We can all imagine the most frequent word uttered in the Boeing (BA) board room these days as it relates to the 787: "Oops..." In any case, we still like the commercial jet maker's long-term prospects and think the 787 Dreamliner will be a tremendous success for its customers -- and, yes, Boeing, too. But are these great long-term prospects reflected in Boeing's stock? Let's take a look.
We think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation vs. 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). Valuentum followers know that more interest in a stock leads to more buying in a stock, which leads to 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. Boeing 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 Boeing to peers General Dynamics (GD), Lockheed Martin (LMT), and Raytheon (RTN).
Our Report on Boeing
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• Boeing earns a ValueCreation™ rating of Excellent, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 36.5% during the past three years.
• Boeing is the largest manufacturer of commercial jetliners and military aircraft combined. Boeing also makes rotorcraft, electronic and defense systems, missiles, satellites, launch vehicles and advanced information and communication systems. The firm is a major service provider to NASA.
• Boeing'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.
• Boeing's massive commercial aerospace backlog of unfulfilled deliveries gives it excellent visibility and a growth trajectory better than most other firms of similar size. Its revolutionary 787 has changed the economics of air travel, and we expect deliveries to surge in coming years. Still, technical concerns with the plane are a big risk.
• The firm sports a very nice dividend yield of 2.5%. We expect the firm to pay out about 38% of next year's earnings to shareholders as dividends.
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 (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Boeing's three-year historical return on invested capital (without goodwill) is 36.5%, which is above the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of Excellent. 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. Boeing's free cash flow margin has averaged about 4.2% during the past three 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 Boeing, cash flow from operations decreased about 29% from levels registered two years ago, while capital expenditures expanded about 44% over the same time period.
The estimated fair value of $73 per share represents a price-to earnings (P/E) ratio of about 13.7 times last year's earnings and an implied EV/EBITDA multiple of about 9.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 10.5% during the next five years, a pace that is higher than the firm's three-year historical compound annual growth rate of 4.1%. Our model reflects a five-year projected average operating margin of 6.4%, which is above Boeing's trailing three-year average. Beyond year five, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Boeing, we use a 10.3% weighted average cost of capital to discount future free cash flows.
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 $73 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 Boeing. We think the firm is attractive below $51 per share (the green line), but quite expensive above $95 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 Boeing's fair value at this point in time to be about $73 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 Boeing'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 three 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 $93 per share in year three represents our existing fair value per share of $73 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