As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Lorillard's (NYSE:LO) case, we think the company is fairly valued at $101 per share, which is slightly lower than where it is currently trading (our report on Lorillard and other companies can be found here).
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 (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. Lorillard scores a respectable 7 on our scale (reflecting its fair value and bullish technicals).
Our Report on Lorillard
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Lorillard earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The company has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 161.8% during the past three years.
The company is trading at attractive valuation mulitples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the shares.
Lorillard has an excellent combination of strong free cash flow generation and low financial leverage. We expect its free cash flow margin to average about 18.1% in coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 114.6%.
The 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 company sports a very nice dividend yield of 4.6%. We expect it to pay out about 67% of next year's earnings to shareholders as dividends. The company remains on the watch list of our Dividend Growth Newsletter, as we prefer Altria (NYSE:MO).
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. Lorillard 's 3-year historical return on invested capital (without goodwill) is 161.8%, which is above the estimate of its cost of capital of 11%. As such, we assign it 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
Companies that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Lorillard 's free cash flow margin has averaged about 19.6% during the past 3 years. As such, we think the company'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. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Lorillard , cash flow from operations increased about 11% from levels registered two years ago, while capital expenditures fell about 9% over the same time period.
Our discounted cash flow model indicates that Lorillard 's shares are worth between $71.00 - $131.00 each. The margin of safety around our fair value estimate is driven by the MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $101 per share represents a price-to-earnings (P/E) ratio of about 14.9 times last year's earnings and an implied EV/EBITDA multiple of about 8.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.6% during the next five years, a pace that is lower than the 3-year historical compound annual growth rate of 14.3%. Our model reflects a 5-year projected average operating margin of 31.5%, which is above Lorillard 's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Lorillard, we use a 11% 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 $101 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 Lorillard. We think the company is attractive below $71 per share (the green line), but quite expensive above $131 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 Lorillard 's fair value at this point in time to be about $101 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 company's current share price with the path of Lorillard '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 shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the company's future cash flow potential change. The expected fair value of $124 per share in Year 3 represents our existing fair value per share of $101 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
Disclosure: MO is included in the portfolio of our Best Ideas and Dividend Growth Newsletter.