As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Sprint's (NYSE:S) case, we think the firm is fairly valued at $6 per share, near current price levels. Remember: price is what one pays for a stock, while value is what the company is worth based on its future free cash flow stream.
We think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks. 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. We like firms that have investment qualities that fall in the center of the diagram below.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Sprint posts a VBI score of 6 on our scale, reflecting our "fairly valued" DCF assessment of the firm and its neutral relative valuation versus peers. We compare Sprint to peers AT&T (NYSE:T), Centurylink (NYSE:CTL), and Frontier Communications (NASDAQ:FTR), and Verizon (NYSE:VZ). In the spirit of transparency, we show how our strategy has created outperformance in the portfolio of our newsletter below:
Our Report on Sprint
• Sprint offers a comprehensive range of wireless and wireline communications services to over 50 million customers. The firm is widely recognized for developing innovative technologies, including the first wireless 4G service from a national carrier in the US.
• Sprint's cash flow generation is robust, but its financial leverage could potentially be concerning down the road. If cash flows begin to weaken, we'd become more cautious on the firm's overall financial health.
• Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
• The Spring/Clearwire tie-up will optimize the value creation of spectrum assets. For one, the deal will give the combined entity full control of valuable spectrum resource and LTE deployment. However, Dish Network's (NASDAQ:DISH) bid for Clearwire has made consummation of the deal unclear.
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 (NASDAQ: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. Sprint's 3-year historical return on invested capital (without goodwill) is 5.9%, which is below the estimate of its cost of capital of 9.9%. 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.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Sprint's free cash flow margin has averaged about 8.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. 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 Sprint, cash flow from operations decreased about 37% from levels registered two years ago, while capital expenditures expanded about 54% over the same time period.
The estimated fair value of $6 per share represents an implied EV/EBITDA multiple of about 5.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -1.9%. Our model reflects a 5- year projected average operating margin of 1.2%, which is above Sprint's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.1% for the next 15 years and 3% in perpetuity. For Sprint, we use a 9.9% weighted average cost of capital to discount future free cash flows.
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 $6 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 Sprint. We think the firm is attractive below $3 per share (the green line), but quite expensive above $9 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.
Future Path of Fair Value
We estimate Sprint's fair value at this point in time to be about $6 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 Sprint'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 $9 per share in Year 3 represents our existing fair value per share of $6 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.