Many investors strive to understand the stock market. Some follow many of the great investment managers, while others set out on their own. Still, very few truly understand what makes the market tick. But whatever philosophy an investor ascribes to, an understanding of what a company is worth is par for the course. In Philip Morris' (PM) case, we think the firm is fairly valued at $72 per share (with upside to the mid-$90s). Let's dig in.
Our Report on Philip Morris
• Philip Morris 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 93.1% from 75.3% during the next two years.
• Phillip Morris benefits from its exposure to faster growing regions of the world, including Asia and EEMA. Still, it remains exposed to regulatory risk and excise price shocks that may impact demand for tobacco in certain countries.
• Philip Morris 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 32% in coming years. Total debt-to-EBITDA was 1.3 last year, while debt-to-book capitalization stood at 98.8%.
• 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.
• Pricing continues to be the main driver of Phillip Morris' income growth. We like the company's ability to raise prices despite a challenging economic backdrop in several regions of the world.
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. Philip Morris' 3-year historical return on invested capital (without goodwill) is 60.2%, which is above the estimate of its cost of capital of 11%. 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. Philip Morris' free cash flow margin has averaged about 30.6% 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 Philip Morris, cash flow from operations increased about 34% from levels registered two years ago, while capital expenditures expanded about 25% over the same time period.
The estimated fair value of $72 per share represents a price-to earnings (P/E) ratio of about 14.8 times last year's earnings and an implied EV/EBITDA multiple of about 9.9 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.6%. Our model reflects a 5-year projected average operating margin of 47.2%, which is above Philip Morris' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Philip Morris, we use a 11% 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 $72 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 Philip Morris. We think the firm is attractive below $50 per share (the green line), but quite expensive above $94 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 Philip Morris' fair value at this point in time to be about $72 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 Philip Morris' 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 $91 per share in Year 3 represents our existing fair value per share of $72 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