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Investors tend to make one major misconception: there is a difference between good companies and good stocks. Good companies generate strong returns on invested capital, have excellent competitive advantages, and throw off lots of cash flow. Good stocks, on the other hand, tend to be undervalued and just starting to exhibit strong technical/momentum indicators. A good company can be a bad stock, and a bad company can be a good stock. A good company can be a great stock, and a bad company can be a terrible stock. Let's see how UPS (NYSE:UPS) stacks up in this article.

But first, a little background. At Valuentum, we employ a systematic process that let's investors compare companies on even ground to see which ones are the strongest and which ones aren't worth your time. Every company will have good and bad attributes, so we like to take a holistic view into each firm. A company's cash-flow generation may be good or bad, but the stock may still be undervalued -- in which case, we think it will be a good stock. We help investors parse through these differences in our 16-page reports on our website because no stock is completely good and no company is completely bad.

United Parcel Service posts a score of 6 on our methodology, the Valuentum Buying Index. For reference, we compare United Parcel Service to peers FedEx (NYSE:FDX), CH Robinson (NASDAQ:CHRW), and UTI Worldwide (NASDAQ:UTIW) with respect to how we assign our relative valuation ranking. Let's dig in.

Investment Considerations

Investment Highlights

• United Parcel Services 'shrinks the globe.' The firm is the world's largest package delivery company, a leader in the US less-than-truckload industry and the premier provider of global supply chain management solutions.

• United Parcel Service 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 10.2% in coming years. Total debt-to-EBITDA was 1.7 last year, while debt-to-book capitalization stood at 73.4%.

• United Parcel Services boasts an industry-leading adjusted operating margin (small package). At roughly 14%, it is nearly double that of DHL, FedEx, and TNT.

• We're huge fans of UPS' worldwide integrated network, respected brand and consistent cash generation.

• United Parcel Service 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. Return on invested capital (excluding goodwill) has averaged 37.7% during the past three years.

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. United Parcel Service's 3-year historical return on invested capital (without goodwill) is 37.7%, which is above the estimate of its cost of capital of 10.1%. 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. United Parcel Service's free cash flow margin has averaged about 7.9% 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 United Parcel Service, cash flow from operations increased about 88% from levels registered two years ago, while capital expenditures expanded about 55% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that United Parcel Service's shares are worth between $63-$105 each. Please click here to learn why we use a prudent margin of safety in our practice. 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 $84 per share represents an implied EV/EBITDA multiple of about 11.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.1%. Our model reflects a 5-year projected average operating margin of 11.8%, which is below United Parcel Service's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.3% for the next 15 years and 3% in perpetuity. For United Parcel Service, we use a 10.1% 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 $84 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 United Parcel Service. We think the firm is attractive below $63 per share (the green line), but quite expensive above $105 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 United Parcel Service's fair value at this point in time to be about $84 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 United Parcel Service'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 $106 per share in Year 3 represents our existing fair value per share of $84 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: Evaluating The Intrinsic Worth Of UPS