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Union Pacific Corporation (UNP), founded in 1862, is the largest public railroad in North America. An Omaha, Nebraska-based company provides rail transportation and transportation services for chemicals. The company also offers freight transportation services for agricultural products, beverage products, and poultry products. The company operates on almost 32,000 miles across 23 states with its 43,000 employees.

As of Sept. 2, Union Pacific stock was trading at $88 with a 52-week range of $76.33-107.89. It has a market cap of $41.6 billion. Trailing 12-month P/E ratio is 14.7 and forward P/E ratio is 10.8. P/B, P/S, and P/CF ratios stand at 2.3, 2.3, and 8.4, respectively. The three-year annualized revenue and EPS growth stand at 1.4% and 16.9%, respectively. Operating margin is 28.9%, and net profit margin is 16.4%. The company has a low debt-to-equity ratio of 0.5. Union Pacific has a yield of 1.9% for its shareholders.

Union Pacific has a four-star rating from Morningstar. While its trailing P/E ratio is 14.7, it has a five-year average P/E ratio of 15.6. Out of 31 analysts covering the company, 21 have buy, four have outperform, and six have hold ratings. Wall Street has diverse opinions on Union Pacific’s future. The bottom line is 15.1% growth, whereas the top-line growth estimate is 23.5% for the next year. Average five-year annualized growth forecast estimate is 17.9%.

Here's a step-by-step calculation of Union Pacific’s fair value using discounted earnings plus equity model.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Union Pacific’s Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of $6.01along with the mean estimate of $7.85 for the next year.

E0 = EPS = ($6.01 + $7.85) / 2 = $6.93

Wall Street holds diversified opinions on Union Pacific’s future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 17.9%. Book value per share is $37.51.

The rest is as follows:

Fair Value Estimator

V0

E0

$6.93

V1

E0 (1+g)/(1+r)

$7.36

V2

E0((1+g)/(1+r))2

$7.82

V3

E0((1+g)/(1+r))3

$8.30

V4

E0((1+g)/(1+r))4

$8.82

V5

E0((1+g)/(1+r))5

$9.37

D

E0(1+g)5/[r(1+r)5]

$85.17

BV

Equals

$37.51

Fair Value Range

Lower Boundary

$133.77

Upper Boundary

$171.28

Potential

94.64%

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my five-year discounted-earnings-plus-book-value model, the fair-value range for Union Pacific is between $133.77 and $171.28 per share.

As of Sept. 2, Union Pacific was trading at a price of $88. I like Union Pacific as a company. Union Pacific ranked in Fortune’s World’s Admired list in 2011 with its growing trucking, logistics, and transportation subsidiaries. I see great growth potential, as well. The market does not seem to appreciate Union Pacific’s growth potential. The current price of $88 indicates the stock is deeply undervalued. Based on my FED+ fair value estimate, Union Pacific is significantly cheaper than my fair-value range. The stock has 94.64% upside potential to reach the upper boundary of its fair value range.

O – Metrix Confirmation

If the math above looks too complicated for you, try estimating the fair value using the O-Metrix as such:

O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5

  • Dividend Yield: Higher is better.
  • EPS Growth: Higher is better.
  • P/E Ratio: Lower is better.

The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far.

What is the O-Metrix Score?

  • Union Pacific has a yield of 1.9%. Therefore the yield is 1.9.
  • Growth estimate is the same as the discounted earnings model and is equal to 17.9%.
  • Since we are at the middle of the year, taking the average of ttm (14.7) and forward (10.8) P/E ratios will smooth the results. Thus, the average P/E ratio to be used in the model is 12.75.

O-Metrix = [(17.9 + 1.9) / (12.75)] * 5 = 7.76

Depending on the benchmark chosen, the market has an O-Metrix score range between 4 and 5. Union Pacific's O-Metrix score of 7.76 is in the higher-than-average fair-value range. Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. At a price of $88, the company is trading within the B-Grade, above-average-return zone.


Summary

Union Pacific stock has been priced at a discount contrary to its growth potential. The average P/E ratio in the last five years was 15.6. However, it is trading with a lower P/E ratio of 14.7, and forward P/E ratio of 10.8. With a profit margin of 16.39%, Union Pacific offered 1.9% dividend yield last year. The stock lost 11.38% in the last quarter, but returned 14.09% in a year. In the last five years, annualized EPS growth was 23.49%. With a market cap of $41.6 billion, I expect the company will keep its growth pace.

The stock has a relatively high PEG ratio of 1.22. On the other hand, it is trading with a low debt to equity ratio of 0.5 and Beta of 1.17. Its return on equity ratio of 16.7 is well-above the market. Analysts mean target price of $116.22 also implies a strong upside potential in the stock. With its substantial dividends and relatively low P/E ratio, I would prefer this stock. I think the current price offers a convenient entry point.

Source: Union Pacific Has Almost 100% Upside Potential