Simplicity is the name of the game. We were reminded recently of how Warren Buffett allocated a total of $100 million in roughly 20-25 Korean companies in 2004 by simply leafing through a reference book that dedicated *only* a single page to each listed company -- a book much like those that we make available to financial advisors. Mr. Buffett understands simplicity -- knowing which metrics matter and which metrics don't. He picked those companies in roughly 6 hours. In this article, let's talk about what metrics matter at Ingersoll-Rand (NYSE:IR).

For those that don't know, 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. For a seminar on our process, please visit our YouTube page here.

If a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores highly on our scale. For relative valuation purposes, we compare Ingersoll-Rand to peers Dover (NYSE:DOV), Flowserve (NYSE:FLS), and Illinois Tool Works (NYSE:ITW). We understand the pitfalls of relative valuation analysis, which is why we combine the relative valuation process with a rigorous discounted cash-flow exercise. We like to take a holistic view.

Ingersoll-Rand posts a VBI score of 7 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and very bullish technicals. Though its score isn't poor, we prefer firms with higher Valuentum Buying Index ratings - firms that register a 9 or 10. These companies are not only underpriced on both a discounted cash flow and relative valuation basis but also are exhibiting strong technical and momentum indicators.

In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score, as it relates to firms in the Best Ideas portfolio:

**Our Report on Ingersoll-Rand**

**Investment Considerations**

**Investment Highlights**

- Ingersoll-Rand earns a ValueCreationâ˘ 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 20.8% during the past three years.
- Ingersoll-Rand's diverse portfolio of industrial products have well-recognized brand names (Ingersoll-Rand, Trane), but the firm remains exposed to intense competition and cyclical end markets.
- Ingersoll-Rand 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 9.4% in coming years. Total debt-to-EBITDA was 1.7 last year, while debt-to-book capitalization stood at 31.1%.
- The firm is trading at attractive valuation multiples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the firm's shares. If Ingersoll-Rand begins to trade a steeper discount to our estimate of its intrinsic value, the company will register a higher rating on the Valuentum Buying Index.

**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 (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Ingersoll-Rand's 3-year historical return on invested capital (without goodwill) is 20.8%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreationâ˘ 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. Ingersoll-Rand's free cash flow margin has averaged about 5.9% 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 Ingersoll-Rand, cash flow from operations increased about 46% from levels registered two years ago, while capital expenditures expanded about 46% over the same time period.

**Valuation Analysis**

Our discounted cash flow model indicates that Ingersoll-Rand's shares are worth between $44-$72 each. Shares are trading within our fair value estimate range at the time of this writing at $55 each (at the midpoint of the fair value range). The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRiskâ˘ rating, which is derived from the historical volatility of key valuation drivers. We think the wider the fair value range, the wiser the investor, in many cases.

The estimated fair value of $58 per share represents a price-to-earnings (P/E) ratio of about 17.6 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 0.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 2.1%. Our model reflects a 5-year projected average operating margin of 12.1%, which is above Ingersoll-Rand's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Ingersoll-Rand, 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 $58 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 ValueRiskâ˘ 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 Ingersoll-Rand. We think the firm is attractive below $44 per share (the green line), but quite expensive above $72 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 Ingersoll-Rand's fair value at this point in time to be about $58 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 Ingersoll-Rand'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 $75 per share in Year 3 represents our existing fair value per share of $58 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: **The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.