Vale Has Substantial Upside Potential

May.20.13 | About: Vale S.A. (VALE)

By Cagdas Ozcan

Vale S.A. (NYSE:VALE) is one of the largest producers of iron ore in the market. Founded in 1942, Vale has more than 85,300 employees around the world. Besides producing iron and nickel, the company extracts several elements such as manganese, ferroalloy, copper, bauxite, potash, kaolin, alumina and aluminum. Vale is also well known for its integrated logistics, including railroads, maritime terminals and ports. The integrated logistics segments generate 7% of the company's total revenues.

Vale reported its first quarter financial results three weeks ago. According to this report, quarterly earnings amounted to $3.2 billion, representing an increase of 63% compared to the previous quarter. Cash generation through adjusted EBITDA was $5.2 billion, which is $800 million higher from the last quarter cash flow. Operating income for the first quarter is $4.2 billion, which is 41.4% higher than the previous quarter.

As of the time of writing, Vale was trading at $15.64 with a 52 week range of $15.47-$21.88. It has a market cap of $81.8 billion. Trailing twelve month [ttm] P/E ratio is 13.17 and forward P/E ratio is 6.8. P/B, P/S and P/CF ratios stand at 1.5, 1.7 and 4.7, respectively. Operating margin is 20.2%, and net profit margin is 10.3%. The company has a debt/equity ratio of 0.5, slightly more than the industry average of 0.4.

Vale has a 4-star rating from Morningstar. Its projected yield is 4.72%. What is the fair value of Vale given the forecast estimates? We can estimate the fair value using a 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 growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

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.

E0 = EPS = ($1.24 + $2.34) / 2 = $1.79

Wall Street holds diversified opinions on the company's future. 2 analysts have buy, 2 have hold and 1 has a sell rating. Vale's average five-year growth forecast is 1.2% according to Morningstar. Book value per share is $14.62. The rest is as follows:

Fair Value Estimator

V (t=0)

E0

1.79

V (t=1)

E0 (1+g)/(1+r)

1.58

V (t=2)

E0((1+g)/(1+r))2

1.40

V (t=3)

E0((1+g)/(1+r))3

1.23

V (t=4)

E0((1+g)/(1+r))4

1.09

V (t=5)

E0((1+g)/(1+r))5

0.96

Disposal Value

E0(1+g)5/[r(1+r)5]

8.73

Book Value

BV

14.62

Fair Value Range

Lower Boundary

16.77

Upper Boundary

31.39

Minimum Potential

5.60%

Maximum Potential

97.64%

Click to enlarge

(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 Vale is between $16.77 and $31.39 per share. At a price of $15.67, Vale is at least 6% undervalued.

Click to enlarge

Summary

Vale used to be a government enterprise until it was privatized by the Brazilian government in 1997. The company partially owes its success to its strategic acquisitions. With acquisitions of Socoimex, MBR, Samitri, and Fertecoand Rio Verde, Vale became the largest exporter of iron ores.

In 2006, Vale acquired Inco. With this acquisition, Vale became the second largest nickel company in the world. This situation affected the stock performance. Vale stock climbed to its lifetime top of almost $40 within 2 years after the INCO acquisition.

Vale's market cap is $82 billion. One of its competitors, Rio Tinto PLC (NYSE:RIO), also has a market cap of $82 billion. Both companies are trading at a premium over the book value. However, they can be good plays to invest in the global economic recovery. Based on my FED+ valuation, Vale is trading at least 6% below its fair value range. I rate Vale as a buy for long-term investors. At the current prices, Vale is trading at the bottom of its 52-week trading range. Therefore, it might offer a cheap entry point to those interested in mining companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Efsinvestment is a team of analysts. This article was written by one of our equity analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.