Often, investors forget to answer the most important question in investing: What's a company worth? In this article, let's take a deep dive into Barrick Gold's (NYSE:ABX) valuation through the lens of a discounted cash-flow valuation model.
At Valuentum, 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 know that more interest in a stock leads to more buying, which often 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. Barrick Gold posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. We compare Barrick Gold to peers Eldorado Gold (NYSE:EGO), Kinross Gold (NYSE:KGC), and Yamana Gold (NYSE:AUY).
Our Report on Barrick Gold
• Barrick Gold 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 23.5% during the past three years.
• Barrick is the top global gold miner in terms of production and reserves. Though this sounds appealing, gold prices are volatile, and production costs can increase unexpectedly. Restoring reserves via exploration remains a speculative activity.
• Barrick Gold's cash flow generation is below what we'd expect from an average company in our coverage universe, and the firm's financial leverage is somewhat elevated. If cash flows continue to be weak, we'd grow more cautious on the firm's overall financial health.
• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
• Investing in a gold miner is largely a speculative bet on the direction of gold prices. The yellow metal exhibits many 'greater fool' tendencies in that it relies mostly on speculative demand for its price to move higher.
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 (NASDAQ: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. Barrick Gold's 3-year historical return on invested capital (without goodwill) is 23.5%, which is above the estimate of its cost of capital of 10.4%. 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. Barrick Gold's free cash flow margin has averaged about -8.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. 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 Barrick Gold, cash flow from operations moved into positive territory from levels two years ago, as capital expenditures expanded about 110% during this time period.
Our discounted cash flow model indicates that Barrick Gold's shares are worth between $31.00 - $63.00 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $47 per share represents a price-to earnings (P/E) ratio of about 10.5 times last year's earnings and an implied EV/EBITDA multiple of about 6.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 21.8%. Our model reflects a 5-year projected average operating margin of 47.7%, which is above Barrick Gold's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3% for the next 15 years and 3% in perpetuity. For Barrick Gold, we use a 10.4% 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 $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 Barrick Gold. We think the firm is attractive below $31 per share (the green line), but quite expensive above $63 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 Barrick Gold'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 Barrick Gold'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 $63 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
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.