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Phillips 66's (PSX) stock price has increased rapidly in this past year, leaving investors wondering if the stock price has finally exceeded its fair value range (a range between which we think the stock is fairly valued). To answer this question, we performed a rigorous discounted cash-flow methodology and assigned an appropriate margin of safety to our point fair value estimate (key components of our Valuentum Buying Index). If Phillips 66's stock price falls outside this range, only then do we consider the stock to be undervalued or overvalued. Let's see if Phillips 66 could be headed for a fall on the basis of its valuation.

Our Report on Phillips 66

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Investment Considerations

Investment Highlights

• Phillips 66'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.

• The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $50, we'd take a closer look.

• 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.

• On April 4, 2012, ConocoPhillips' board approved the separation of its downstream businesses into an independent, publicly traded entity, Phillips 66. The firm remains exposed to the highly volatile and unpredictable nature of refining margins.

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. Phillips 66's 3-year historical return on invested capital (without goodwill) is 7.3%, which is below the estimate of its cost of capital of 10.7%. 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 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. Phillips 66's free cash flow margin has averaged about 0.5% 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. At Phillips 66, cash flow from operations increased about 691% from levels registered two years ago, while capital expenditures fell about 58% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Phillips 66's shares are worth between $50.00 - $84.00 each. 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. As such, we think Phillips 66's stock price is largely justified by its valuation (even after its meteoric rise). So to answer the question, we don't think Phillips 66 is overvalued and headed for a fall. Still, the market can be irrational at times, and investors should be aware of the significant leverage in the firm's operating model.

The estimated fair value of $67 per share represents a price-to earnings (P/E) ratio of about 8.8 times last year's earnings and an implied EV/EBITDA multiple of about 5.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -1.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 10.5%. Our model reflects a 5-year projected average operating margin of 3.6%, which is above Phillips 66's trailing 3-year average thanks to lower cost feedstock. 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 Phillips 66, we use a 10.7% weighted average cost of capital to discount future free cash flows.

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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 $67 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 Phillips 66. We think the firm is attractive below $50 per share (the green line), but quite expensive above $84 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 Phillips 66's fair value at this point in time to be about $67 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 Phillips 66'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 $87 per share in Year 3 represents our existing fair value per share of $67 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

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Source: Is Phillips 66 Headed For A Fall?

Additional disclosure: PSX is included in the portfolio of our Dividend Growth Newsletter.