Price is what the stock costs to buy, but value is what the stock is actually worth, after considering its future free cash flow stream. Price and value are two different things. In Praxair's (PX) case, we think the firm is worth about $100 per share. Though the stock is trading higher than our fair value estimate, we still think it's fairly valued. We'll explain why in this article.
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 (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). More interest in the stock = buying of the stock = a higher stock price.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Praxair posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. We compare Praxair to peers Airgas (ARG), Dow Chemical (DOW), and DuPont (DD). In the spirit of transparency, we show how our strategy has performed:
Our Report on Praxair
• Praxair generates roughly 25% of its revenue from attractive 15-year take-or-pay contracts. The company also has exclusive supply agreements in its merchant liquid business that make up an additional 30% of its revenue base.
• Praxair's scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 12.9% during the past three years.
• The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $79, we'd take a closer look.
• Praxair has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 13.2% in coming years. Total debt-to-EBITDA
was 1.9 last year, while debt-to-book capitalization stood at 53.5%.
• 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.
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. Praxair's 3-year historical return on invested capital (without goodwill) is 12.9%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of GOOD. 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. Praxair's free cash flow margin has averaged about 6.7% 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 Praxair, cash flow from operations increased about 13% from levels registered two years ago, while capital expenditures expanded about 33% over the same time period.
The estimated fair value of $100 per share represents a price-toearnings (P/E) ratio of about 18.3 times last year's earnings and an implied EV/EBITDA multiple of about 10.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 6% 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 26.6%, which is above Praxair's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.5% for the next 15 years and 3% in perpetuity. For Praxair, we use a 9.7% 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 $100 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 Praxair. We think the firm is attractive below $79 per share (the green line), but quite expensive above $121 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 Praxair's fair value at this point in time to be about $100 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 Praxair'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 $129 per share in Year 3 represents our existing fair value per share of $100 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.
Pro Forma Financial Statements
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