Enphase Energy: Too Pricey For An Investment (NASDAQ:ENPH)

Thesis

Enphase Energy (NASDAQ:ENPH), which designs and markets components that convert sun-based energy into electricity, is most certainly a quality company. Moreover, the firm operates in a sector – green energy technology – that is likely to enjoy an enormous business boom through the next decade. However, the company’s stock is also valued at accordingly rich multiples and any disappointment – perhaps even a minor one – could catalyze a sharp sell-off.

Personally, I value ENPH stock based on a residual earnings model anchored on analyst consensus EPS and a 10% cost of capital. My calculation indicates that the fair value for Enphase stock is likely somewhere around $101/share.

As a function of valuation concerns, ENPH stock is a ‘Sell’ for me.

A Breathtaking Stock Performance

Enphase stock has outperformed the S&P 500 (SPY) YTD, being up almost 60% versus a loss of about 20% for the SPY (80 percentage points outperformance).

Although Enphase performance YTD is considerable, it does not fully capture ENPH’s share appreciation. In the past 5 years, Enphase stock has surged by almost 12,000%, while the S&P 500 has grown at a ‘reasonable’ 43.3% only. Enphase 5-year stock price CAGR is approximately 260%!

Fundamentals Are Lagging Valuation

It is true that the ENPH share price performance was somewhat supported by a notable business expansion. But the valuation expansion versus the business expansion is still considerable. For reference, Enphase revenues have grown from $286 million in 2017 to $2.02 billion in 2022 (TTM reference), which reflects a 5-year CAGR of approximately 44.5%. Over the same period, Enphase’ operating income has grown from a loss of $22.5 million in 2017 to a gain of $356 million in 2022 (TTM reference).

As a consequence, ENPH looks overvalued. According to data compiled by Seeking Alpha, Enphase is valued at a one-year forward P/E of x67, which implies a 279% premium to the respective median multiple in the IT sector. The argument of a valuation dispersion can be made for all relevant multiples, including P/S and P/B. Below is some more data.

Can Enphase Grow Into Its Valuation?

The key question for investors is, of course, if the company can grow into its rich valuation. Although there are strong drivers for sustainable growth, including the global long-term energy transition towards green energy, as well as the short-term energy crisis in Europe, it is very unlikely that Enphase will grow into its valuation soon.

Notably, in the Q&A session following Q3 results, when asked about long-term growth, Enphase CEO Badri Kothandaraman implied that growth rates will likely decelerate as compared to the past few years (emphasis mine):

When you start from a small base, of course the growth is going to be high. And then when you build it to some respectable numbers after that, the question is are we going to be able to sustain the growth? We think there are great drivers for sustaining the growth, which is the utility rates even in Europe, for example, in Germany are quite high. The energy crisis is accelerating in our renewables in Europe. So all of those are external drivers. They’re tailwinds that are in our favor. So we think we can sustain good double-digit growth percentages in general. But we do need to maintain a focus on quality and customer experience. And many of the installers love the quality on microinverters. And our market share gain that we have is based upon our quality plus the customer service that we provide them on microinverters.

I talked about the – some stumbling blocks on storage and we are working on them and we expect storage will be also providing a similar customer experience enabling us to unleash that opportunity as well in Europe. So we are incredibly optimistic like what I said, we doubled from 2020 to 2021. We doubled a gain from 2021 or we will double the gain from 2021 to 2022. And 2022 to 2023 it may not be possible for us to double, but we will have very healthy double digit, high double digit growth percentage.

Analyst consensus expects that Enphase will likely grow to be a $6 billion revenue company by 2027, which would reflect a 25% CAGR from 2022 levels. Personally, I believe this is a reasonable estimate. But it might not be enough to justify Enphase’s valuation. Assuming a 20% net profit margin, the company would generate approximately $1.2 billion of net income in 2027. This implies that Enphase stock would now be trading at an approximate FWD 2027 x33 P/E ratio. No matter how you argue about Enphase’s business, such a multiple appears unreasonably speculative in my view.

ENPH Likely To Be Worth Approximately $101/Share

To estimate a company’s fair implied valuation, I am a great fan of applying the residual earnings model, which anchors on the idea that a valuation should equal a business’ discounted future earnings after a capital charge. As per the CFA Institute:

Conceptually, residual income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company’s capital.

With regard to my Enphase Energy stock valuation model, I make the following assumptions:

• To forecast EPS, I anchor on the consensus analyst forecast as available on the Bloomberg Terminal ’till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework. But for 2-3 years, analyst consensus is usually quite precise.

• To estimate the capital charge, I anchor on ENPH’s cost of equity at 10%.

• For the terminal growth rate after 2025, I apply 3.25%, which is slightly lower than the estimated long-term nominal GDP growth (to reflect prudent assumptions).

Given these assumptions, I calculate a base-case target price for ENPH of about $101.39/share.

My base case target price does not calculate a lot of upside. But investors should also consider the risk reward profile. To test various assumptions of ENPH’s cost of equity and terminal growth rate, I have constructed a sensitivity table. Note that the matrix looks very favorable from a risk/reward perspective.

Upside Risks

Given the speculative nature of ‘short selling’, I do not recommend betting against ENPH – despite the considerable valuation premium.

And in any case, an investor could consider that the long-term energy transition could offer enough of a tailwind to justify investing in ENPH even though the company’s valuation is arguably out of touch with fundamentals.

Conclusion

Enphase Energy stock has appreciated by nearly 12,000% within 5 years, while the company’s revenue has ‘only’ expanded by approximately 700% over the same period. Now trading at x19 EV/Sales, the stock looks overvalued.

Personally, I value ENPH stock based on a residual earnings model anchored on analyst consensus EPS and a 10% cost of capital. My calculation indicates that the fair value for Enphase stock is likely somewhere around $101/share.