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Valero Energy (VLO) is one of the largest independent oil & gas refiners in North America. The company owns and operates several petroleum refineries throughout the U.S., Canada, and Aruba. Established in 1955, the San Antonia-based Valero employs over 20,000 employees. The company took my attention, after Jim Cramer mentioned it as a bearish call. Contrary to Jim Cramer, I think Valero is a great deal which has significant upside potential.

As of the time of writing, Valero stock was trading at $19.85 with a 52-week range of $16.40 - $31.12. It has a market cap of $11.1 billion. Trailing twelve month [ttm] P/E ratio is 5.2, and forward P/E ratio is 5.1. P/B, P/S, and P/CF ratios stand at 0.7, 0.1, and 2.4, respectively. Operating margin is 3.4%, and net profit margin is 1.4%. The company does not have any significant debt issues. Debt/equity ratio is 0.4. Valero is a nifty dividend payer, which increased its dividends by three-fold in the last quarter. Based on the latest dividend of $0.15, projected yield is 2.9%.

Valero has a 4-star rating from Morningstar. Out of 15 analysts covering the company, 6 have buy, 2 have outperform, and 7 have hold ratings. Wall Street has diverse opinions on Valero's future. Top line growth estimate is -7.2%, and the bottom line growth estimate is -36.7% for the next year. Average five-year annualized growth forecast estimate is 13.2%. However, that sounds too bullish, given the company's past 5-year growth record of -22.7%. Therefore, I will slash the growth estimate by half to 6.6% for the FED+ analysis.

What is the fair value of Valero given the forecast estimates? We can estimate Valero's 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 = ($3.91 + $3.93) / 2 = $3.92

For the annualized growth forecast I will use a pretty conservative growth estimate of 6.6%. Book value per share is $29.8.

The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$3.92

V (t=1)

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

$3.76

V (t=2)

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

$3.62

V (t=3)

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

$3.47

V (t=4)

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

$3.33

V (t=5)

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

$3.20

Disposal Value

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

$29.11

Book Value

BV

$29.8

Fair Value Range

Lower Boundary

$50.4

Upper Boundary

$80.2

Minimum Potential

147%

Maximum Potential

293%

(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 Valero is between $50.4 and $80.2 per share. At a price of $29, Valero is a likely candidate to double in 2012.

Summary

Refinery stocks are among the cheapest stocks in the market, and Valero is no exception. It is actually much cheaper than its peers. At a trailing P/E ratio of 5.2, Valero is trading well below the industry average of 11.

The stock did not perform well over the last year, and it is trading near 36% lower than its 52-week high. Surely, the company was deeply affected from the global crises, and it had to slash its dividends by two third. However, Valero showed a remarkable growth this year, and the company was able to boost its yield by 200% in the most recent quarter. The company trades at 13.66 times the cash flow.

Valero's balance sheet has near $5 of cash per share. Even if the company makes no profits, it can keep paying the current yield for at least 5-6 more years. The CFO, Mike Ciskowski, recently announced significant improvements in operating margin as well as net income. I think, the current price offers a great entry point. RBC is also bullish on the stock. They rate Valero as an 'outperform' with a target price of $32. Moreover, based on my FED+ valuation, Valero is trading at least 147% below its fair value range. Therefore, I rate Valero as a buy for big profits in 2012.

Source: Valero Energy Has A 147% Upside Potential