Calculating the intrinsic value of a firm is as much art as it is science. The art rests in determining the future forecasts and estimates of a company's earnings and cash flow, while the science is the mathematics behind a free cash flow to the firm model. Both are necessary, and both are required. There's no way around it. Let's calculate Caterpillar's (NYSE:CAT) intrinsic value.

But first, a little background so you can better understand this article. 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.

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. Caterpillar posts a VBI score of 3 on our scale, reflecting our "fairly valued" DCF assessment of the firm and its neutral relative valuation versus peers. We compare Caterpillar to peers CNH Global (NYSE:CNH), Deere (DE) and AGCO Corp (NYSE:AGCO).

## Our Report on Caterpillar

## Investment Considerations

## Investment Highlights

• Caterpillar 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 38% during the past three years.

• Caterpillar has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 8.8% in coming years. Total debt-to- BITDA was 1.6 last year, while debt-to-book capitalization stood at 69.6%.

• The firm sports a very nice dividend yield of 2.3%. We expect the firm to pay out about 26% of next year's earnings to shareholders as dividends.

## 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 (NASDAQ: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. Caterpillar's 3-year historical return on invested capital (without goodwill) is 38%, which is above the estimate of its cost of capital of 9.9%. 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. Caterpillar's free cash flow margin has averaged about 8.3% 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 Caterpillar, cash flow from operations increased about 17% from levels registered two years ago, while capital expenditures expanded about 71% over the same time period.

## Valuation Analysis

Our discounted cash flow model indicates that Caterpillar's shares are worth between $83.00 - $138.00 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 $110 per share* represents a price-to earnings (P/E) ratio of about 13 times last year's earnings and an implied EV/EBITDA multiple of about 6.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 26.7%. Our model reflects a 5-year projected average operating margin of 15%, which is below Caterpillar's trailing 3- year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Caterpillar, we use a 9.9% 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 $110 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 Caterpillar. We think the firm is attractive below $83 per share (the green line), but quite expensive above $138 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 Caterpillar's fair value at this point in time to be about $110 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 Caterpillar'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 $144 per share in Year 3 represents our existing fair value per share of $110 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

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.