Texas Instruments (TXN, Financial), a broad line semiconductor company, has been trading at a premium for the better part of the last five years. Thanks to the growth of the analog integrated circuits market, Texas Instruments is consistently trading at or around a price-earnings ratio of 20 based on trailing earnings.
The market, however, has gotten more complacent in pricing Texas Instruments lately as the trailing price-earnings ratio has jumped sharply since the beginning of the year. The Texas-based semiconductor company is now trading at a trailing price-earnings ratio of 28.4, up 42% over the last year. This calls for a review of growth prospects and valuation.
What’s driving the price-earnings ratio expansion?
One of the reasons for the expansion of price-earnings is the anticipated growth in the analog integrated circuit market. This market is set to grow at a compound annual growth rate of 6.9% between 2017 and 2022, the fastest among all the product categories. As Texas Instruments generates more than 60% of its revenue from the analog integrated circuits market, the industry growth forecast might have acted as the catalyst for stock price growth, resulting in price-earnings expansion.
IC Insights, however, forecasted the market would grow at an 8.9% rate between 2013 and 2018. Texas Instruments was trading around a trailing price-earnings ratio of 23 at that time.
This means that either the company's expanding price-earnings ratio might not be related to the anticipated growth in the analog integrated circuits market, or the market is getting sloppy in pricing one of the leading companies. The latter appears to be the case as the earnings growth rate has also been in decline for the past several years.
As illustrated in the chart above, while net income is witnessing growth, the rate of growth is declining. Note the decline in earnings growth is also contributing to the expansion of trailing price-earnings.
The most likely reason for the expanding price-earnings of Texas Instruments might be analysts’ bottom line consensus for the next couple of years. The Street is modeling for earnings per share growth of 25% and 10% in 2018 and 2019.
Moreover, earnings are expected to grow 13% per year over the next five years. Double-digit earnings growth potential might have catalyzed the stock price of Texas Instruments, resulting in the expansion of the stock’s price-earnings ratio. It’s worth mentioning the stock is priced at 20 times forward earnings, making it cheap on a price-earnings to growth basis.
In short, analysts’ earnings forecasts along with industry growth prospects are among the reasons the market is assigning a premium to Texas Instruments.
Is the price-earnings ratio premium justified?
Following a historical perspective, the current price premium can’t be justified. For starters, analog integrated circuit market growth has declined since 2013. The market is now expected to grow at a rate of 6.9% over the next five years, which is 200 basis-points lower than the yearly growth over the past five years. A higher price-earnings ratio now doesn’t make sense based on industry growth.
It can be argued that Texas Instruments managed to grow its revenue at a much higher rate than the industry in the past five years and, hence, the trend in industry growth doesn’t apply to the company. While true to some extent, this line of reasoning can’t discard the possibility of a correlation between the growth of the analog integrated circuits industry and the top-line growth of Texas Instruments. Nevertheless, earnings might grow at a higher rate than the industry growth amid cost controls. Therefore, a valuation approach is necessary to see whether the price-earnings premium is justified for Texas Instruments.
According to the economic value-added approach, including dividends, the stock is priced for perfection.
Assumptions include:
- Approximately 6.9% growth in earnings is assumed between 2020 and 2023, in line with the analog integrated circuit market forecast of mid-single-digit growth going forward.
- Analyst consensus earnings are used for 2018 and 2019. No growth is assumed in perpetuity.
- Cost of equity is calculated based on the CAPM, but market beta is used instead of Texas Instruments’ beta value to reflect the return foregone by investor due to investment in the company.
- Cost of equity is assumed to grow in line with the company's earnings.
- Dividends are assumed to grow 10% per annum between 2018 and 2023; 2% growth is assumed in perpetuity.
Value of Texas Instruments, excluding dividends
| Projections | Â | Â | 2018 | 2019 | 2020 | 2021 | 2022 | Perpetuity |
| Â | Â | Notes | Â | Â | Â | Â | Â | Amounts in million |
| Net Income | Â | Â | 5370.01 | 5909.95 | 6317.74 | 6753.67 | 7219.67 | 7717.83 |
| Â | Cost of capital | r*capital invested | 775.3 | 773.5 | 777.8 | 774.2 | 761.7 | 738.9 |
| Dividends | Â | Â | 2199.05 | 2418.96 | 2660.85 | 2926.94 | 3219.63 | 3541.60 |
| Discount factor | Â | Â | 1.00 | 0.93 | 0.87 | 0.80 | 0.75 | 11.52 |
| Economic Value Added | Â | Â | 2395.68 | 2527.88 | 2491.39 | 2457.17 | 2424.90 | 39597.89 |
| Â | Â | Â | Â | Â | Â | Market value added | 51895 | Â |
| Â | Â | Â | Â | Â | Â | Invested Capital | 10337 | Â |
| Â | Â | Â | Â | Â | Â | Value of the equity | 62232 | Â |
| Â | Â | Â | ` | Â | Â | Total Capital Value Per Share | $63.4 | Â |
The valuation sheet reveals the total capital value of Texas Instruments – the value excluding the value of dividends — stands at $63.4 per share. This is just one part of the valuation, however; dividends make up the second part of the valuation.
Value of dividends
| Projections, Amounts in million dollars | 2018 | 2019 | 2020 | 2021 | 2022 | Perpetuity | |||||||
| Dividends | Â | 2199.1 | 2419.0 | 2660.9 | 2926.9 | 3219.6 | 3541.6 | ||||||
| [email protected]% | Â | 1.00 | 0.93 | 0.87 | 0.80 | 0.75 | 11.52 | ||||||
| PV of Dividends | Â | 2199.1 | 2250.2 | 2302.5 | 2356.1 | 2410.9 | 40799.2 | ||||||
| Â | Â | Â | Â | Â | Total value of dividends | 52317.9 | |||||||
| Â | Â | Â | Â | Â | Value per share | $53.3 | |||||||
Note that the rationale for splitting the valuation between capital value and value of dividends is the difference of the cost of capital between the two approaches. A combined valuation would have resulted in a lower price for Texas Instruments amid higher cost of capital. As Texas Instruments is a dividend paying company, a split of valuation is a more appropriate approach. Overall, the value of the stock for investors is around $116.7 based on the assumptions presented above, translating into an upside of around 2%.
Takeaways
- Texas Instruments is trading around its fair value despite the increase in the price-earnings ratio over the last several months amid higher earnings growth potential.
- Dividends are also keeping the cost of capital low, resulting in a premium for the company.
- Nonetheless, the stock isn’t worth holding from a long-term perspective as it’s trading around its fair value. Dividend payments are also baked in as far as price is concerned.
- Unless something changes materially for Texas Instruments, there isn’t much upside left. Yield is effectively zero on current pricing as dividends will merely offset the deficit in capital value of the stock in the longrun.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
