Earnings Watch: Will the Adobe money machine continue?

We have long wanted to write about growth decay concepts and equity valuations, and now is a good time and Adobe is a great example. Many variables influence the value of a business but for a high growth company the key is the growth decay, which is how fast and at what level revenue growth will stabilize? The second key variable is what the free cash flow generation profile will be like. For our example and with the knowledge we have today about the industry, Adobe’s market position, and the current trajectory of revenue and free cash flow, the table below shows a likely projection of Adobe’s business until 2028.

Source: Bloomberg and Saxo Group

In our example we are modeling a gradual decline in the revenue growth stabilizing around 5% in 2028 and the free cash flow generation on revenue increasing from 41% in 2020 to 45% in 2024 and stabilizing. Under these assumptions, revenue will grow to $29.4bn and free cash flow to $13.2bn in 2028. What is a business of this kind worth in 2028 and what does that translate into in terms of expected returns? The free cash flow in 2028 will have to have a discount factor and for equities this is basically the required rate of return, which is the sum of the risk-free rate and an equity risk premium.

On various scenarios for the US 10-year yield and the equity risk premium we get a range of possible annualized returns from the current market value in March 2021. In the one extreme we get a high 30.5% annualized return over until 2028 if our assumptions come true and the US 10-year yield and equity risk premium collapses to 0.5% respectively, and -0.4% annualized if the equity risk premium goes to 3.5% and the US 10-year yield goes to 3%. What is the equity risk premium likely to be in 2028? The historical average for US equities has been around 5% but the nature of Adobe’s business and the predictability of cash flow means that it should be lower. Somewhere between 2-4% is not unreasonable. The example is not to provide an investment recommendation of Adobe but to show how various assumptions and changing their values produces an outcome matrix that can be used for decision making.