AMD Stock Is So Richly Valued It Can Be a Currency To Buy Other Companies

Advanced Micro Devices (NASDAQ:AMD) shares have risen so far, so fast that the company now wants to use them as a currency of sorts. The Wall Street Journal reported recently it is offering to take over a rival chipmaker, Xilinx (NASDAQ:XLNX), using AMD stock.

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The stock has risen so far that it can be the main currency for the deal. The reason is that by issuing up to $30 billion in shares to Xilinx shareholders, it won’t be too dilutive to existing shareholders.

I want to explain how that might work and how a company like AMD can use its currency for acquisition.

How AMD Stock Could Be Currency

In the past year, AMD stock has risen more than 191%. It is now trading at a sky-high valuation, as I pointed out in several previous articles.

For example, AMD trades for 77 times this year’s forecast earnings and 51 times 2021 earnings per share (EPS), according to analyst data on Seeking Alpha. Meanwhile, Yahoo! Finance shows similar price-to-earnings (P/E) ratios for 2020 and 2021. (Note: Seeking Alpha data is from S&P Market Intelligence, while Yahoo! Finance sources its data from Refinitiv.)

Both of these imply that earnings in 2021 will grow by about 50%. That allows the company to consider using its stock as a currency. For one, it makes the stock very likely to rise. Therefore a seller might be willing to accept the all-stock or majority of the offer by stock offer.

Second, the combined earnings of the company might not be as expensive as it appears. For example, AMD now has a $98.9 billion market capitalization. This is because it has 1.174 billion shares outstanding and the stock price is $84.21 as of Oct. 14.

Now, Xilinx has a $28.8 billion market cap, since it has 244.3 million shares outstanding and its price is $117.76. However, XLNX stock is much cheaper and trades for just 33.5x next year’s earnings.

Therefore, the combined company would have 1.481 billion shares outstanding and its market cap would be about $127 billion. But here is the thing. It’s projected earnings would be $2.816 billion. On a pro forma EPS basis, that would be $1.90 per share.

Therefore the combined P/E ratio would be just 44x next year’s EPS (i.e., $84.31 divided by $1.90). This is much cheaper than AMD’s present P/E ratio of 51x.

Despite Dilution, Acquirer’s Stock Rises

The fact is anytime you have a high P/E stock and use it to acquire another company with a lower P/E ratio, the combined company will have a lower P/E. That is, the combined earnings will lower the overall P/E ratio compared to the original P/E ratio of the acquiring company.

Many tech companies know this. That is why they try to use their stock as a currency. As a result, despite the dilution, the stock of the acquiring company will still rise.

Moreover, as a result of the high P/E stock acquisition, there will be higher cash levels, higher free cash flow (FCF). The company can then begin to acquire smaller companies using their combined cash and FCF. This lowers the dilution.

In fact, in a virtuous circle, the higher levels of cash and FCF will allow the acquiring company to buy back shares and effectively sterilize the dilution effect. In other words, it can repurchase the extra shares used as a currency to buy the lower P/E company.

Various forms of this have happened over the years, especially with software, drug makers, and other high tech companies.

No Guarantees of Deal

There is no guarantee that the AMD offer talks with Xilinx will succeed. In fact, the WSJ article implied that the talks have been on and off. Top-ranked blogger Bram de Haas, writing on Seeking Alpha, suggested that AMD’s offer of a 20% premium for Xilinx stock may not be enough. CNBC’s Jim Cramer believes that Xilinx may not be ready to sell just yet at this price.

In any case, the point is that apparently the seller is not completely balking in accepting AMD stock as a payment form. That is the luxury you get when your stock is expensive and people expect it will rise further.

In the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.

Mark Hake runs the Total Yield Value Guide which you can review here.

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