Raytheon Is Slightly Undervalued, But We Demand A Larger Margin of Safety

| About: Raytheon Company (RTN)

"But how, you will ask, does one decide what [stocks are] "attractive"? Most analysts feel they must choose between two approaches customarily thought to be in opposition: "Value" and "growth" ... We view that as fuzzy thinking ... Growth is always a component of value [and] the very term "value investing" is redundant." -- Warren Buffett, Berkshire Hathaway (NYSE:BRK.A) annual report, 1993

We take Buffett's thoughts one step further. We think the best opportunities arise from a complete understanding of all investing disciplines in order to identify the most attractive stocks at any given time. We therefore analyze each stock across a wide spectrum of philosophies, from deep value through momentum investing.

This involves performing significant valuation analysis, both on a DCF and relative value basis, as well as a strong consideration of the firm's fundamentals (cash flow, risk, etc.), technicals and momentum indicators. The best stocks, we believe, will be attractive from a number of investment perspectives -- from value through momentum (hence our name, Valuentum). On the other hand, the worst stocks will be shunned by most investment disciplines and display expensive valuations and poor technicals and momentum indicators.

As part of our process, we employ a discounted cash-flow model to arrive at a fair value estimate for every company within our equity coverage universe. In Raytheon's (NYSE:RTN) case, our fair value estimate for the company is $33 per share, over 20% lower than where it is currently trading. We like its valuation, but are waiting for the firm's Valuentum Buying Index rating to improve to above 8 before diving in (it is currently 4, per the report picture below). The full report that corresponds to the first page shown below for Raytheon can be found at Stock Reports.

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Source: Valuentum Securities, Inc.

Valuation Summary

Our discounted cash flow model indicates that Raytheon 's shares are worth between $23.00 - $43.00 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.

Source: Valuentum Securities, Inc.

The estimated fair value of $33 per share represents a price-to-earnings (P/E) ratio of about 6.9 times last year's earnings and an implied EV/EBITDA multiple of about 6.2 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 5.7%. Our fair value reflects a 5-year projected average operating margin of 11%, which is below Raytheon 's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 1.3% for the next 15 years and 3% in perpetuity. For Raytheon, our model uses a 9.3% weighted average cost of capital to discount future free cash flows.

We'd consider adding Raytheon to our Best Ideas portfolio, if it scored higher on our Buying Index and therefore became relatively more attractive than our existing long ideas.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Tagged: , Aerospace/Defense - Major Diversified
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