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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Union Pacific's (UNP) case, we think it is worth $96 per share, which is slightly lower than where it is currently trading. To learn more about our process, click here for a video.

For some background, 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. In the spirit of transparency, we show the performance of our VBI system (based on our Best Ideas Newsletter) below:

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. Union Pacific scores a respectable 6 on our scale (reflecting its fair value and bullish technicals).

Our Report on Union Pacific

(Click to enlarge images)

Investment Considerations

Investment Highlights

Union Pacific's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle.

The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $72, we'd take a closer look.

Union Pacific 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 13.5% in coming years. Total debt-to-EBITDA was 1.4 last year, while debt-to-book capitalization stood at 34.2%.

Although we think there may be a better time to dabble in the company's shares based on our DCF process, the stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.

The company experienced a revenue CAGR of about 1.4% during the past 3 years. We expect its revenue 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 (WACC). The gap or difference between ROIC and WACC is called the economic profit spread. Union Pacific 's 3-year historical return on invested capital (without goodwill) is 7.9%, which is below the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of POOR. 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

Companies that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Union Pacific 's free cash flow margin has averaged about 17.6% during the past 3 years. As such, we think the 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. At Union Pacific, cash flow from operations increased about 1% from levels registered two years ago, while capital expenditures fell about 96% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Union Pacific 's shares are worth between $72 and $120 each. The margin of safety around our fair value estimate is driven by the company's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $96 per share represents a price-to-earnings (P/E) ratio of about 17.4 times last year's earnings and an implied EV/EBITDA multiple of about 8.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.5% during the next five years, a pace that is higher than the 3-year historical compound annual growth rate of 1.4%. Our model reflects a 5-year projected average operating margin of 31.5%, which is above Union Pacific '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 Union Pacific , our model uses a 9.8% 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 fair value at about $96 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 were 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 Union Pacific. We think the company is attractive below $72 per share (the green line), but quite expensive above $120 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation, in our opinion.

Future Path of Fair Value

We estimate Union Pacific 's fair value at this point in time to be about $96 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 current share price with the path of Union Pacific'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 shares three years hence. This range of potential outcomes is also subject to change over time, should our views on future cash flow potential change. The expected fair value of $124 per share in Year 3 represents our existing fair value per share of $96 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.

Pro Forma Financial Statements

Source: Investors Shouldn't Expect Much Upside From Union Pacific