One of the most important things investors can learn is the difference between price and value. Price is what a stock is currently trading for, while intrinsic value represents what the company's true worth is based on estimates of its future free cash flows. At times, a large difference between price and value can present investors with undervalued investment gems. Let's see if Align Tech (ALGN) is one of them.
But first, a little background to 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. 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). As the '12 Steps to Understand the Stock Market' reveals, Valuentum investors know that it is interest by other investors buying a stock that drives its price to intrinsic 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. Align Tech 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 Align Tech to peers Baxter Intl (BAX), Becton, Dickinson (BDX), and Stryker (SYK).
Our Report on Align Tech
• Align Tech 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 58.3% during the past three years.
• Align Technology makes Invisalign, a proprietary method for treating malocclusion, or the misalignment of teeth. Invisalign uses a series of clear, nearly invisible, removable appliances that gently move teeth to a desired final position.
• Align Tech 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 17.1% in coming years, and the firm had no debt as of last quarter.
• Align's Invisalign system seeks to capitalize on a clinical dental condition that affects nearly a billion people, or roughly 50%-75% of the population of developed countries. There are as many as 7 million people each year that elect treatment by orthodontists across the globe. This is a huge market for Align.
• The firm experienced a revenue CAGR of about 16.4% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.
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. Align Tech's 3-year historical return on invested capital (without goodwill) is 58.3%, which is above the estimate of its cost of capital of 10.8%. 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. Align Tech's free cash flow margin has averaged about 23.7% 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. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Align Tech, cash flow from operations increased about 76% from levels registered two years ago, while capital expenditures expanded about 323% over the same time period.
Our discounted cash flow model indicates that Align Tech's shares are worth between $24.00 - $38.00 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 $31 per share represents a price-to earnings (P/E) ratio of about 37.3 times last year's earnings and an implied EV/EBITDA multiple of about 21 times last year's EBITDA. The stock is trading at roughly $32 per share, so we'd view it as fairly valued. Our model reflects a compound annual revenue growth rate of 12.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 16.4%. Our model reflects a 5-year projected average operating margin of 23.1%, which is above Align Tech's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5.7% for the next 15 years and 3% in perpetuity. For Align Tech, 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 $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 Align Tech. We think the firm is attractive below $24 per share (the green line), but quite expensive above $38 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 Align Tech'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 Align Tech'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 $42 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