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Established in 1902, St. Paul, Minnesota-based 3M Company (MMM) is one of the largest conglomerates in the world. 3M is a highly diversified technology company that operates in several segments. The company is best known for its innovations in the adhesive and abrasive materials used as office supplies such as Post-It notes. Recently, 3M announced its intention to acquire Avery Dennison Corp.'s (AVY) office and consumer products business for $550 million. The deal is expected to complement 3M's position in the office supply sector.

As of the time of writing, 3M stock was trading at $83.5 with a 52-week range of $68 - $98. It has a market cap of $58.5 billion. Trailing twelve month [ttm] P/E ratio is 13.9, and forward P/E ratio is 13.2. P/B, P/S, and P/CF ratios stand at 3.4, 2.1, and 11.7, respectively. Operating margin is 20.9%, and net profit margin is 14.6%. The company does not have any significant debt issues. Debt/equity ratio is 0.3. 3M is a nifty dividend payer. Current yield is 2.7% with a payout ratio of 36%.

3M has a 4-star rating from Morningstar. Out of 14 analysts covering the company, 7 have buy, 1 have outperform, 5 have hold, and only 1 has underperform ratings. Wall Street has diverse opinions on 3M's future. Top line growth estimate is 5%, and the bottom line growth estimate is 2.5% for the next year. Average five-year annualized growth forecast estimate is 12%.

What is the fair value of 3M given the forecast estimates? We can estimate the fair value using discounted earnings plus equity model as follows.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.

E0 = EPS = ($5.88 + $6.31) / 2 = $6.10

Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 12%. Book value per share is $24.21.

The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$6.10

V (t=1)

E0 (1+g)/(1+r)

$6.07

V (t=2)

E0((1+g)/(1+r))2

$6.04

V (t=3)

E0((1+g)/(1+r))3

$6.01

V (t=4)

E0((1+g)/(1+r))4

$5.99

V (t=5)

E0((1+g)/(1+r))5

$5.96

Disposal Value

E0(1+g)5/[r(1+r)5]

$54.18

Book Value

BV

$24.21

Fair Value Range

Lower Boundary

$90.34

Upper Boundary

$114.55

Minimum Potential

8%

Maximum Potential

37%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for 3M is between $90 and $114.5 per share. At a price of $83.5, 3M is at least 8% undervalued with an upside potential up to 37%.

(Click chart to expand)

Summary

3M was subject to a massive sell-off in the 2011 third quarter. Between July and October, the stock literally crashed from $95 to $70, losing near 26% of its market cap. Since then, there is a strong recovery, and the stock is steadily moving in its upward trend. The current price is 22.5% above the stock's 52-week low, but the stock is still trading 14% below its 52-week high.

As Stephen Simpson suggests, 3M is an exceptionally diverse conglomerate that derives two-thirds of its revenues out of the United States. Therefore, it is a great company to play global economic recovery.

Based on my FED+ valuation, 3M is trading at least 8% below its fair value range. Analysts' mean target price of $92 fits near the lower end of my fair value estimate. Deutsche Bank has a target price of $105, which is near the upper-end of my fair value estimate. Therefore, I think 3M will hit $100 in the first half of the year. Therefore, I rate it as a buy for 2012. The current price offers a compelling entry point for those interested.

Source: 3M Has Up To 37% Upside Potential