As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In PPG Industries' (PPG) case, we think the firm is fairly valued at $155.
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 (we like firms that fall in the center of the diagram below):
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. PPG Industries posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We compare PPG Industries to peers AirGas (ARG), Dow Chemical (DOW), and DuPont (DD).
• PPG Industries' business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe.The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• PPG Industries is comprised of six reportable business segments: Performance Coatings, Industrial Coatings, Architectural Coatings - EMEA (Europe, Middle East and Africa), Optical and Specialty Materials, Commodity Chemicals and Glass.
• PPG Industries 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 10.9% in coming years. Total debt-to-EBITDA was 1.6 last year, while debt-to-book capitalization stood at 49.7%.
• The firm isn't too capital-intensive (capex averages about 2.5% of sales), has pricing power, and its top market share position in a consolidating industry is hard not to like.
• PPG Industries is acquisitive, but for the most part, we like its organic growth potential via emerging market expansion, increased sales content per airplane, and improving auto production.
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. PPG Industries' 3-year historical return on invested capital (without goodwill) is 24.5%, 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. PPG Industries' free cash flow margin has averaged about 8.7% 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 PPG Industries, cash flow from operations increased about 32% from levels registered two years ago, while capital expenditures expanded about 34% over the same time period.
The estimated fair value of $155 per share represents a price-to-earnings (P/E) ratio of about 25.5 times last year's earnings and an implied EV/EBITDA multiple of about 10.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 7.5%. Our model reflects a 5-year projected average operating margin of 15.2%, which is above PPG Industries' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3% for the next 15 years and 3% in perpetuity. For PPG Industries, we use a 10.1% 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 $155 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 PPG Industries. We think the firm is attractive below $124 per share (the green line), but quite expensive above $186 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 PPG Industries' fair value at this point in time to be about $155 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 PPG Industries' 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 $203 per share in Year 3 represents our existing fair value per share of $155 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