We think a discounted cash-flow modeling approach is the most appropriate valuation application for a broad swath of companies, ranging from small, probabilistic biotechs to established global cyclical industrials. In the same way that a long-term view is needed to capture the probability of future revenue/earnings from early-stage biotechs, using a DCF, which considers a 5- to 7-year discrete forecast horizon (before later stages are applied), enables the investor to better capture the vicissitudes of an industrial company through the course of the global economic cycle. In valuation, applying mid-cycle margins (i.e. normalized earnings) in the out-years to arrive at a fair value estimate is vital to not overestimating a company's intrinsic worth during both peak and trough economic periods. We think this is one of the biggest pitfalls that investors make -- forecasting peak and/or improving margins into infinity. It leads them to pay too much for a company's shares, as the economic cycle is inevitable. Let's calculate United Technologies' (NYSE:UTX) cash-flow-derived intrinsic value and evaluate the firm via the Valuentum style.
For those that may not be familiar with Valuentum, 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. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's 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. United Technologies posts a Valuentum Buying Index score of 7, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technicals. Though this score is a good one relative to the remainder of our coverage universe, we tend to prefer companies that register a 9 or a 10 (a "we'd consider buying" rating) for consideration into the Best Ideas portfolio. We then tend to hold these firms until they register a 1 or 2 (a "we'd consider selling rating). With that said, let's evaluate United Technologies' report.
United Technologies' Investment Considerations
• United Technologies' 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. The company also boasts an attractive Economic Castle rating.
• United Tech's commercial businesses are Otis elevators and escalators and UTC Climate, Controls & Security. The firm's aerospace businesses are Sikorsky aircraft and UTC Propulsion & Aerospace Systems, which includes Pratt & Whitney aircraft engines and UTC Aerospace Systems products.
• United Technologies 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 10.8% in coming years. Total debt-to-EBITDA was 2 last year, while debt-to-book capitalization stood at 38.8%.
• We're big fans of the company's decision to pick up Goodrich to augment its commercial aerospace portfolio. Revenue passenger miles (air travel) are expected to expand at a rapid pace in coming decades, and annual aircraft deliveries should follow suit. The commercial backlogs at the airframe makers are simply tremendous.
• New equipment orders at Otis in China continue to perform well, and we like the backdrop for large commercial engine spares at Pratt & Whitney. We continue to pay close attention to the pace of order expansion.
• United Technologies' shares register a solid rating of a 7 on the Valuentum Buying Index, but we prefer companies that are included in the Best Ideas portfolio, which have registered higher ratings in the past.
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 with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. United Technologies' 3-year historical return on invested capital (without goodwill) is 24.1%, which is above the estimate of its cost of capital of 9.9%. 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. United Technologies' free cash flow margin has averaged about 7.9% 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 United Technologies, cash flow from operations increased about 15% from levels registered two years ago, while capital expenditures expanded about 145% over the same time period.
Our discounted cash flow model indicates that United Technologies' shares are worth between $90-$136 each. Shares of United Technologies are trading just shy of $120 each at the time of this writing. Though the company continues to trade within our fair value range, we wouldn't consider the company to be overpriced, until it shares were trading north of $136 each. In the same light, we think United Technologies would present investors with a fantastic bargain under $90 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $113 per share represents a price-to-earnings (P/E) ratio of about 18.2 times last year's earnings and an implied EV/EBITDA multiple of about 12.2 times last year's EBITDA. United Technologies is trading just higher than our point fair value estimate at this time. The view that we think shares are fairly valued (they are trading in the fair value range) is one of the reasons why the company doesn't register a 9 or 10 on the index (or a "we'd consider buying" rating).
Our model reflects a compound annual revenue growth rate of 4.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 4.9%. Our model reflects a 5-year projected average operating margin of 16.7%, which is above United Technologies' trailing 3-year average. In United Technologies' case, we're mid-single-revenue growth thanks to its exposure to aerospace expansion, and we also think ongoing synergies and operating leverage will drive margin expansion higher over the immediate five-year period. Said differently, we think United Technologies' mid-cycle margins and earnings are higher than they are today.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For United Technologies, we use a 9.9% weighted average cost of capital to discount future free cash flows. For a company as large as United Technologies, a long-term rate that approximates global GDP expansion and a discount rate that is roughly average within our coverage universe are reasonable assumptions.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint.
For relative valuation purposes, we compare United Technologies to peers 3M (NYSE:MMM) and Honeywell (NYSE:HON), as well as a few of its other industrial peers. On a relative valuation basis, shares of United Technologies reveal the potential for additional upside. However, we think 3M is significantly overvalued at present, revealing one of the biggest pitfalls of using relative valuation analysis exclusively in any approach -- the likelihood of the industry being overvalued as a whole cannot be corrected for. This is why we place the DCF first and foremost in our process. The fair value is unique to each and every company.
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 $113 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 United Technologies. We think the firm is attractive below $90 per share (the green line), but quite expensive above $136 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 United Technologies' fair value at this point in time to be about $113 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 United Technologies' 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 $146 per share in Year 3 represents our existing fair value per share of $113 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
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. Past results are not a guarantee of future performance.
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.