Intrinsic value represents the conclusion to any and all stock research: What is the company worth? DCF valuation captures the expectations of a firm's competitive advantages, growth prospects, strategic endeavors, and any other qualitative factor. No other process does this. Putting to numbers a plethora of advanced fundamental items in arriving at a fair value estimate is the cornerstone--and the most critical component--of any stock research analysis. Without an in-depth intrinsic-value assessment, research is but a story that has no ending. -- Brian Nelson, President, Valuentum Securities, 2011
We don't think it could be said any better. Let's evaluate Norfolk Southern's (NSC) intrinsic value in this article.
Our Report on Norfolk Southern
• Norfolk Southern'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 firm is trading at attractive valuation multiples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the firm's shares.
• Norfolk Southern 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 10.3% in coming years. Total debt-to-EBITDA was 2.1 last year, while debt-to-book capitalization stood at 47.1%.
• Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
• The firm sports a very nice dividend yield of 2.7%. We expect the firm to pay out about 36% of next year's earnings to shareholders as dividends.
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. Norfolk Southern's 3-year historical return on invested capital (without goodwill) is 8.2%, which is below the estimate of its cost of capital of 9.4%. 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. Norfolk Southern's free cash flow margin has averaged about 10% 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. At Norfolk Southern, cash flow from operations increased about 13% from levels registered two years ago, while capital expenditures expanded about 52% over the same time period.
Our discounted cash flow model indicates that Norfolk Southern's shares are worth between $48.00 - $80.00 each. For more info on why we use a large margin of safety for some firms, please click here. 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 $64 per share represents a price-to-earnings (P/E) ratio of about 11.9 times last year's earnings and an implied EV/EBITDA multiple of about 7.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 11.5%. Our model reflects a 5-year projected average operating margin of 29.8%, which is above Norfolk Southern'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 Norfolk Southern, we use a 9.4% 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 $64 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 Norfolk Southern. We think the firm is attractive below $48 per share (the green line), but quite expensive above $80 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 Norfolk Southern's fair value at this point in time to be about $64 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 Norfolk Southern'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 $81 per share in Year 3 represents our existing fair value per share of $64 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