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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 Magna Intl's (NYSE:MGA) case, we think the firm is undervalued, we think it is fairly valued at $53 per share (our report on Magna Intl and other companies can be found here).

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 information 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. Magna Intl scores a respectable 7 on our scale (reflecting its undervaluation and very bullish technicals).

Our Report on Magna Intl

[click to enlarge images]

Investment Considerations

Investment Highlights

Magna Intl'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. We think there are better quality firms out there.

Although we think the firm's DCF valuation indicates a potential attractive investment opportunity, we'd be more comfortable investing in the firm if it was more attractively priced on a relative basis versus
peers as well.

Magna Intl's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 1.7% during the past three years, lower than the mid-single-digit range we'd
expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.

The firm posts a VBI score of 7. We don't find the firm that attractive based on this measure, and we'd grow more constructive if it registered an 8 or higher on our scale.

The firm's technicals look very attractive. If current prices hold, the firm's moving averages could create a golden cross, a very bullish 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 (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. Magna Intl's 3-year historical return on invested capital (without goodwill) is 11.4%, which is below the estimate of its cost of capital of 11.7%. 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

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Magna Intl's free cash flow margin has averaged about 1.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. 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 Magna Intl, cash flow from operations increased about 76% from levels registered two years ago, while capital expenditures expanded about 6% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Magna Intl's shares are worth between $37.00 - $69.00 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 $53 per share represents a price-to-earnings (P/E) ratio of about 12.7 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% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -2.6%. Our model reflects a 5-year projected average operating margin of 5.4%, which is above Magna Intl's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.9% for the next 15 years and 3% in perpetuity. For Magna Intl, we use a 11.7% 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 $53 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 Magna Intl. We think the firm is attractive below $37 per share (the green line), but quite expensive above $69 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 Magna Intl's fair value at this point in time to be about $53 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 Magna Intl'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 $69 per share in Year 3 represents our existing fair value per share of $53 increased at an annual rate of the firm's cost of equity less itsdividend 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.

Source: Magna International Looks Really Cheap