Arista Networks (NYSE:ANET), a fast-growing cloud software services company, produced stellar results for its third quarter ending Sept. 30. However, despite what some analysts think given its already-high valuation, ANET stock could still rise higher.
Arista Networks produces cloud networking solutions for corporate America. In this regard, it is sort of like Cloudflare (NYSE:NET), but with a much more profitable operation.
For example, revenue in Q3 rose 23.7% to $748.7 million year-over-year (YOY). This was also 5.8% higher than last quarter. But more importantly, its gross margins are very high at 64.9% on a non-GAAP basis. This shows that the company’s software and server solutions for the cloud have pricing power.
Arista Networks’ Huge Profitability and Cash Flow
Everything else falls into place after that, in terms of profitability. For example, its operating income was $233.3 million. That represents a huge 31.1% of its revenue for the quarter. That shows the company is very profitable on an operating basis.
In fact, if you look at its cash flow statement, you see the same things. For the nine months ending Sept. 30, cash flow from operations was $790.6 million. This can be seen on page seven of its latest 10-Q filing. After deducting $55.5 million in capital expenditures, its free cash flow (FCF) works out to $735.1 million, or 34.6% of its $2.124 billion in nine-month sales.
That is a very high FCF margin. In fact, we can use that to estimate the company’s valuation going forward.
For example, 22 analysts estimate that sales will rise more than 29% to $3.76 billion by the end of 2022, according to Seeking Alpha. We can use this estimate to derive an FCF estimate for next year.
To be conservative, let’s use a 34% margin (rather than 34.6% from the last nine months) against that $3.76 billion sales forecast. That results in an FCF estimate of $1.278 billion for 2022.
Valuing Arista Networks Stock
This can lead us to the value of Arista Networks stock. For example, using a 3% FCF yield metric, we can derive a target market cap of $42.6 billion. That is about 10% higher than today’s market cap of $38.8 billion.
However, since the company is so incredibly profitable with its 34% FCF margins, we should use a higher metric. For example, if we were to use a 38 times FCF multiple (the same thing as a 2.63% FCF yield metric), the resulting target market cap is $48.564 billion.
That can be seen by multiplying $1.278 billion in FCF for 2022 by 38, the FCF multiple, or dividing $1.278 billion by the 2.63% FCF yield.
This results in a $10 billion higher target market compared to a $38.8 billion market cap today. That’s a 25% higher price for Arista Networks, which means its target price is $160.95 per share based on its Dec. 9 price of $128.66.
Where This Leaves Investors in ANET Stock
Some analysts think that at 37 times forward earnings (using Seeking Alpha’s price-to-earnings measures), ANET stock is too expensive. For example, one analyst at Seeking Alpha noted the company had “great execution, but valuation is a constraint.”
We have shown, however, that the company enjoys great profitability and huge margins. Moreover, using conservative free cash flow margins and a reasonable multiple, it looks to be at least 25% undervalued.
However, most analysts do not agree with me. For example, TipRanks reports that 15 Wall Street analysts have provided 12-month price targets on ANET stock in the last three months. Their average price target is just $134.37, or just 4.44% over yesterday’s price.
So, you can believe these analysts or you can look at my analysis, which shows the company’s profitability deserves a very high rating. I suspect that over the next 12 months, these analysts will have to raise their price targets.
On the date of publication, Mark Hake did not hold (either directly or indirectly) any positions in 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.