We think Valero Energy (NYSE:VLO) represents one of the most compelling refinery valuation plays on the market today. We think it fits perfectly within Valuentum's stock-picking methodology (the Valuentum Buying Index), which focuses on undervalued stocks that generate significant economic value for shareholders, while demonstrating identifiable avenues of growth. Though capacity and throughput expansion is one avenue for growth, we focus primarily on the range of possible outcomes in refining margins (and the impact to our estimate of its intrinsic value) to assess a refiner's investment attractiveness at any given time.
In Valero's case, the firm is trading well below the low end of our fair value estimate range ($28 per share) as determined by sensitivity analysis we perform on our projections of the company's future free cash flow stream. No other refiner comes close to being this undervalued.
What is Valero Energy Worth?
There are many schools of thought on valuation, but we feel a comprehensive discounted cash-flow process coupled with a rigorous relative value assessment versus peers is the best way to identify stocks poised for material capital appreciation. We prefer stocks that are trading at a discount to our fair value (based on our discounted cash-flow process) and are trading at a discount versus peers based on a relative value basis.
But what really gets us excited is Valero's valuation as determined by our DCF process, which why we are considering the firm in the portfolio of our Best Ideas Newsletter. Importantly, however, we look for stocks with identifiable growth prospects and employ a technical and momentum assessment in order to avoid value traps from buying great stocks but at an inopportune time. We don't just buy stocks because they're cheap -- as all investors know that stocks can often become cheap for good reasons.
For Valero, we expect intermediate strength in its refining segment operations, and margins for its distillate products, to recover in the years ahead as the global economy puts the European debt crisis in the rear-view mirror. Such a recovery should largely absorb the majority of excess refining capacity and relatively high levels of refined product inventories. Though reported inventories will swing over time, the October 5 report showed meaningful declines, which we view as a notable, recent positive.
We reveal our discounted cash-flow valuation assumptions for Valero below. In our opinion, Valero Energy is worth about $46 per share (and is still trading well below our $28 fair value downside level). The firm's shares are undervalued by over 50% and may provide the best opportunity for investors looking for a play within the refinery space.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.