What is stock analysis? Well, there are some that think it has everything to do with the dividend. There are others that only look at charts. There are others that think analyst estimate misses (notice how this is equivalent to companies' earnings beats) are a way to gauge the trajectory of a stock. And yet there are other groups that are lost in medieval times. We as investors need to move beyond these individual frameworks and start taking a holistic view. Let's take a look at what we mean as it relates to our analysis with Kinder Morgan Partners (NYSE:KMP).
At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers 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 (click here for an in-depth presentation about our methodology), 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.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Kinder Morgan Partners posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. We compare Kinder Morgan Partners to peers Energy Transfer Partners (NYSE:ETP), NuStar (NYSE:NS), and Spectra Energy (NYSE:SE). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
• Kinder Morgan Partners 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 11.7% during the past three years.
• Kinder Morgan is the largest midstream company in North America and owns thousands of miles of pipelines and terminals that would be difficult for new entrants to replicate.
• Kinder Morgan Partners operates like a giant toll road and receives a fee for services, while avoiding commodity price risk. We think this is one of its most attractive qualities.
• Kinder Morgan's cash-flow profile and ongoing access to the capital markets will facilitate continued increases in its already robust distribution.
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. Kinder Morgan Partners' 3-year historical return on invested capital (without goodwill) is 11.7%, which is above the estimate of its cost of capital of 9.8%. 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. Kinder Morgan Partners' free cash flow margin has averaged about 16.4% 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 Kinder Morgan Partners, cash flow from operations increased about 36% from levels registered two years ago, while capital expenditures fell about 9% over the same time period.
The estimated fair value of Kinder Morgan is $84 per share. Our model reflects a compound annual revenue growth rate of 13% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -11.2%. Our model reflects a 5-year projected average operating margin of 15.2%, which is below Kinder Morgan Partners' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.2% for the next 15 years and 3% in perpetuity. For Kinder Morgan Partners, we use a 9.8% 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 $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 Kinder Morgan Partners. 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 Kinder Morgan Partners' 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 Kinder Morgan Partners' 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 $95 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
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: KMP and ETP are included in the portfolio of our Dividend Growth Newsletter.