As followers of Valuentum know, we like to use a discounted-cash-flow process that uncovers the true intrinsic value of firms. In Caterpillar's (CAT) case, we think the firm is worth over $100 per share. Find our full reports on Caterpillar and hundreds of other companies here.
We believe a complete assessment of a company's discounted cash-flow valuation, relative valuation versus its closest competitors, as well as an evaluation of technical and momentum indicators, is the best way to identify the most attractive stocks at the best time to buy. 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.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. We think our methodology and broad coverage universe is largely responsible for the meaningful outperformance of our portfolio.
Our Report on Caterpillar (click to enlarge images):
With every company in our coverage universe, we rate them on 13 unique measures. To get started, we show Caterpillar's below:
In the most recent quarter, Caterpillar showed strong growth in revenue and earnings, but also revealed cost pressures inherent to the business. However, the prospect of slowing economic growth in the US and Europe also has led to uncertainty.
Excluding Bucyrus, the firm raised its 2011 profit outlook to the range of $6.75 to $7.25 per share versus $6.25 to $6.75 per share previously. We're forecasting earnings-per-share just below the mid point of the range, at $6.83.
Caterpillar scores fairly well on our business quality matrix (which we show in the picture below). The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 14.9% during the past three years.
We expect the firm to trade within our fair value estimate range for the time being. However, if the firm's share price fell below $83 (just a couple dollars more), we'd be tempted to pull the trigger.
Caterpillar 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 7.1% in coming years. Total debt-to-EBITDA was 1.1 last year, while debt-to-book capitalization stood at 72.4%.
The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
The firm sports a very nice dividend yield of 2.2%. We expect the firm to pay out about 25% of next year's earnings to shareholders as dividends.
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 (ROIC) with its weighted average cost of capital (GM:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Caterpillar's 3-year historical return on invested capital (without goodwill) is 14.9%, which is above the estimate of its cost of capital of 10.7%. As such, we assign the firm a ValueCreation™ rating of "good." 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.
We think Catepillar is worth $110 per share, which represents a price-to-earnings (P/E) ratio of about 26.5 times last year's earnings and an implied EV/EBITDA multiple of about 9.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 12.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -1.8%. Our model reflects a 5-year projected average operating margin of 14.4%, which is above Caterpillar's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Caterpillar, our model uses a 10.7% weighted average cost of capital to discount future free cash flows.
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 $110 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 Caterpillar. We think the firm is attractive below $83 per share (the green line), but quite expensive above $138 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 Caterpillar 's fair value at this point in time to be about $110 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 Caterpillar '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 $145 per share in Year 3 represents our existing fair value per share of $110 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