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Alcoa (AA) is a prominent player in the aluminum business. Established in 1888, the New York-headquartered company specializes in the production of aluminum, alumina and related products. These products are used to produce final-end products, such as aircrafts, automobiles, construction services, as well as, other industrial outputs. Alcoa is a global company with operations worldwide. While, the company was able to boost its earnings significantly, the stock has been a big loser in the last year. Even after returning 21% in 2012, Alcoa is still trading 43% below its 52-week high.

As of the time of writing, Alcoa stock was trading at $10.43 with a 52-week range of $8.45 - $18.47. It has a market cap of $11.1 billion. Trailing twelve month [ttm] P/E ratio is 19, and forward P/E ratio is 10.8. P/B, P/S, and P/CF ratios stand at 0.8, 0.5, and 5.5, respectively. Operating margin is 6% and net profit margin is 2.5%. The company has some debt issues. Debt/equity ratio is 0.6. Alcoa pays a yield of 1.15%.

Alcoa has a 5-star rating from Morningstar. Out of 7 analysts covering the company, 2 have buy, 1 has outperform, 3 have hold, and 1 has sell ratings. Wall Street has diverse opinions on Alcoa's future. Average five-year annualized growth forecast estimate is 16.4%. This is a pretty bullish estimate, given Alcoa's negative growth in the last few years. However, it is attainable, as we experience a strong global recovery which is likely to boost the demand for aluminum products.

What is the fair value of Alcoa given the forecast estimates? We can estimate Alcoa'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 = ($0.53 + $0.96) / 2 = $0.75

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 16.4%. Book value per share is $12.96. The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$0.75

V (t=1)

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

$0.78

V (t=2)

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

$0.82

V (t=3)

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

$0.86

V (t=4)

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

$0.90

V (t=5)

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

$0.94

Disposal Value

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

$8.59

Book Value

BV

$12.96

Fair Value Range

Lower Boundary

$13.64

Upper Boundary

$26.60

Minimum Potential

31%

Maximum Potential

155%

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 Alcoa is between $13.64 and $26.6 per share. At a price of $10.43, Alcoa is undervalued by at least 30%. The stock has up to 155% upside potential.

click to enlarge

Peer Performance

Alcoa is not only the only stock that suffered from the drastic reduction in aluminum prices. Competitors' stock prices also followed a similar pattern. Aluminum Corporation of China (ACH), Alumina (AWC), Century Aluminum (CENX), and Noranda Aluminum (NOR) also disappointed their shareholders with significantly negative returns in the last year. Kaiser Aluminum (KALU) is the only exception among its peers with a slightly positive return in the same period. However, there are strong signs of recovery in the aluminum prices, which created a strong momentum for aluminum related stocks. The following table shows the performance breakdown of these companies:

Ticker

Performance (Week)

Performance (Month)

Performance (Quarter)

Performance (Half Year)

Performance (Year)

Performance (YTD)

Alcoa

1.46%

-0.19%

13.00%

-11.61%

-36.36%

21.00%

Aluminum Corp. of China

0.00%

0.37%

18.02%

-20.05%

-42.98%

25.56%

Alumina

5.40%

-2.59%

-0.75%

-25.98%

-42.72%

17.11%

Century Aluminum

-1.69%

-4.21%

18.73%

-5.08%

-34.95%

22.91%

Kaiser Aluminum

-1.81%

-0.44%

17.43%

0.47%

4.21%

8.32%

Noranda

7.94%

16.82%

72.41%

43.51%

-13.25%

51.52%

It is quite hard to choose between these companies, as they all have remarkably similar ratios. Alumina offers the best yield, but it is also trading at a significant premium. I think the market performances of these companies are remarkably correlated with aluminum prices. If the global recovery keeps its momentum, the demand for aluminum will increase. The increased demand will push the aluminum prices to higher levels, which, in turn, will lift the market prices of these stocks.

Summary

Those looking for a safer play in this field, should consider Alcoa with a priority over its peers. As the largest producer of alumina, Alcoa has a great moat in its field. The scale of its operations combined with cost minimization through efficient resource utilization puts Alcoa ahead of its peers.

From a technical perspective, Alcoa is on the bounce. The stock found itself a strong support level between $8-$9 range. Since the beginning of this year, it returned 21%. Based on my FED+ valuation, its fair value range implies at least 31% upside potential. That is why, I think, Alcoa is ready for a big bounce.

Source: Alcoa: Ready For A Big Bounce