General Dynamics (NYSE:GD) is a powerhouse as far as defense contractors go, but savvy investors know that there is much more to investing than just finding a good company. In fact, many great companies with significant competitive advantages can be terrible investments. As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. Let's dig into what we think of General Dynamics' true intrinsic worth in this article.

But first a little background for new readers. 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 (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). Valuentum followers know that in order for a company to converge to intrinsic value, there has to be interest in the company, which drives buying.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. General Dynamics posts a VBI score of 7 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technicals. We compare General Dynamics to peers Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT), and Raytheon (NYSE:RTN).

**Our Report on General Dynamics**

**Investment Considerations**

**Investment Highlights**

â€¢ General Dynamics earns a ValueCreationâ„¢ 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 45.8% during the past three years.

â€¢ General Dynamics is a leader in business aviation; combat vehicles/systems, armaments, and munitions; shipbuilding/marine systems; and information systems and technology. The firm's product line-up ranges from Gulfstream business jets to nuclear-powered submarines.

â€¢ General Dynamics 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 6.8% in coming years. Total debt-to- EBITDA was 0.9 last year, while debt-to-book capitalization stood at 22.9%.

â€¢ 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.

â€¢ The firm sports a very nice dividend yield of 2.9%. We expect the firm to pay out about 29% of next year's earnings to shareholders as dividends. Its Dividend Cushion is 2.5.

**Business Quality**

**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. General Dynamics' 3-year historical return on invested capital (without goodwill) is 45.8%, which is above the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreationâ„¢ 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. General Dynamics' free cash flow margin has averaged about 8.1% 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 General Dynamics, cash flow from operations increased about 13% from levels registered two years ago, while capital expenditures expanded about 19% over the same time period.

**Valuation Analysis**

Our discounted cash flow model indicates that General Dynamics's shares are worth between $55.00 - $91.00 each, a rather large range. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRiskâ„¢ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $73 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 7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.7%. Our model reflects a 5-year projected average operating margin of 11.5%, which is below General Dynamics's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For General Dynamics, we use a 9.9% 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 $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 ValueRiskâ„¢ 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 General Dynamics. We think the firm is attractive below $55 per share (the green line), but quite expensive above $91 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 General Dynamics' 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 General Dynamics' 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 $92 per share in Year 3 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**

**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.