As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Cooper Tire and Rubber's (NYSE:CTB) case, we think the firm is fairly valued at $31, offering upside to our point fair value estimate. However, the firm still falls within our fair value range, so we label the company as 'Fairly Valued.' This may run counter to logic, but we like to use a margin of safety before investing, and a margin of safety sets the bounds around our fair value estimate (only when a price falls outside that range do we find a company under- or overvalued).
We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators 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 move buying, which leads to the greatest likelihood of convergence to fair value.
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. Cooper Tire and Rubber posts a VBI score of 5 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and neutral technicals. We compare Cooper Tire and Rubber to peers BorgWarner (NYSE:BWA), Johnson Controls (NYSE:JCI), and Tenneco (NYSE:TEN).
Our Report on Cooper Tire and Rubber
• Cooper Tire & Rubber's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.
• Cooper Tire & Rubber is a global company with affiliates, subsidiaries and joint ventures that specialize in the design, manufacture, marketing and sales of passenger car and light truck tires. The company also has subsidiaries that specialize in medium truck, motorcycle and racing tires.
• Cooper Tire & Rubber's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 4.8% during the past three years, lower than the mid single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.
• The tire industry has been relatively resilient in the US. Light truck and passenger tire replacement shipments have hovered around levels reached in the mid-1990s (about 220 million tires). And while successful new product launches may support growth, broadline and winter tires continue to be economically sensitive.
• As one of the largest tire makers, Cooper faces significant competition from the likes of Bridgestone (OTCPK:BRDCY), Goodyear (NASDAQ:GT), and Michelin (OTCPK:MGDDY), which will ultimately keep a lid on long-term profitability. Volatile input costs, namely rubber, only compound the situation.
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. Cooper Tire & Rubber's 3-year historical return on invested capital (without goodwill) is 8.6%, which is below the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of POOR. 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. Cooper Tire & Rubber's free cash flow margin has averaged about 4.8% 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 Cooper Tire & Rubber, cash flow from operations decreased about 74% from levels registered two years ago, while capital expenditures expanded about 96% over the same time period.
Our discounted cash flow model indicates that Cooper Tire & Rubber's shares are worth between $19.00 - $43.00 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 $31 per share represents a price-to-earnings (P/E) ratio of about 7.7 times last year's earnings and an implied EV/EBITDA multiple of about 8.5 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 lower than the firm's 3-year historical compound annual growth rate of 10.9%. Our model reflects a 5-year projected average operating margin of 8.5%, which is above Cooper Tire & Rubber's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For Cooper Tire & Rubber, we use a 10.2% 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 $31 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 Cooper Tire & Rubber. We think the firm is attractive below $19 per share (the green line), but quite expensive above $43 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 Cooper Tire & Rubber's fair value at this point in time to be about $31 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 Cooper Tire & Rubber'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 $41 per share in Year 3 represents our existing fair value per share of $31 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.