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 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.
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 PetroChina's (PTR) case, we think the shares look undervalued at today’s prices. Our fair value estimate for PetroChina is $191 per share, more than 50% higher than where it is currently trading. In the spirit of transparency, our DCF valuation model template can be found here. We make this template available to investors, and it can be re-used to value any other operating firm in your portfolio.
Our discounted cash flow model indicates that PetroChina's shares are worth between $128 and $254 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $191 per share represents a price-to-earnings (P/E) ratio of about 16.5 times last year's earnings and an implied EV/EBITDA multiple of about 8.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 12.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 24.8%.
Our model reflects a 5-year projected average operating margin of 12.7%, which is below PetroChina's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. We use a relatively high 12.4% weighted average cost of capital to discount future free cash flows.
Future Path of Fair Value
We estimate PetroChina's fair value at this point in time to be about $191 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 PetroChina'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 $261 per share in Year 3 represents our existing fair value per share of $191 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. All things considered, we think PetroChina looks cheap at today's levels, and we're waiting patiently to add them to the portfolio in our Best Ideas Newsletter.