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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Toyota's (TM) case, we think the firm is undervalued. We think it is fairly valued at $118 per share.

For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Simply put, we think more interest in the shares represents more potential buying power. And as we're well aware, more buying power often leads to higher stock prices.

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If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Toyota posts a VBI score of 3 on our scale, reflecting our 'undervalued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. We compare Toyota to peers Ford (F), General Motors (GM), and Honda (HMC). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

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Our Report on Toyota

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Investment Considerations

Investment Highlights

• Toyota's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.

• Although we think the firm's DCF valuation indicates a potential attractive investment opportunity, we'd be more comfortable investing in the firm if it was more attractively priced on a relative basis versus
peers as well.

• Toyota's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.

• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.

• The firm experienced a revenue CAGR of about 2.8% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Toyota's 3-year historical return on invested capital (without goodwill) is 0.9%, which is below the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

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Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Toyota's free cash flow margin has averaged about 2.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Toyota, cash flow from operations decreased about 36% from levels registered two years ago, while capital expenditures expanded about 21% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Toyota's shares are worth between $87.00 - $149.00 each. Please visit our website at Valuentum.com for more fair value estimates. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Our model reflects a compound annual revenue growth rate of 6.3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.8%. Our model reflects a 5-year projected average operating margin of 6.6%, which is above Toyota's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 10.6% for the next 15 years and 3% in perpetuity. For Toyota, we use a 10.5% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $118 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After
all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Toyota. We think the firm is attractive below $87 per share (the green line), but quite expensive above $149 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

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Future Path of Fair Value

We estimate Toyota's fair value at this point in time to be about $118 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Toyota's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $161 per share in Year 3 represents our existing fair value per share of $118 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

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Pro Forma Financial Statements

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Source: Why Toyota Is Cheap

Additional disclosure: F is included in our Best Ideas Newsletter.