Ever wonder what Avon is really worth after adding up all of the future free cash flows it may generate in the future? Using a discounted cash flow valuation model is one of the 12 Most Important steps to Understand the Stock Market, according to Valuentum President Brian Nelson. Let's do this for Avon (AVP).
In fact, the DCF process remains a key component of 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. Avon Products posts a VBI score of 5 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and neutral technicals. We compare Avon Products to peers Coach (COH), Estee Lauder (EL), and Nike (NKE). In the spirit of transparency, we show how our strategy has compared versus peers:
Our Report on Avon Products
• Avon Products 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. We expect the firm's return on invested capital (excluding goodwill) to expand to 33.2% from 32.3% during the next two years.
• Avon Products' cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.
• 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.
• Avon competes in the highly competitive cosmetic space. Though the firm continues to exhibit brand strength, its sales growth will face pressure in coming 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. Avon Products' 3-year historical return on invested capital (without goodwill) is 31.8%, which is above the estimate of its cost of capital of 8.8%. 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. Avon Products' free cash flow margin has averaged about 3.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. 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 Avon Products, cash flow from operations decreased about 19% from levels registered two years ago, while capital expenditures fell about 31% over the same time period.
The estimated fair value of Avon is $19 per share. Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.1%. Our model reflects a 5-year projected average operating margin of 12.8%, which is above Avon Products' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1% for the next 15 years and 3% in perpetuity. For Avon Products, we use a 8.8% 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 $19 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 Avon Products. We think the firm is attractive below $14 per share (the green line), but quite expensive above $24 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 Avon Products' fair value at this point in time to be about $19 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 Avon Products' 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 $25 per share in Year 3 represents our existing fair value per share of $19 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