Masco (MAS) has been on a tear as of late due to its association with an improving housing market, but savvy investors know that a rising stock price could have little to do with the company's intrinsic value. In this case, let's dig into what we think Masco's true intrinsic worth is on the basis of a three-stage discounted cash flow model.
But let's get some terminology out of the way first. If a company is undervalued both on a DCF and on a relative valuation, it scores highly on our Valuentum Buying Index (VBI). We've identified a large number of firms that fit this bill, but Masco is not one of them. The firm posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. We compare Masco to peers Deltic Timber (DEL), Koppers (KOP), and USG Corp (USG).
Our Report on Masco
• Masco 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 30.5% during the past three years.
• Masco makes brand-name products for the home improvement and new home construction markets, with labels such as BEHR and Delta. The firm also provides a variety of installed products and services for homebuilders.
• Masco's cash flow generation is about what we'd expect from an average company in our coverage universe. However, the firm's financial leverage is on the high side. If cash flows begin to falter, we'd grow more cautious on the firm's overall financial health.
• Masco is the largest maker of faucets in the world, the largest manufacturer of kitchen cabinets in the world, and the largest non-commodity supplier to The Home Depot. The firm also boasts an enviable position in the architectural coatings market.
• The company's strategic initiatives include leveraging its brands to create innovative products, pursuing supply chain initiatives to reduce costs, addressing underperforming businesses, and strengthening its balance sheet.
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. Masco's 3-year historical return on invested capital (without goodwill) is 30.5%, which is above the estimate of its cost of capital of 8.6%. 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. Masco's free cash flow margin has averaged about 5% during the past 3 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 Masco, cash flow from operations decreased about 53% from levels registered two years ago, while capital expenditures
expanded about 21% over the same time period.
Our discounted cash flow model indicates that Masco's shares are worth between $13.00 - $21.00 each, suggesting its recent price advance is within the range and was largely anticipated by our members. 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 $17 per share represents a price-to earnings (P/E) ratio of about -12.7 times last year's earnings and an implied EV/EBITDA multiple of about 18 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -8%. Our model reflects a 5-year projected average operating margin of 7.5%, which is above Masco'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 Masco, we use a 8.6% 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 $17 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 Masco. We think the firm is attractive below $13 per share (the green line), but quite expensive above $21 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 Masco's fair value at this point in time to be about $17 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 Masco'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 $22 per share in Year 3 represents our existing fair value per share of $17 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