There are many ways to look at a company. But we think the very first thing investors should ask is: What's a company worth? At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation is the best way to identify the most attractive stocks. Let's dig into what we think International Paper (IP) is worth.
Our Report on International Paper
• Intl Paper 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 16.4% during the past three years.
• International Paper's global paper and packaging operations are complemented by an extensive distribution system. However, that doesn't insulate it from the threat of industry overcapacity during the troughs of the economic cycle.
• Intl Paper 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 5.5% in coming years. Total debt-to-EBITDA was 2.7 last year, while debt-to-book capitalization stood at 59.9%.
• International Paper has a dominant position in corrugated packaging, coated paperboard, and distribution in North America and a solid platform for uncoated papers in Brazil and paper, pulp and packaging in Russia.
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. Intl Paper's 3-year historical return on invested capital (without goodwill) is 16.4%, which is above the estimate of its cost of capital of 9.4%. 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. Intl Paper's free cash flow margin has averaged about 8.6% 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 Intl Paper, cash flow from operations decreased about 43% from levels registered two years ago, while capital expenditures expanded about 50% over the same time period.
The estimated fair value of $47 per share represents a price-to earnings (P/E) ratio of about 15.9 times last year's earnings and an implied EV/EBITDA multiple of about 7.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.6%. Our model reflects a 5-year projected average operating margin of 8.4%, which is below Intl Paper's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Intl Paper, we use a 9.4% 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 $47 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 Intl Paper. We think the firm is attractive below $33 per share (the green line), but quite expensive above $61 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 Intl Paper's fair value at this point in time to be about $47 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 Intl Paper'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 $59 per share in Year 3 represents our existing fair value per share of $47 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