The most critical component of any investment framework rests on determining what a company is worth. There are many ways to do so, but there is only one way that is most appropriate, and that's discounted cash flow (DCF) analysis. Think of it this way: do you want your pay check paid in cash? Or do you want it paid in accounting earnings? We think you know the correct answer -- cash, please. And while the DCF process is not perfect, it's the best approach out there and doesn't suffer from the many pitfalls of using multiple analysis, residual income models, and the dividend-discount analysis. Don't get us wrong, investors should use a variety of triangulation tools, but let's dig into what Southern Copper (NYSE:SCCO) is worth on the basis of its future free cash flow stream.
But first, one quick note to help with the understanding of this article: the DCF process is a component of our stock-selection methodology, the Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Also, Valuentum followers have read and understand "The 12 Most Important Steps to Understand the Stock Market" -- a must read for investors of any investment level.
Our Report on Southern Copper
• Southern Copper 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 39.4% during the past three years.
• Southern Copper 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 20.5% in coming years. Total debt-to-EBITDA was 1.2 last year, while debt-to-book capitalization stood at 46.9%.
• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
• Though Southern Copper's dividend payout is impressive, we expect substantial volatility in it going forward.
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. Southern Copper's 3-year historical return on invested capital (without goodwill) is 39.4%, which is above the estimate of its cost of capital of 10%. 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. Southern Copper's free cash flow margin has averaged about 21.7% 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. At Southern Copper, cash flow from operations increased about 4% from levels registered two years ago, while capital expenditures expanded about 157% over the same time period.
Our discounted cash flow model indicates that Southern Copper's shares are worth between $24.00 - $40.00 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 $32 per share represents a price-to-earnings (P/E) ratio of about 14 times last year's earnings and an implied EV/EBITDA multiple of about 8.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 21.3%. Our model reflects a 5-year projected average operating margin of 51.3%, which is above Southern Copper's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.7% for the next 15 years and 3% in perpetuity. For Southern Copper, we use a 10% 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 $32 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 Southern Copper. We think the firm is attractive below $24 per share (the green line), but quite expensive above $40 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 Southern Copper's fair value at this point in time to be about $32 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 Southern Copper'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 $41 per share in Year 3 represents our existing fair value per share of $32 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.