Intuitive Surgical (NASDAQ:ISRG) recently received some favorable news that may help with its stock's sentiment. Such a favorable ruling may help set the tone for the stock to make a large move higher. But how much higher? Well, let's dig into how to value this medical device firm in this article.

But first, a little background on how to interpret some "research jargon" from this article. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators 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. Intuitive Surgical posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. We compare Intuitive Surgical to peers Medtronic (NYSE:MDT), Varian Medical Systems (NYSE:VAR), and Zimmer (ZMH).

**Our Report on Intuitive Surgical**

**Investment Considerations**

**Investment Highlights**

â˘ Intuitive Surgical earns a ValueCreationâ˘ 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 150.9% during the past three years.

â˘ Intuitive Surgical is the global leader in the field of robotic-assisted minimally invasive surgery. Since it shipped its first da Vinci System, Intuitive Surgical has expanded its installed base to more than 2,000 sites.

â˘ Intuitive Surgical 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 30.6% in coming years, and the firm had no debt as of last quarter.

â˘ The clinical benefits of da Vinci prostatectomy and hesterectomy versus open surgury are many, including shorter hospital stays and less blood loss. Growth in the number of da Vinci surgeries for both procedures has been exponential in recent years.

â˘ The company generates as much as $170k/year in customer annual service agreements and as much as $2.2k per procedure. There were approximately 360,000 da Vinci procedures in 2011. We love its razor/razor-blade model.

**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 (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. Intuitive Surgical's 3-year historical return on invested capital (without goodwill) is 150.9%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreationâ˘ 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. Intuitive Surgical's free cash flow margin has averaged about 31.8% 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 Intuitive Surgical, cash flow from operations increased about 54% from levels registered two years ago, while capital expenditures expanded about 48% over the same time period.

**Valuation Analysis**

**Our discounted cash flow model indicates that Intuitive Surgical's shares are worth between $425.00 and $709.00 each.** The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRiskâ˘ rating, which is derived from the historical volatility of key valuation drivers. You'll notice that the high end of our fair value estimate range is over $700, suggesting significant upside from today's levels.

**The estimated fair value of $567 per share represents a price-to-earnings (P/E) ratio of about 35.5 times last year's earnings and an implied EV/EBITDA multiple of about 22.7 times last year's EBITDA.** Our model reflects a compound annual revenue growth rate of 15.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 27.5%. Our model reflects a 5-year projected average operating margin of 40.5%, which is above Intuitive Surgical's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 7.4% for the next 15 years and 3% in perpetuity. For Intuitive Surgical, we use a 10.8% 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 $567 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 ValueRiskâ˘ 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 Intuitive Surgical. We think the firm is attractive below $425 per share (the green line), but quite expensive above $709 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 Intuitive Surgical's fair value at this point in time to be about $567 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of Intuitive Surgical'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 $772 per share in Year 3 represents our existing fair value per share of $567 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.

**Additional disclosure:** ISRG is included in our Best Ideas portfolio, while MDT is included in our Dividend Growth portfolio.