billion in total revenue for the year. That is an extremely high margin. Last year, its margin was just 29.6%.
This is is slightly better than some of Oracle’s peers. For example, ServiceNow (NYSE:NOW) has a 32.65% FCF margin based on its historical trailing 12 month (TTM) FCF in Q1. Its FCF of $1.5783 billion divided by its sales of $4.8335 billion is 32.65%.
Valuing ORCL Stock Using FCF Yield
We can use this margin to estimate Oracle’s FCF going forward. Analysts surveyed by Yahoo! Finance forecast sales will hit $42.25 billion in the year ending May 31, 2022. If we apply Oracle’s historical 34% FCF margin, we can estimate that FCF will hit $14.465 billion. This is 6.6% more than its FCF last year. Now, we can use that figure to value ORCL stock.
Right now, Oracle has a market capitalization of $238.97 billion. Since it made $13.572 billion in FCF, this works out to an FCF yield of 5.67%. However, this yield is too cheap given its FCF profitability.
For example, ServiceNow produced $1.5783 billion in TTM FCF compared to its $110.66 billion market value. That works out to an FCF yield of 1.43%. And don’t forget that Service Now had a slightly lower margin than Oracle in the last 12 months. Therefore, ORCL stock should have an FCF low closer to 1.43% rather than its 5.67% FCF yield today.
However, VMWare has a slightly higher FCF yield. Its TTM FCF in Q1 was $3.989 billion, compared to its present market capitalization of $66.28 billion. That works out to an FCF yield of 6%. The average of these two Oracle peers is an FCF yield of 3.715%.
ORCL Stock’s Current Value
We can use this 3.715% average FCF yield to value ORCL stock. Let’s divide its forecast May 2022 FCF of $14.465 billion by 3.715%. That works out to a market value of $389.37 billion. This implies a potential upside of 62.9% in ORCL stock over its $238.97 billion market cap. That means its price target is around $142.96 based on yesterday’s closing price of $87.76.
In fact, even if we use a higher FCF yield of 4.5%, the target market works out to $321.44 billion. That is still 34.5% more than its current market cap. This means a conservative valuation for ORCL stock is $118 per share, up 34.5% from yesterday’s price.
On the date of publication, Mark R. Hake did not hold a position in any security mentioned in the article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.