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Dow Chemical (NYSE:DOW) has had better days, but is it ready for new heights? The high end of our fair value range indicates valuation upside potential, but is the firm worth the risk? Let's take a deep dive into the company.

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 at the best time to buy. This process culminates in what we call our Valuentum Buying Index, 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). Remember: more interest = more buying = higher stock price.

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If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Dow Chemical posts a VBI score of 7 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and very bullish technicals. We compare Dow Chemical to peers Airgas (NYSE:ARG), DuPont (NYSE:DD), and Praxair (NYSE:PX).

Our Report on Dow Chemical

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Investment Considerations

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Investment Highlights

• Dow boasts a world-class portfolio that is poised to capture market share. Still, the firm remains laser-focused on reducing costs and prioritizing growth due to the poor structure of the industry in which it operates.

• Dow Chemical'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.

• Dow Chemical'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.

Business Quality

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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. Dow Chemical's 3-year historical return on invested capital (without goodwill) is 3.3%, which is below the estimate of its cost of capital of 8.8%. 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. Dow Chemical's free cash flow margin has averaged about 5.6% 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 Dow Chemical, cash flow from operations increased about 97% from levels registered two years ago, while capital expenditures fell about 96% over the same time period.

Valuation Analysis

The estimated fair value of $33 per share represents a price-to-earnings (P/E) ratio of about 13.9 times last year's earnings and an implied EV/EBITDA multiple of about 8.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.4%. Our model reflects a 5-year projected average operating margin of 7.9%, which is above Dow Chemical's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For Dow Chemical, we use a 8.8% 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 $33 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 Dow Chemical. We think the firm is attractive below $23 per share (the green line), but quite expensive above $43 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 Dow Chemical's fair value at this point in time to be about $33 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 Dow Chemical'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 $40 per share in Year 3 represents our existing fair value per share of $33 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: Is Dow Chemical Worth The Risk?