As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Northrop Grumman (NYSE:NOC) case, we think the firm is fairly valued at $70 per share, which is considerably higher than where it is currently trading.

For some background, we think a comprehensive analysis of a firm'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 (click here for more info on our methodology), 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. Northrop Grumman scores a 3 on our scale (reflecting its negative ValueTrend™ rating and very bearish technicals). Once its technicals turn the corner, we will consider it in the portfolio of our Best Ideas Newsletter.

## Our Report on Northrop Grumman

*click to enlarge images*

## Investment Considerations

## Investment Highlights

Northrop Grumman earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value

for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to

45.9% from 40.4% during the next two years.

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 $49, we'd take a closer look. However, currently, the company is trading at a sizeable discount to our point estimate of its intrinsic value.

Northrop Grumman has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin

to average about 7.4% in coming years. Total debt-to-EBITDA was 1.2 last year, while debt-to-book capitalization stood at 26.3%.

The firm'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.

The firm's technicals look very weak. If current prices hold, the firm's moving averages could create a death cross, a very bearish technical pattern.

## 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 (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Northrop Grumman's 3-year historical return on invested capital (without goodwill) is 31.4%, which is above the estimate of its cost of capital of 9.9%. 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. Northrop Grumman's free cash flow margin has averaged about 5.3% 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. At Northrop Grumman, cash flow from operations decreased about 24% from levels registered two years ago, while capital expenditures expanded about 14% over the same time period.

## Valuation Analysis

Our discounted cash flow model indicates that Northrop Grumman's shares are worth between $49.00 - $91.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $70 per share represents a price-to-earnings (P/E) ratio of about 10.3 times last year's earnings and an implied EV/EBITDA multiple of about 5.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -5.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 2.8%. Our model reflects a 5-year projected average operating margin of 12.3%, which is above Northrop Grumman's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 0.5% for the next 15 years and 3% in perpetuity. For Northrop Grumman, we use a 9.9% 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 $70 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 Northrop Grumman. We think the firm is attractive below $49 per share (the green line), but quite expensive above $91 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 Northrop Grumman's fair value at this point in time to be about $70 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 Northrop Grumman'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 $88 per share in Year 3 represents our existing fair value per share of $70 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

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.