Advanced Micro Devices (NASDAQ:AMD) is now producing large amounts of free cash flow (FCF). This is apparent from its latest second-quarter results for the quarter ending June 26. As a result, AMD stock is likely to move up to 16% higher to $120 per share. This article will explain how I came up with that estimate.
This is a change for me since in the past I wrote that AMD stock looked overvalued with its high P/E ratio. But the Q2 results revealed AMD had two strong quarters producing high levels of FCF and a high FCF margin.
The net result is that despite the recent downdraft in AMD stock, investors now have a chance to buy into a strong FCF producer at a relatively reasonable valuation. Let’s look into this.
Estimating FCF Going Forward
Fortunately, on page 10 of the July 27 earnings press release, AMD calculates its own free cash flow figures. It seems that most high-tech companies that are doing well with FCF production always produce these figures. In fact, on page 11, the company shows how it derived the FCF figures.
For example, in the middle of page 10, you can see that in Q2 2021 AMD made $888 million of FCF. This compares to $152 million last year. Moreover, in Q1 2021 its FCF was also strong at $832 million.
To put these figures in perspective, let’s calculate AMD’s FCF margin (i.e., FCF dividend by sales). For example, in Q2 AMD made $3.85 billion in total net sales. Therefore its net margin was 23% (i.e., $888m/$3,850m). This is slightly lower than the FCF margin in Q1, but we can use this to estimate the company’s ongoing FCF.
Later in the press release, AMD estimates that its 2021 revenue will be 60% higher than last year, putting it at $15.616 billion, 60% over its $9.76 billion last year. But analysts now project $15.68 billion in sales for 2021 and $18.12 billion in sales for next year.
Therefore, if we use the 23% FCF margin metric, we can estimate that on a pro forma run-rate basis, FCF will reach $3.606 billion in 2021. By 2022 FCF can be forecast as $4.168 billion. This assumes that the FCF margin stays stable. However, it is likely to dramatically rise with higher revenue. This is because capex spending does not tend to rise at the same rate as sales growth. So it is very possible that FCF margins could reach 25% to 30% by 2022. But to be conservative, let’s stick with the 23% margin.
Estimating AMD’s Valuation Going Forward
One way I like to value FCF-positive high-tech stocks is an FCF yield metric. For example, we can divide AMD’s forecast FCF of $3.6 billion by yesterday’s market cap of 125.86 billion. This results in an FCF yield today of 2.865%.
If we apply this metric to the forecast 2022 FCF figure of $4.168 billion (i.e., dividing $4.168b by 2.865%), we get a target market cap of $145.48 billion. That implies a potential upside of 15.59% for AMD stock. This, in turn, leads to our forecast price of $120 per share (based on yesterday’s price of $103.88).
Keep in mind that if the FCF margin rises just slightly to 25%, the price target moves quite a bit. For example, with a 25% margin, FCF will reach $4.53 billion. And at a slightly more favorable FCF yield of 2.50%, the market cap could jump to $181.2 billion. This is 44.0% over today’s $125.86 billion and works out to a target price of $149.59. As FCF margins improve, this could lead to an improved FCF yield and a significantly higher price.
What To Do With AMD Stock
My baseline estimate is that AMD stock will rise to at least $120 per share and could reach as high as $150 or so within the next year. However, other analysts’ estimates are not as cheery as mine. Seeking Alpha indicates that the average target price of 38 analysts is $112.52, and TipRanks.com says 15 analysts have a $116.21 price target on average.
However, I have shown that just a simple FCF margin model along with a reasonable FCF yield metric can produce huge upside for AMD stock. It all depends on the company’s forecast of higher sales and reasonable levels of capex.
As a result, I think investors might want to begin taking a position in AMD stock. Keep in mind though that it is unusually volatile and could result in having to average down in a position.
On the date of publication, Mark R. Hake did not (either directly or indirectly) own 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.