SAP is expensive because of positive outlook

The shares of SAP (SAP) are currently a bit richly valued. However, the current share price still provides an 8% annual return potential from this moment onwards.

Majority of investors are more likely interested in how the valuation and possible long-term return for a specific stock look like. Let us start with valuation first. I will not be delving into the current business situation of SAP as there are already plenty of excellent articles covering this topic. Personally, I prefer to keep my estimates as conservative as possible in order to avoid negative surprises. In case of SAP, if we were to assume the historical 10 year annual revenue growth of 8% and free cash flow (FCF) to sales ratio of 19% could be sustained in the future, we would arrive at a normalized free cash flow level worth of $4412 million. With the current amount of outstanding shares, this translates into roughly $3.6 per share. Just as a reference, the 20 year historical values for the annual revenue growth and FCF to sales have been 9.2% and 20% respectively. For 2017, analysts are expecting free cash flow per share of around $3.19 per share, which is more pessimistic than mine.

For simplicity’s sake, when estimating the current valuation, let us only use the Gordon formula. This formula is simply valuation = dividend / (required rate of return – growth). In this exercise, I will replace the dividend in the previous formula with free cash flow. This is because we do not care whether profits are distributed to shareholders via share buybacks or via dividend payments. If SAP would not grow at all, free cash flow would equal to net profit as there are no costs related to growth. In addition, if management has no growth projects in sight exceeding the company’s weighted cost of capital, all profits can be distributed to shareholders.

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