Individual investors sometimes think that every idea should work out and immediately at that. Wrong. If you are a good investor, your winners will outperform your losers and you will make money. If you're an excellent investor, you'll still have a lot of losers, but you'll end up beating the market. The fact of the matter is that you will be wrong at times. You will make mistakes. Some of your investments will lose money. Will investors lose money In Union Pacific (NYSE:UNP)? Well, let's calculate Union Pacific's intrinsic value.
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, 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. 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). More interest = more buying = higher stock price.
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. Union Pacific posts a VBI score of 6 on our scale, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We compare Union Pacific to peers Canadian National (NYSE:CNI), CSX Corp (NYSE:CSX), and Norfolk Southern (NYSE:NSC).
Our Report on Union Pacific
• Union Pacific's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.
• The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $96, we'd take a closer look. Why such a large discount? Click here.
• Union Pacific 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 15.8% in coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 31.2%.
• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.
• The firm experienced a revenue CAGR of about 14% during the past 3 years. We expect its revenue growth to be better than 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. Union Pacific's 3-year historical return on invested capital (without goodwill) is 9.4%, which is below the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of POOR. 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. Union Pacific's free cash flow margin has averaged about 13.9% 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 Union Pacific, cash flow from operations increased about 50% from levels registered two years ago, while capital expenditures expanded about 33% over the same time period.
Our discounted cash flow model indicates that Union Pacific's shares are worth between $96.00 - $160.00 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 $128 per share represents a price-to-earnings (P/E) ratio of about 15.5 times last year's earnings and an implied EV/EBITDA multiple of about 7.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 14%. Our model reflects a 5-year projected average operating margin of 35.2%, which is above Union Pacific'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 Union Pacific, we use a 9.9% 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 $128 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 Union Pacific. We think the firm is attractive below $96 per share (the green line), but quite expensive above $160 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 Union Pacific's fair value at this point in time to be about $128 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 Union Pacific'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 $165 per share in Year 3 represents our existing fair value per share of $128 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.