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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In this article, let's take a look at Seadrill's (SDRL) valuation.

But first, a little background. 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 firm is undervalued both on a discounted cash-flow and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Seadrill posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. We compare Seadrill to peers Baker Hughes (BHI), Cameron International (CAM), and Halliburton (HAL). We prefer firms that register a 9 or 10 on our scale, so Seadrill doesn't quite make the cut.

Our Report on Seadrill

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Investment Considerations

Investment Highlights

• Seadrill scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 13.8% during the past three years.

• Seadrill is a leading offshore deepwater drilling company. The company operates a versatile fleet of more than 60 units that comprises drillships, jack-up rigs, semi-submersible rigs and tender rigs.

• Seadrill has among the most modern fleet of all the offshore drillers and has a diverse asset base. The company expects to achieve 50% growth in annualized EBITDA by 2015 from 2012 levels. Contract backlog remains robust and has roughly doubled from 2010 levels.

• 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.

• Though Seadrill boasts a hefty payout, we don't think its dividend is safe over the long haul on the basis of our Valuentum Dividend Cushion measure (which considers its hefty debt load). We're not saying the dividend is going to get cut at this time, but as was displayed in the financial crisis, the firm's over-leverage can be a recipe for disaster (when shares dropped from nearly $37 to $6 and change). When it comes to dividend growth investing, we don't ignore the capital risks.

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. Seadrill's 3-year historical return on invested capital (without goodwill) is 13.8%, which is above the estimate of its cost of capital of 9.1%. As such, we assign the firm a ValueCreation™ rating of GOOD. 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. Seadrill's free cash flow margin has averaged about -6.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. 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 Seadrill, cash flow from operations increased about 26% from levels registered two years ago, while capital expenditures expanded about 86% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Seadrill's shares are worth between $35-$57 each. Why such the large range? 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 $46 per share represents a price-to-earnings (P/E) ratio of about 12.6 times last year's earnings and an implied EV/EBITDA multiple of about 13.9 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 9%. Our model reflects a 5-year projected average operating margin of 40.9%, which is above Seadrill's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.2% for the next 15 years and 3% in perpetuity. For Seadrill, we use a 9.1% weighted average cost of capital to discount future free cash flows.

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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 $46 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 Seadrill. We think the firm is attractive below $35 per share (the green line), but quite expensive above $57 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 Seadrill's fair value at this point in time to be about $46 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 Seadrill'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 $49 per share in Year 3 represents our existing fair value per share of $46 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

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Source: Seadrill Doesn't Quite Make The Cut