Adobe (NASDAQ:ADBE) stock is currently undervalued, and investors who buy it now could achieve a 25% compound annual growth rate in price over the next two years, based on my valuation model. In addition, the margin of safety for investment appears to be around 17%. Not only does Adobe offer a strong two-year value trade, the investment is supported by a robust operational profile. The company has a high chance of enduring growth, supporting returns even in the case of lower market sentiment on the stock remaining constant throughout the two-year period in my model.
Operations & financialsFirstly, we should assess the opportunity at hand here. Adobes stock price declined significantly recently as the companys guidance for Fiscal 2025 fell below market expectations. The company projected annual revenue of between $23.30 billion and $23.55 billion, compared to analysts estimates of $23.78 billion. This near-term moderation in the growth outlook has been a significant factor in opening up what I consider a great value opportunity for investors.
In addition, several investment banks have lowered their price targets, including Deutsche Bank (ETR:DBKGn) (DB) and UBS (UBS). This has been the result of concerns of competition in key markets reducing overall growth from AI initiatives. However, it appears expectations were too lofty to begin with, rather than Adobes operational strength and growth horizon being notably weak. As such, I think negative sentiment at the moment is overblown.
The company has a dominant position in the creative and document software markets. It potentially has around an 80% market share in creative software based on my research, which is particularly remarkable. This is supported by world-class design software, including flagship products like Photoshop, Adobe Express, Illustrator, After Effects, and Lightroom.
Though growth may be slower in the next few years than many analysts initially expected, I believe it is safe to assert that growth will indeed continue. This is the key point, and any moderation in the companys valuation multiples will likely be offset significantly by this growth in the next 18 months or so.
In addition, while there have been concerns with how much Adobe Firefly (the companys family of generative AI models) will drive growth within the company, it will certainly provide customer retention benefits for those already using the platform, and I believe likely continue to sustain growth through word of mouth and opening up a new audience of designers that can rely on automated software rather than innate technical skill.
Adobes three-year revenue growth rate is 13.3%, but its future three-year revenue growth rate consensus estimate is lower, at 9.61%. Adobes three-year EPS without NRI growth rate is 13.9%, but its future three-year EPS without NRI growth rate is a little lower, at 11.89%. However, the companys price-to-sales ratio is down from 12.5 as a 10-year median to 8.6 today. In addition, the companys price-to-earnings ratio is down from 51 as a 10-year median to 33.3 today. This represents a substantial valuation contraction that is much more validated by revenue growth reduction rather than earnings growth reduction. As earnings are more likely to drive overall sentiment over time, this is the foundation for my bullish outlook on Adobe stock.
ValuationFor my valuation model, I will be using a period of two years, because I estimate that this is all the time needed for the stock price to recalibrate to fair value.
Adobe has trailing 12-month revenue of $21.5 billion. I conservatively forecast that this will grow to $26 billion by January 2027. To be conservative, I used the companys 10-year median net margin in my model, which is 27%. The result of this is a net income estimate of $7 billion for Adobe in January 2027.
The companys diluted average shares outstanding have decreased at a -1.5% compound annual decline rate over the past five years due to share buybacks. If this trend continues over the next two years, the company will have 430 million outstanding shares, given current trailing 12-month shares of 443 million. Therefore, I forecast that the company will have a diluted EPS of $16.30 in January 2027.
I mentioned that the companys price-to-earnings ratio has contracted significantly from its 10-year median of around 50 to just under 35 today. To be conservative, I take just below the midpoint of these figures, 40, for my terminal multiple. The result is a stock price target of $650 for Adobe in January 2027. The current stock price is $415, so the implied two-year compound annual growth rate is 25%. This is an excellent return prospect.
Adobe's weighted average cost of capital is 14.12%, with an equity weight of 97.15% and a debt weight of 2.85%, based on a cost of equity of 14.45% and an after-tax cost of debt of 2.57%. When discounting back my January 2027 price target for Adobe stock over two years using the companys weighted average cost of capital as my discount rate, the implied intrinsic stock value is $500. This indicates a margin of safety for investment of 17%.
RisksThe greatest threat here to the two-year thesis is if Adobe keeps reporting guidance lower than analysts consensus expectations. This could result from a diversifying software market that is being penetrated by cheaper coding teams reliant on AI to reduce operational expenses and the costs charged to consumers. It is inevitable that as AI capabilities scale the original software manufacturers will find there is more competition in the market due to the accessibility and ease of practical application of world-class automated code. However, I expect that this will take at least five to 10 years to be noticeable, and Adobe will actually gain many of the accretive benefits from AI in the interim as customers seek new generative AI tools in creative workflows.
Of course, there is also no guarantee that Adobes price-to-earnings ratio will rerate to 40. In a bear-case outcome at a price-to-earnings ratio equal to currently, the stock will likely have a price of around $570 in January 2027. This indicates a compounded annual return over two years of just 11%. I find this unlikely, and even in this instance, one has achieved the same returns as the S&P 500 (SPY (NYSE:SPY)) usually does in an average year. So the risk-to-reward profile here is very strong, and such sensitivity analysis actually reaffirms my bullish outlook on Adobe stock. That said, because of the potential for only moderate returns, my rating is a Buy, not a Strong Buy.
ConclusionAdobe stock is one of the stalwarts of the tech industry, and the current weakness in sentiment offers a value opportunity worth capitalizing on. In my reasonable and conservative valuation model, the stock price will rise to about $650 by January 2027, aligning with a compound annual growth rate of 25% from the present price of $415 in January 2025. I am bullish on the company operationally, and have personal experience with its products. Given my confidence in the quality of the business, I feel even more secure in my outlook that Adobe stock is currently a remarkably strong value opportunity.
This content was originally published on Gurufocus.com
