We cover a lot of companies. Our mission is not to make a call on every company -- that's foolish, and we don't. We only stake our reputation on firms in the actively-managed portfolios. However, we think it is valuable to the investment community to view their holdings through the eyes of the Valuentum process, whether we include them in the portfolios or not. We think there's value in our stating that a firm is fairly valued. We are so grateful for the work that Seeking Alpha does to make this happen. We can only put a slice of our work here, but it has been helpful to so many. Let's take a look at Nokia (NYSE:NOK) through the eyes of the Valuentum process.
If there's one word that describes what our name means, it's "comprehensive" (from value through momentum). You can see how much depth there is with respect to our process on our YouTube page here. 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. There's a lot that goes into these considerations. Building a fully-populated discounted cash flow model, for one. But 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.
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 high on our scale. Nokia posts a Valuentum Buying Index score of 3 on our scale, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. Firms in our Best Ideas portfolio and Dividend Growth portfolio have much more attractive attributes.
Our Report on Nokia
- Nokia 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. We expect the firm's return on invested capital (excluding goodwill) to expand to 110.9% from 87.1% during the next two years.
- Nokia continues to be troubled. Though the firm looks forward to a new line of Lumia products, competition remains fierce from the likes of Apple (NASDAQ:AAPL), and significant traction from new product launches will be hard to come by.
- The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $4, we'd take a closer look. However, it may not be in very good shape if its equity hits that level. The company needs to be closely monitored.
- The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
- Competitive industry dynamics continue to negatively affect the firm's Smart Devices and Mobile Phones business units, and we don't expect this to change anytime soon. It's in a very tough business.
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. Nokia's 3-year historical return on invested capital (without goodwill) is 58.4%, which is above the estimate of its cost of capital of 10.5%. 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. Nokia's free cash flow margin has averaged about 3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. 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. At Nokia, cash flow from operations dropped into negative territory from levels two years ago, while capital expenditures fell about 33% during this time period.
Our discounted cash flow model indicates that Nokia's shares are worth between $4.00-$11.00 each. The margin of safety around our fair value estimate is driven by the firm's VERY HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $7 per share represents a price-to-earnings (P/E) ratio of about -6.3 times last year's earnings and an implied EV/EBITDA multiple of about 20.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -13.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -12.1%. Our model reflects a 5-year projected average operating margin of 2.9%, which is above Nokia'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 Nokia, we use a 10.5% 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 $7 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 Nokia. We think the firm is attractive below $4 per share (the green line), but quite expensive above $11 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 Nokia's fair value at this point in time to be about $7 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 Nokia'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 $10 per share in Year 3 represents our existing fair value per share of $7 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.