There are many ways to pick stocks, from having a "gut feeling", to applying multiple analyses, to targeting dividend growth and acceptable income levels. Though each investor has his or her own favorite secret sauce, we think a comprehensive understanding of what moves stock prices and a deep knowledge of analytical processes gives investors a leg up in generating outperformance in the stock market. Outperformance is never guaranteed, but having an understanding of the moving parts behind the equity markets is certainly not a disadvantage. Let's take a look at how a comprehensive view can help investors make better decisions with Potash's (NYSE:POT) equity.
Understanding How the Stock Market Works
For those that may not be familiar with our boutique research firm, 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. Potash boasts 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. Though this falls short of a 9 or 10 (a "we'd consider buying" rating), the score is better than average. Learn more about the Valuentum Buying Index here.
How the Valuentum Buying Index Has Performed in the Best Ideas Portfolio
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.
Potash's Investment Considerations
- Potash Corp.'s 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.
- Potash is the world's largest producer of potash and the third-largest producer of phosphates and nitrogen. The firm has access to decades of high-quality reserves in Canada, and its production facilities are among the lowest-cost potash operations in the world.
- Potash Corp. has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 23.8% in coming years. Total debt-to-EBITDA was 1.2 last year, while debt-to-book capitalization stood at 29%.
- Russian fertilizer company Uralkali announced it will leave the Belarusian Potash Company in order to grab market share. With rational behavior and discipline likely thrown out the window, the potash industry has in one move become just another commodity. Things may never be the same for Potash Corp.
- Despite recent improvements in demand and pricing, realizations in all three nutrient segments (potash, nitrogen, phosphate) continue to lag peak levels. Pricing remains the most important driver.
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. Potash Corp.'s 3-year historical return on invested capital (without goodwill) is 21.5%, which is above the estimate of its cost of capital of 10%. 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. Potash Corp.'s free cash flow margin has averaged about 16.3% 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 Potash Corp., cash flow from operations decreased about 8% from levels registered two years ago, while capital expenditures fell about 28% over the same time period.
The estimated fair value of $35 per share represents a price-to-earnings (P/E) ratio of about 17.1 times last year's earnings and an implied EV/EBITDA multiple of about 10.7 times last year's EBITDA. Shares are trading roughly in line with our fair value estimate at the time of this writing. Our model reflects a compound annual revenue growth rate of 2.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.8%. Our model reflects a 5-year projected average operating margin of 40.6%, which is above Potash Corp.'s trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.6% for the next 15 years, and 3% in perpetuity. For Potash Corp., we use a 10% weighted average cost of capital to discount future free cash flows.
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 Potash to peers CF Industries (NYSE:CF) and Monsanto (NYSE:MON), among others.
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 $35 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 Potash Corp. We think the firm is attractive below $28 per share (the green line), but quite expensive above $42 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 Potash Corp.'s fair value at this point in time to be about $35 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 Potash Corp.'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 $43 per share in Year 3 represents our existing fair value per share of $35 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.