Savvy investors understand the importance of knowing what a company's intrinsic value is. Not only does an estimate of a firm's intrinsic value provide a baseline of a company's true worth, but it also identifies undervalued gems and keeps investors from selecting overvalued "bubble" stocks that can head lower on even the slightest speculation of bad news. Let's calculate Tesoro's (TSO) intrinsic value.
But first, a little background to better help understand this article. 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, which ranks stocks on a scale from 1 to 10, with 10 being the best. Though it is a simple numerical ranking, it is the culmination of advanced fundamental and financial analysis.
For example, 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. Tesoro posts a VBI score of 9 on our scale, reflecting our 'undervalued' DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technicals. This is one of the top ratings we can assign to a stock. We compare Tesoro to peers Hess (HES), Murphy Oil (MUR), and Phillips 66 (PSX).
Our Report on Tesoro
• Tesoro'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.
• Tesoro's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.
• Tesoro's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.
• The company's stock price has outperformed the benchmark during the last quarter, and its valuation still looks interesting at these levels. Investors could be accumulating shares, as the stock continues to trade at bargain-basement levels.
• Tesoro is a refiner and marketer of petroleum products. The company operates refineries in the western US with a combined daily capacity of about 665,000 barrels. Tesoro's retail-marketing system includes nearly 1,200 retail stations.
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 (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Tesoro's 3-year historical return on invested capital (without goodwill) is 4.9%, which is below the estimate of its cost of capital of 10.8%. 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. Tesoro's free cash flow margin has averaged about 1% 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 Tesoro, cash flow from operations increased about 4% from levels registered two years ago, while capital expenditures fell about 32% over the same time period.
Our discounted cash flow model indicates that Tesoro's shares are worth between $46.00 - $78.00 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. The estimated fair value of $62 per share represents a price-to earnings (P/E) ratio of about 16.3 times last year's earnings and an implied EV/EBITDA multiple of about 6.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 2.3%. Our model reflects a 5-year projected average operating margin of 4.9%, which is above Tesoro's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.7% for the next 15 years and 3% in perpetuity. For Tesoro, we use a 10.8% 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 $62 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 Tesoro. We think the firm is attractive below $46 per share (the green line), but quite expensive above $78 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 Tesoro's fair value at this point in time to be about $62 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 Tesoro'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 $86 per share in Year 3 represents our existing fair value per share of $62 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
Additional disclosure: PSX is included in the portfolio of our Dividend Growth Newsletter.