Buy Norfolk Southern For 15%+ Total Returns In The Next Year

Aug.15.14 | About: Norfolk Southern (NSC)

Summary

NSC shares have nearly doubled in the past two years.

Despite the rally shares remain cheap.

Given NSC's outlook and dividend, investors could see ~15%+ total returns over the next 12 months.

Norfolk Southern (NYSE:NSC) shares have been on a very strong uptrend since December of 2012, nearly doubling in that short amount of time. Shares have been rising on terrific operating results and improving sentiment for railroads in general and investors in the stock have been rewarded handsomely. In this article, we'll take a look at NSC's valuation to see if the company's rally still has some room to run or if NSC has gotten expensive.

Click to enlarge

To do this I'll use a DCF-type calculator you can read more about here. The model takes inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've estimated at 8% annual growth, and a discount rate, which I've set as the 10 year Treasury rate plus a risk premium of 6.5%, reflecting the nature and stability of NSC's business.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

             

Prior Year earnings per share

 

$5.85

$6.48

$7.35

$8.16

$9.06

$10.07

x(1+Forecasted earnings growth)

 

10.80%

13.40%

11.05%

11.05%

11.05%

11.05%

=Forecasted earnings per share

 

$6.48

$7.35

$8.16

$9.06

$10.07

$11.18

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$39.02

$43.34

$48.36

$54.00

$60.35

$67.47

Earnings per share

 

$6.48

$7.35

$8.16

$9.06

$10.07

$11.18

-Dividends per share

 

$2.16

$2.33

$2.52

$2.72

$2.94

$3.17

=Equity book value at EOY

$39.02

$43.34

$48.36

$54.00

$60.35

$67.47

$75.48

               

Abnormal earnings

             

Equity book value at begin of year

 

$39.02

$43.34

$48.36

$54.00

$60.35

$67.47

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$3.51

$3.90

$4.35

$4.86

$5.43

$6.07

               

Forecasted EPS

 

$6.48

$7.35

$8.16

$9.06

$10.07

$11.18

-Normal earnings

 

$3.51

$3.90

$4.35

$4.86

$5.43

$6.07

=Abnormal earnings

 

$2.97

$3.45

$3.81

$4.20

$4.64

$5.11

               

Valuation

             

Future abnormal earnings

 

$2.97

$3.45

$3.81

$4.20

$4.64

$5.11

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$2.72

$2.90

$2.94

$2.98

$3.01

$3.04

               

Abnormal earnings in year +6

           

$5.11

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$85.10

               

Estimated share price

             

Sum of discounted AE over horizon

 

$14.56

         

+PV of terminal year AE

 

$50.74

         

=PV of all AE

 

$65.30

         

+Current equity book value

 

$39.02

         

=Estimated current share price

 

$104.32

         
Click to enlarge

As you can see the model produces a fair value of $104 from the inputs described above, mere pennies above the current price of NSC as I write this. With the fair value right in line with the actual price, does it mean that NSC's rally is done?

Not exactly. First, we need to understand that the price the model gives is a fair value and not a price target. The model is saying that NSC is a good buy under $104.32 today; a price target would be somewhat higher as it is forward looking. Thus, the present value of the company's discounted cash flows given the inputs I described above, adjusted for dividends, is right where the company's shares are trading right now.

Now, the other implication of the current price equaling the fair value of the model is that the current price is implying that NSC will grow at the rates shown in the model. After posting record numbers in the most recent quarter shares actually sold off. However, the quarter was still good as volumes were up and NSC made it clear its core business is performing quite well. Thus, I'm not particularly concerned about NSC hitting ~10% EPS growth over the medium term as the company has shown its ability to do so with its impressive operating results.

To that end, Barclays recently upgraded NSC on strong sector trends as well as company-specific valuation. We can see this in analyst earnings projections as well as NSC's EPS for next year has been increased a whopping 20 times in the past month as analysts scramble to ratchet their respective estimates higher to meet the increasingly favorable environment for railroad stocks and NSC's own valuation.

So what do we do with NSC? The company has several things going for it; it is in an industry that has experienced an enormous rejuvenation in recent years, leading to higher volumes and revenues, it is a reliable dividend payer and it is trading for only 14 times next year's earnings. Even after the huge run shares have had in the past couple of years they are still quite cheap as any company that is growing EPS at 10%+ and paying more than 2% in dividends likely deserves a higher multiple than that.

I think we'll see NSC around $120 next year based on a conservative $8 in EPS and an earnings multiple of 15. Given NSC's success in recent years and the fact that analysts can't keep up with NSC's earnings growth, I think the company's earnings multiple will creep higher as impressive results continue to roll in. I also think there is upside to the earnings estimates laid out here so we could easily see more than $120 in 2015. However, as a base case, I think ~15% upside over a year and dividends to boot are quite attractive and in particular, for a company as stable and reliable as NSC. And keep in mind that doesn't include dividend increases on the current 2.1% yield. I like NSC here but will wait for it to dip back to $100 before pulling the trigger to avoid chasing shares higher unnecessarily.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in NSC over 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.