Zoom Video Communications (NASDAQ:ZM) stock has now shown that it can consistently produce large amounts of free cash flow (FCF).
If its upcoming results for the quarter ending Oct. 31 continue this trend, expect to see ZM stock much higher.
This possibility could not come at a more opportune time for the stock. Over the past seven months, ZM stock has drifted lower since it peaked at $444.51 as of Feb. 16. The stock trades today at around $267.
On Feb. 4, I wrote that ZM stock was likely overvalued given its valuation at the time, but now I’ve changed my mind, as I am impressed by the company’s huge and consistent FCF growth.
As a result, the market seems to see the same thing and the stock has bottomed out. It reached a trough of $263.55 on Oct. 6.
I now believe that ZM stock could be worth as much as 31.9% more at $352.18 per share.
Last quarter ending July 31, Zoom reported that sales rose 54% year-over-year (YoY) to $1.0215 billion. However, this was just 6.83% over the prior quarter sales.
Never mind, this slowing growth as FCF is now flowing straight to the bottom line in a significant way.
For example, last quarter its free cash flow was $455 million, as the company reported in its quarterly results statement. That represents 44.5% of its sales. This is a huge margin and shows that Zoom is now very profitable.
A Closer Look at Zoom
Over the past year, the company had an even higher FCF margin.
Seeking Alpha shows that the FCF it generated over the trailing 12 months (TTM) was $1.675 billion (i.e., $1.812 b operating cash flow minus $136.8m in capex).
As TTM sales were $3.637 billion, the TTM FCF margin was 46% (i.e., $1.675 b/$3.637b). In other words, the past year’s 46% FCF was higher than the most recent quarterly 44.5% margin, but this is still a very high rate.
In fact, if we use this rate and project it out for the next year, we can see where the free cash flow level will be going forward. Analysts now expect to see $4.73 billion by the end of Jan. 2023.
So if we apply the FCF 44.5% margin to this Zoom could produce $2.1 billion in FCF. We can use that to value ZM stock.
What ZM Stock is Worth
Despite the slowing sales growth, the market is now likely to realize that its huge FCF generation allows the company to have a higher valuation. For example, if we apply a 1.5% FCF yield to the Jan. 2023 forecast FCF, the result is a target market value of $140 billion (i.e., $2.1b/0.015=$140b).
This is over 75% higher than its market value today of $79.588 billion, according to Yahoo! Finance. They use the Refinitiv database to calculate market capitalization and it is usually the most accurate.
In fact, even if we use just a 2.0% FCF yield figure to value Zoom’s free cash flow, it results in a potential market cap of $105 billion (i.e., $2.1b/0.02). This is still 31.9% higher than today’s market value.
This implies that ZM stock is worth 31.9% more than its price today of $267.01 per share. That works out to $352.18 per share, up potentially 31.9% over $267.01.
What to Do With ZM Stock
Analysts are now even more positive on ZM stock. For example, Yahoo! Finance indicates that 20 analysts have an average target price of $374.40 per share.
This is higher than my $352.18 price target, but at least we both agree that the stock is significantly undervalued.
The same is true with Seeking Alpha’s compilation survey of 25 analysts whose average price target is $359.79. This is much closer to y $352 price target.
Any way you slice it, ZM stock looks to be undervalued now that it is consistently producing large amounts of free cash flow.
If this keeps up for the quarter ending Oct. 31, I expect you will see ZM stock start to approach my 32% higher price target of $352 per share.
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.
Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.
