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👋 Introduction

Hello readers! We’re picking back up with ASML, a Netherlands-based equipment manufacturing company that supplies TSMC and other chip foundries with the machines needed to print ever-smaller transistors on the latest GPUs. Get up to speed with the previous three articles:

• Understanding the industry

• Understanding the product

• Understanding the financials

What did we learn? ASML builds a lithography machine that uses extreme ultraviolet light (EUV), a feat of engineering that many scientists and engineers thought was impossible. The EUV machine is required for foundries to be able to print 7 nm and smaller chips, and is therefore widely credited with having saved Moore’s Law. ASML’s monopoly has driven a lot of revenue growth, but there are questions about the future of both its products and its sales.

Today is the final article on ASML. I’ll see if the market is offering a fair price, and make a decision on the investment opportunity.

Let’s dive in!

Understanding the valuation

As mentioned in last week’s article, please use the glossary if you have any confusion over terms I use below. Everything is explained using common sense terms.

What is the company valued at?

The total market capitalization of ASML is $314 billion, good for 29th biggest company in the world. That feels about right to me, given its importance in the modern digital economy. It’s not too high that feels overhyped, but it’s not too low that it feels ignored either.

Interestingly, the company has lost 32% of its value in the last two months. On July 12th, it reached its all time high with a market cap of over $460 billion. With the AI and semiconductor sell-off that’s been going on during the summer, ASML has seen its market cap drop.

What do the price ratios say about the premium we’d be paying?

The price-to-earnings (PE) ratio has been between 20 and 50 over the last 6 years, which is a pretty big window. It peaked in 2020, and ended 2023 with the lowest multiple (35) that it’s been in 5 years. But it has increased since then, and in spite of the recent drop in share price, it still sits at a PE of 43x. That’s pricey. Compare that to Canon at 17x or Nikon at 17x, or even the historical average of the S&P500 at around 25x.

The price-to-cash-flow (PCF) ratio recently peaked at 80x after 2024 Q1, which isn’t surprising. We saw how cash flow has decreased significantly lately; with the share price not decreasing, the unavoidable outcome would be a PCF multiple that explodes through the roof. During the summer downturn, the PCF has reduced to 58x, but that’s still a high premium to pay. Compare this to Canon’s 9x or Nikon’s 11x.

Let’s see if adjusting for growth tells a different story.

How about the growth-adjusted PE?

Unlike for previous companies, the price-to-earnings-to-growth (PEG) ratio for ASML isn’t simple to calculate. First, there’s a range of projected earnings to sift through. Second, it’s hard to choose a growth rate because of the recent financial volatility that we discussed last week. I decided to handle this by running a number of scenarios, and then taking the median of the results:

For reference, ASML’s 3 year average earnings is $18. And their 6 year CAGR is 23.7%.

If we get the high earnings plus high growth scenario, then a PEG of 1.15 is great (remember, a PEG of 1 means a company is fairly valued). Things are easy in that scenario! But on the other end of the spectrum (low growth and low earnings), I’m looking at a serious overpay.

The median of these six scenarios is a 1.95 PEG multiple. Not bad, not great. Certainly not as much of an overpay as the PE or PCF ratios indicated, but not in no-brainer territory either.

That seems to be the theme of ASML as we continue to dive deeper.

What are possible outcomes in a DCF analysis?

Once again, the free cash flow volatility complicated the calculations.

I couldn’t simply extrapolate from the last year, because that would have shown negative growth, a trend that is unlikely to continue. Nor could I ignore the downturn, and assume that record-setting growth would continue for a decade.

Similar to the PEG, I analyzed 7 different periods of FCF growth. Some are overlapping, some are distinct, but I was trying to calculate the growth across different time periods. I then used the median range as inputs to various scenarios in my DCF analysis.

If all of that sounds complicated, it basically means this: I tried to estimate (as best as I could) the free cash flow growth to use for the DCF analysis. Then I ran a handful of scenarios, as I usually do.

Those are some pretty good outcomes! For the first time, even the most conservative outcome doesn’t result in us losing money. I like when my downside is protected.

On the most optimistic side, we aren’t seeing blowout CAGRs, but that’s expected given ASML’s history of slow and steady growth. It would still be a desirable outcome. ASML would outperform the S&P500 historical CAGR of ~8%, which is the baseline I use when deciding whether an investment is worth it. The question is, what do I implicitly need from ASML for it to be considered a very optimistic future?

Takeaways

Let’s wrap up the valuation section. The premiums we’d be paying today seem pricey at worst, and a toss-up at best. But while the present seems hazy, the future (DCF) seems more promising than I would have expected. It’s an interesting dichotomy, and frankly quite strange if you consider how it reverses the trend we saw in the product and financials sections.

It’s time to tie everything together and analyze ASML from a birdseye view.

Decision time

We now have all the information about ASML in front of us. We’ve analyzed the industry, product, financials, and valuation:

ASML has been a fantastic company to learn about. The engineering and technological prowess of this company is unarguably impressive. But the future of their products and financials are what I’d describe as murky or uncertain.

I enjoyed watching a show called Billions, where the head of the hedge fund would ask his employees, “How certain are you?” and if they were confident in their investment thesis, they would always respond, “I am not uncertain.”

If I was asked that question today, I wouldn’t be able to respond the same way. I am uncertain. After all, just look at the table above. Almost half of the cells are yellow. There’s clearly a significant degree of uncertainty, even after all the analysis we went through.

I handle a situation like this with a simple strategy - margin of safety. The greater my uncertainty, the greater the margin of safety that I apply.

It’s really useful tool in situations like this, because it gives me a buffer for my uncertainty. If I’m wrong, but I'm wrong by less than 33%, then I’ve already baked that into my investment decision. For the amount of research I’ve done on ASML, I feel like a 33% margin of safety is appropriate and gives me the cushion I need. I can now look at the possible outcomes and decide whether the risk-reward tradeoff is worth it.

If we look back at the DCF analysis, what happens if I apply a 33% margin of safety?

It’s not terrible on the downside, but the upside has now totally disappeared. Even in the best case scenario, ASML would underperform the S&P500. That paints things in a different light.

You can probably see where this is going by now. The risk and uncertainty are too high for me to be eager to invest in ASML today. Tougher still, I don’t have the engineering expertise to definitively say whether their future bets, like High-NA and Hyper-NA, will pan out. That’s outside of my circle of competence, and I have to understand the limits of my knowledge when making investment decisions.

In the end, ASML doesn’t get added to my portfolio, but it does get added to my shortlist to keep an eye on for the future. If I see indicators that their financials are stabilizing, or High-NA has commercial viability, then it could mitigate my uncertainty and make ASML a buy. For now, I’m content to watch the show unfold.

Hope you enjoyed the ASML research, and found this deep dive to be informative and valuable. Thanks for reading! See you next week!

Did you like the 4-part article format? Would love to hear your thoughts - leave a comment.

1  I’m not looking at whether a future price is fair or not. I’m looking at whether today’s prices are fair, since any purchasing decision would happen today. If I was going to buy in the future, I’d re-run these analyses at that time. The DCF, while obviously related to the future, is about predicting where the share price could be, not about assessing if the future price is a fair price.