By Cagdas Ozcan
Norfolk Southern (NSC) is one of the largest transportation companies in the country. The company operates the most extensive intermodal network in the East. It is also a key transporter of coal and industrial products. Norfolk Southern is doing well, and its stock reflects the performance of the company. However, we still think that it has substantial upside potential. In order to calculate the fair value of the stock, we decided to use our fair value model. Results of the model are discussed below.
As of the time of writing this article, NSC stock was trading at around $77, with a 52-week range of $56.05 - $77.42. It has a market cap of about $24.2 billion. The trailing twelve-month P/E ratio of 14.30 is above the forward P/E ratio of 11.10. P/B, P/S, and P/CF ratios stand at 2.5, 2.3, and 8.2, respectively. The operating margin is 28.3% while the net profit margin is 15.8%.
Norfolk Southern has a 3-star rating from Morningstar. Out of twenty eight analysts covering the stock, thirteen have buy recommendations and fifteen have hold recommendations. Average five-year annualized growth forecast estimate is 5%.
We can estimate Norfolk Southern's fair value using discounted earnings plus equity model as follows.
Discounted Earnings plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.
In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year. The average EPS for Norfolk Southern is $5.98.
While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 5%. Book value per share is $30.88.
Fair Value Estimator
Fair Value Range
(You can download FED+ Fair Value Estimator, here.)
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Norfolk Southern is between $72.54 and $103.42 per share. At a price of about $77, Norfolk Southern is trading close to the lower boundary of its fair value range. The stock is trading substantially below its fair value maximum at the moment.
Norfolk has been rising since the start of the year. The stock has gained more than 20% year to date. According to our fair value model, it still has substantial potential. At the moment, the demand for transportation services is growing, which will allow the company to have strong pricing power. Investment in infrastructure will also allow the company to have higher growth in the long-term. Freight pricing is also strong, which has resulted in strong growth in intermodal and merchandise segments.
Currently, the stock offers a dividend yield of over 2.5%, which is an attractive one for dividend-growth investors. Note that our analysis is based on the long-term earnings potential and the future growth of the company. As the company reports new results, the fair value needs to be updated as well.