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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. Let's dig into Canadian National's (NYSE:CNI) valuation, and why from a fundamental standpoint, we think it is a top rail idea.

But first, a litte background to help you get to know us. 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:

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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. Canadian National posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its poor relative valuation versus peers, and very bullish technicals. We compare Canadian National to peers CSX Corp (NYSE:CSX), Union Pacific (NYSE:UNP), and Norfolk Southern (NYSE:NSC). In the spirit of transparency, we show how the performance of our strategy has stacked up relative to peers:

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Investment Considerations

Investment Highlights

  • Canadian National is engaged in the rail and related transportation business. The firm's network of about 20,000 route miles of track spans Canada and mid-America, connecting three coasts: the Atlantic, the Pacific and the Gulf of Mexico. Its freight revenues are derived from seven commodity groups representing a diversified portfolio of goods.
  • Canadian National's operating ratio--operating expenses divided by revenue--is the lowest among railroad peers. We think the firm boasts highly efficient operations.
  • Canadian National 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 21.3% in coming years. Total debt-to-EBITDA was 1.5 last year, while debt-to-book capitalization stood at 38.5%.
  • Though Canadian National's dividend yield isn't that high, we think it boasts one of the stronger dividends in the railroad space. We like the firm a lot and view it as a top rail idea, but let's not get too far ahead of ourselves. We have to withhold judgment until we place a value on the company's shares (which we do below).

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. Canadian National's 3-year historical return on invested capital (without goodwill) is 7.5%, which is below the estimate of its cost of capital of 10%. 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. Canadian National's free cash flow margin has averaged about 15.1% 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 Canadian National, cash flow from operations increased about 2% from levels registered two years ago, while capital expenditures expanded about 9% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Canadian National's shares are worth between $70-$106 each. Why such a 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 $88 per share represents a price-to-earnings (P/E) ratio of about 14.3 times last year's earnings and an implied EV/EBITDA multiple of about 9.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 12.4%. Our model reflects a 5-year projected average operating margin of 39.1%, which is above Canadian National'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 Canadian National, we use a 10% 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 $88 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 Canadian National. We think the firm is attractive below $70 per share (the green line), but quite expensive above $106 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 Canadian National's fair value at this point in time to be about $88 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 Canadian National'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 $115 per share in Year 3 represents our existing fair value per share of $88 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: Why Canadian National Is A Top Rail Idea

Additional disclosure: UNP is included in the portfolio of our Best Ideas Newsletter.