As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Zimmer's (ZHM) case we think the company is worth just over $60 per share, about in line where it is currently trading. Though we think Zimmer is fairly valued today, investors should expect a market return from the shares in coming years.
Further, we think a comprehensive analysis of a company's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment 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 the portfolio in our Best Ideas Newsletter. In Zimmer's case, the firm scores a 4 on our Valuentum Buying Index, which is about average for our universe.
Our Report on Zimmer
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For every company in our coverage universe, we rate them on 13 unique measures. To get started, we show Zimmer's ranking below:
Zimmer earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The company has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the return on invested capital (excluding goodwill) to expand to 32.7% from 31.6% during the next two years.
The company is trading at attractive valuation mulitples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the shares.
Zimmer has an excellent combination of strong free cash flow generation and low financial leverage. We expect the company's free cash flow margin to average about 21.9% in coming years. Total debt-to-EBITDA was 0.8 last year, while debt-to-book capitalization stood at 16.5%.
The company'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.
We thought Zimmer's second quarter results were solid. Revenue jumped over 7% (about 2% constant currency), while adjusted earnings per share increased 11%. The company also narrowed its full-year earnings guidance toward the top end of its previous range in the report. We're forecasting an earnings beat over the high end of its range for this year, as reflected below.
The company experienced a net income CAGR of about negative 8% during the past 3 years. However, we expect its net income growth to be better than its peer median during the next five years.
Economic Profit Analysis
The best measure of a company's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the company's economic profit spread. Zimmer's 3-year historical return on invested capital (without goodwill) is 29.9%, which is above the estimate of its cost of capital of 11%. As such, we assign the company a ValueCreation™ rating of EXCELLENT. 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.
Cash Flow Analysis
We think Zimmer is worth $61 per share, which represents a price-to-earnings (P/E) ratio of about 20.6 times last year's earnings and an implied EV/EBITDA multiple of about 8.3 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 4% during the next five years, a pace that is higher than the company's 3-year historical compound annual growth rate of 2.7%. Our model reflects a 5-year projected average operating margin of 32.7%, which is above Zimmer'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. For Zimmer, we use an 11% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each company on the basis of the present value of all future free cash flows. Although we estimate the company's value at about $61 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 Zimmer. We think the company is attractive below $46 per share (the green line), but quite expensive above $76 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 company, in our opinion.
Future Path of Fair Value
We estimate Zimmer's fair value at this point in time to be about $61 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 company's current share price with the path of Zimmer'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 company's shares three years hence.
This range of potential outcomes is also subject to change over time, should our views on the future cash flow potential change. The expected fair value of $85 per share in Year 3 represents our existing fair value per share of $61 increased at an annual rate of the company'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.