One of the biggest issues that the beginning investor (and sometimes even the very experienced investor) struggles with is the concept that value is a range of probable outcomes, not a precise point estimate. Only the uninformed will say a company is worth this or a company is worth that. The real answer is that a company is worth somewhere between this and that. Why? Because the value of a company is based on the future cash flows it generates, and the future is inherently unpredictable. In this article, let's determine the valuation range for Medtronic (MDT).
But first, a little background to help with the understanding of this article. 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 (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Medtronic 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 very bearish technicals. We compare Medtronic to peers Intuitive Surgical (ISRG), Waters (WAT), and Zimmer (ZMH).
Our Report on Medtronic
• Medtronic 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 45.4% during the past three years.
• Medtronic is a global leader in medical technology. The company currently functions in two operating segments that manufacture and sell device-based medical therapies: Cardiac/Vascular and Restorative Therapies.
• Medtronic 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 25.6% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 38.3%.
• We think Medtronic's baseline expectations are achievable. The company expects to deliver consistent mid-single-digit revenue growth, consistently grow EPS 200-400 basis points faster than revenue, and return 50% of free cash flow to shareholders.
• The company's emerging market business should be a strong source of growth. Medtronic is targeting a 20% CAGR in emerging markets and expects emerging markets to represent 20% of its revenue mix by mid-decade (it's currently 10%).
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 (GM:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Medtronic's 3-year historical return on invested capital (without goodwill) is 45.4%, which is above the estimate of its cost of capital of 9.8%. 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. Medtronic's free cash flow margin has averaged about 21.9% 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 Medtronic, cash flow from operations increased about 3% from levels registered two years ago, while capital expenditures fell about 21% over the same time period.
Our discounted cash flow model indicates that Medtronic's shares are worth between $36.00 - $60.00 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 $48 per share represents a price-to earnings (P/E) ratio of about 14.9 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 2.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.5%. Our model reflects a 5-year projected average operating margin of 30.6%, which is above Medtronic'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 Medtronic, we use a 9.8% 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 $48 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 Medtronic. We think the firm is attractive below $36 per share (the green line), but quite expensive above $60 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 Medtronic's fair value at this point in time to be about $48 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 Medtronic'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 $61 per share in Year 3 represents our existing fair value per share of $48 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
Additional disclosure: MDT and ISRG are included in our actively-managed portfolios.