We think Boston Scientic (BSX) represents one of the most compelling valuation plays on the market. 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, as measured by the spread between return on invested capital and a firm's cost of capital.
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. What really gets us excited about Boston Scientific is its valuation as determined by our DCF process, which is why we are considering the firm in the portfolio of our Best Ideas Newsletter. We provide the highlights of our report on Boston Scientific below.
Our Report on Boston Scientific
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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 (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Boston Scientific's 3-year historical return on invested capital (without goodwill) is 25.9%, which is above the estimate of its cost of capital of 8.9%. As such, we assign the firm 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
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Boston Scientific's free cash flow margin has averaged about 12.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Boston Scientific, cash flow from operations decreased about 53% from levels registered two years ago, while capital expenditures fell about 23% over the same time period.
Our discounted cash flow model indicates that Boston Scientific 's shares are worth between $6 and $12 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 $9 per share represents a price-to-earnings (P/E) ratio of about -12.8 times last year's earnings and an implied EV/EBITDA multiple of about 8 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 0.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -2.2%. Our model reflects a 5-year projected average operating margin of 19.2%, which is above Boston Scientific 's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 0.2% for the next 15 years and 3% in perpetuity. For Boston Scientific , our model uses a 8.9% 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 $9 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 Boston Scientific . We think the firm is attractive below $6 per share (the green line), but quite expensive above $12 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 Boston Scientific 's fair value at this point in time to be about $9 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of Boston Scientific'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 $13 per share in Year 3 represents our existing fair value per share of $9 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