Yum! Brands (YUM) has had its share of troubles recently after the poultry supplier scandal shook consumer confidence in China, but we still don't believe shares have come back down to reality. Among other investment considerations, let's dig into what Yum Brands is worth on a discounted cash-flow basis in this article.
But first, a little background to help with the understanding of this piece. 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.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Yum Brands posts a VBI score of 4 on our scale, reflecting our 'overvalued' DCF assessment of the firm (yes, you read correctly: overvalued), its neutral relative valuation versus peers, and bullish technicals. We compare Yum Brands to peers Chipotle (CMG), Starbucks (SBUX), and McDonald's (MCD). Without further delay, here's our report on Yum Brands.
Our Report on Yum Brands
• Yum Brands 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 39.1% during the past three years.
• Although we don't think the firm's valuation indicates an attractive investment opportunity at this time, we'd take a closer look if the firm's share price fell below $41 (yes, that's quite the margin of safety from current levels). The market seems to be pricing greater long-term revenue growth and profit expansion than we think is achievable.
• Yum Brands 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 9% in coming years. Total debt-to-EBITDA was 1.1 last year, while debt-to-book capitalization stood at 57.7%.
• We think the firm is doing a fantastic job executing in the US, particularly at Taco Bell. The Mexican themed chain is stealing share from both Chipotle on the high-end and McDonald's on the low-end, making it one of the best performing fast-food chains in the country.
• The firm experienced a revenue CAGR of about 8% during the past 3 years. We expect its revenue growth to be below that of 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. Yum Brands' 3-year historical return on invested capital (without goodwill) is 39.1%, which is above the estimate of its cost of capital of 10.3%. 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. Yum Brands' free cash flow margin has averaged about 9.6% 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 Yum Brands, cash flow from operations increased about 17% from levels registered two years ago, while capital expenditures expanded about 38% over the same time period.
Our discounted cash flow model indicates that Yum Brands' shares are worth between $41.00 - $69.00 each, the high end of the range still below its current share price. 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 $55 per share represents a price-to earnings (P/E) ratio of about 16.3 times last year's earnings and an implied EV/EBITDA multiple of about 10.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 8%. Our model reflects a 5-year projected average operating margin of 16%, which is above Yum Brands' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.9% for the next 15 years and 3% in perpetuity. For Yum Brands, we use a 10.3% 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 $55 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 Yum Brands. We think the firm is attractive below $41 per share (the green line), but quite expensive above $69 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 Yum Brands' fair value at this point in time to be about $55 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 Yum Brands' 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 $71 per share in Year 3 represents our existing fair value per share of $55 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