Investors often lose sight of the fact that companies have intrinsic value and that the price of a stock is just the collective opinion of its intrinsic value set by buyers and sellers on the market. At times, the price of a stock can be significantly different than a firm's true intrinsic worth. Let's take a look at what we think is Crocs' (CROX) intrinsic value.
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). Valuentum followers understand that more interest in a stock equals more potential buying, which in turn equals 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. Crocs posts a VBI score of 6 on our scale, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We compare Crocs to peers Deckers (DECK), Finish Line (FINL) and Foot Locker (FL).
Our report on Crocs
• Crocs 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. We expect the firm's return on invested capital (excluding goodwill) to expand to 49.2% from 41.3% during the next two years.
• Crocs is a designer, manufacturer and retailer of footwear for men, women and children. Crocs' proprietary closed-cell resin, Croslite, enables the firm to produce soft, comfortable, lightweight, nonmarking and odor-resistant shoes for casual wear, boating, hiking, and other uses.
• Crocs has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 9.2% in coming years. Total debt-to-EBITDA was 0 last year, while debt-to-book capitalization stood at 0.2%.
• The global casual, athletic and fashion footwear markets are highly competitive. Portions of the firm's wholesale business compete with companies such as Deckers, Skechers USA, Steve Madden, Wolverine World Wide and VF Corp. Long-term success is not guaranteed.
• The firm experienced a revenue CAGR of about 11.5% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.
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 (GM:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Crocs' 3-year historical return on invested capital (without goodwill) is 31.9%, which is above the estimate of its cost of capital of 12.8%. 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 gray 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. Crocs' free cash flow margin has averaged about 7.6% 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. At Crocs, cash flow from operations increased about 133% from levels registered two years ago, while capital expenditures expanded about 54% over the same time period.
Our discounted cash flow model indicates that Crocs' shares are worth between $11.00 - $19.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $15 per share or its intrinsic value represents a price-to earnings (P/E) ratio of about 12 times last year's earnings and an implied EV/EBITDA multiple of about 6.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 11.5%. Our model reflects a 5- year projected average operating margin of 12.7%, which is above Crocs' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.6% for the next 15 years and 3% in perpetuity. For Crocs, we use a 12.8% 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 $15 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 Crocs. We think the firm is attractive below $11 per share (the green line), but quite expensive above $19 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 Crocs' fair value at this point in time to be about $15 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 Crocs' 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 $22 per share in Year 3 represents our existing fair value per share of $15 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