As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Booz Allen's (NYSE:BAH) case, we think the firm is fairly valued at $21 per share, about in line with where it is currently trading. Let's take a look at how we derive this fair value estimate and also talk a little bit about the importance of investors having a fair value range -- also called a margin of safety.
But first, a little background about our research firm to help with the content of this article. 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. 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):
At the core, 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. Booz Allen posts a Valuentum Buying Index score of 6, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. For relative value purposes, we compare Booz Allen to peers Corrections Corp. (NYSE:CXW), CRA Intl (NASDAQ:CRAI), and FTI Consulting (NYSE:FCN). Let's dig into the report.
Our Report on Booz Allen
- Booz Allen 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 49.4% from 46.5% during the next two years.
- Booz Allen is a leading provider of management and technology consulting services to the US government. The firm's largest client is the US Army, and recent win rates have been approximately 55%.
- Booz Allen's cash flow generation is robust, but its financial leverage could potentially be concerning down the road. If cash flows begin to weaken, we'd become more cautious on the firm's overall financial health.
- Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
- 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 $16, we'd take a closer look. We prefer ideas in the Best Ideas portfolio.
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. Booz Allen's 3-year historical return on invested capital (without goodwill) is 40.7%, which is above the estimate of its cost of capital of 9.3%. 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. Booz Allen's free cash flow margin has averaged about 6.1% 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. At Booz Allen, cash flow from operations increased about 62% from levels registered two years ago, while capital expenditures fell about 63% over the same time period.
Our discounted cash flow model indicates that Booz Allen's shares are worth between $16-$26 each. 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 $21 per share represents a price-to-earnings (P/E) ratio of about 11.5 times last year's earnings and an implied EV/EBITDA multiple of about 8.1 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 1%. Our model reflects a 5-year projected average operating margin of 7.6%, which is above Booz Allen's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Booz Allen, we use a 9.3% 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 $21 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 Booz Allen. We think the firm is attractive below $16 per share (the green line), but quite expensive above $26 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 Booz Allen's fair value at this point in time to be about $21 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 Booz Allen'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 $27 per share in Year 3 represents our existing fair value per share of $21 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.