SAP (New York stock market :New York Stock Exchange: SAP) is one of the world’s largest software providers and the company is considered by many investors to be a must-have blue chip company in Europe. However, the company’s shares have significantly underperformed the market, down around 35% year-to-date. against a loss of around -14% for the Dax 40 (relevant benchmark).
Is the liquidation of SAP against the overall market justified? Or does the company’s current valuation imply an attractive buying opportunity? Personally, I believe the latter to be the case, as I argue in this article.
I value SAP based on a residual income model – backed by consensus analyst forecasts through 2025, an 8% WACC and a terminal growth rate equal to expected nominal GDP growth. My base target price is $110.18/share, which implies an upside of about 25%.
SAP is a leading global software company headquartered in Germany. The company develops and markets enterprise software systems for the digitized management of business operations and is the world’s largest provider of ERP (enterprise resource planning). the company’s flagship product, SAP S/4 HANA, has more than 20,000 customers worldwide, including leading multinationals such as Microsoft (MSFT), LVMH (OTCPK: LVMUY), Kyndryl (ex IBM) and Moderna (MRNA).
Notably, SAP is the largest non-US software company. In 2021, the company recorded $31.7 billion in total revenue and $5.98 billion in net earnings, or 5.07/share. SAP’s mission is:
to help the world run better and improve people’s lives. Our promise is to innovate to help our customers perform at their best. We design solutions to fuel innovation, foster equality and spread opportunity across borders and cultures.
Steady growth and accumulation of value
In recent years, international investors have viewed SAP as a stable blue chip German company, providing investors with steady business growth and value accumulation. From 2015 to 2021, SAP’s revenue grew at a 6-year CAGR of over 6%, from $22.6 billion to $32.7 billion. Respectively, net income available to shareholders increased by a CAGR of more than 7%, from $3.97 billion in 2015 to $5.98 billion in 2021.
Despite a very difficult macro-economic context, SAP has also achieved quite good results since the beginning of the year, generating approximately $15.7 billion in revenue while defending an operating margin above 25%.
SAP’s balance sheet raises no red flags and therefore I view the >2% dividend yield as sustainable: In Q2 2022, SAP recorded $8.9 billion in cash and short-term investments term and a total debt of $14.5 billion. In 2021, cash from operations was $7.1 billion.
Cloud business could offer benefits
A key argument for investing in SAP is the acceleration of the company’s cloud business, which I think the market has long underestimated. Notably, SAP’s cloud business has grown at a CAGR of around 20% since 2020 and is now targeting 50% of the company’s total revenue exposure.
Against the backdrop of accelerating cloud activity, analysts forecast that for 2022, 2023 and 2024, SAP could generate revenues of around $30.9 billion, $33.1 billion and $36 billion respectively. This would indicate a CAGR of around 7%, roughly double the expected global nominal GDP growth for the same period.
In my view, SAP’s continued cloud expansion will be the main catalyst that will help SAP stock appreciate closer to its fundamental value, as calculated in the next section.
Valuation of residual profits
Now let’s look at the valuation. What might be the fair value per share of the company’s shares? To answer the question, I built a residual income framework and anchor on the following assumptions:
- To forecast EPS, I rely on analyst consensus forecasts available on the Bloomberg Terminal through 2025. In my opinion, any estimate beyond 2025 is too speculative to be included in a valuation framework.
- To estimate the cost of capital, I use the WACC framework. I model a three-year regression against the DAX 40 to find the stock’s beta. For the risk-free rate, I used the yield on 10-year US Treasuries as of August 5, 2022. My calculation indicates a fair required return of about 8%.
- To derive the tax rate from SAP, I extrapolate the 3-year average effective tax rate from 2019, 2020, and 2021.
- For the terminal growth rate, I apply 2.5% percentage points. That’s slightly lower than global nominal GDP growth, which I think is a very conservative assumption.
Based on the assumptions above, my calculation returns a base target price for SAP of $110.18/share, implying a significant upside of around 25%.
I understand that investors may have different assumptions regarding the required return from SAP and the growth of the terminal business. Thus, I am also attaching a sensitivity table to test different hypotheses. For reference, red cells imply overvaluation relative to the current market price, and green cells imply undervaluation.
I would like to highlight two key risks for investors interested in buying SAP stock. First and foremost, I would like to highlight the difficult macro-economic environment in Germany and Europe. That said, should the macro outlook deteriorate significantly, investors’ expectations for SAP’s earnings outlook should be adjusted accordingly.
Second, I argue that investors should be aware that SAP has significantly underperformed its US peers, notably Microsoft. And honestly, it’s hard to say that SAP will perform better in the future. Therefore, if an investor is looking for software and cloud exposure, Microsoft might be the best long-term bet.
Third, note that much of SAP’s current stock price volatility is driven by investor sentiment toward risky assets and stocks in general. Thus, investors should expect price volatility even if SAP’s fundamental business outlook remains unchanged.
As a multinational software company, SAP may not be a close competitor to the ubiquitous US FAAMG companies, but I think investors might appreciate buying some geographic exposure to a German software company – appreciating the opportunity to diversify away from the American orientation. Additionally, SAP stock could be an attractive buying opportunity given its relative undervaluation against its financial values. Personally, I value SAP at $110.18/share and see around 25% upside.