The last few weeks were very positive for shareholders of 3M (NYSE: MMM). The company hosted its Investor Day, where management introduced its new 5-year plan, the goal of which is to tackle all of the current problems of the business and make a substantial return for shareholders along the way. 3M stock also performed very well and reached its 52-week high. This is a good improvement considering the fact that 2015 wasn't very successful in terms of returns and the stock was in the red zone most of the time. It also underperformed its major competitors, which include conglomerates like General Electric (NYSE: GE), Danaher (NYSE: DHR), Carlisle (NYSE: CSL) and others:
But based on the new 5-year plan and the outlook issued from the last earnings report, I believe 3M is on the path to recovery and there's a lot of room for growth.
To value 3M, I will use method that NY Stern Professor Aswath Damodaran described in his book The Little Book of Valuation, where he valued the same 3M, but back in 2008. I'll try to stick to his approach, but will update the valuation based on 2015 fiscal numbers.
First, I'll start with the free cash flow-to-equity (FCFE), which measures the cash left after taxes, reinvestment needs and others. Sometimes cash flow-to-equity includes new debt that the company issued for the period, but I'll take a more conservative approach, which Warren Buffett calls "owners' earnings", and ignore it in my calculation. Based on the numbers from the company's SEC filings, 3M's owners' earnings in 2015 would have been $3.174 million (Image 1). I'll also calculate free cash flow to firm (FCFF), which is the cash left after taxes and after all reinvestment needs have been met, but before interest and principal payments on debt. In 2015, 3M's FCFF was $5.156 million (Image 1).
To calculate the risks that 3M presents for investors, I used three inputs:
- Risk-free rate: I used 10-year Treasury bond that was yielding 1.73% on April 8 as my risk-free rate.
- Equity risk premium (ERP): As of April 1, implied ERP was 5.15% (trailing 12-month, with adjusted payout).
- Beta: Since 3M is diversified company, I used beta for the Diversified Industry, which is 1.01% as of January 2016.
These three inputs helped me to calculate cost of equity and after-tax cost of debt of 3M, which can be seen in Image 2 below:
Note: The default spread number in the after-tax cost of debt calculation was given 0.75%, based on 3M's interest rate coverage ratio. Marginal tax rate in my calculation was given 40%, based on KPMG's Corporate Tax table.
Now, to calculate 3M's cost of capital, I used the numbers from above and added the company's market cap ($103 billion) and debt ($10.8 billion) to the equation.
Based on my calculation, in growing periods, 3M's return on capital (cost of capital) is 6.44%.
After that, I decided to find out what the expected FCFF of the company will be in coming years. To do that, I used 3M's after-tax operating income from Image 1 as my starting point and calculated the reinvestment rate by dividing its operating income growth, which is 5.50%, on the return on equity, which is 37.50%, and got 15% (Reinvestment rate = Operating Income Growth/ROE):
As we can see, at the current growth rate, 3M could finance most of its activities and reinvest more in the business each year.
However, there's a point in the company's lifetime where excessive growth stops. So, I decided to calculate 3M's reinvestment rate in stable growth periods and its terminal value in year 6. As the growth declines after year five, the beta is adjusted towards one and the debt ratio is raised to the industry's average of 20% (in this case, I used the Electrics industry) to reflect the overall stability of the company. Since the cost of debt is relatively low, I leaved it unchanged, which resulted in a drop in the cost of capital to 6.08%. I also assumed that the risk-free rate at that time would be around 1.50%. And here's what I got:
Now, by having most of the numbers that I need to value the company, I start with the valuation of 3M's operating assets and equity, which are as follows:
If we divide the value of equity, which is $128.231 million, by 614 (the number of outstanding shares), we will get $209 per share of 3M, which represents an upside of more than 20% of the current price.
As we can see, the overall picture for 3M looks pretty attractive, and based on the new 5-year plan, positive outlook and my valuation, it's a "buy".
Disclosure: I am/we are long MMM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Note: In the analysis, I didn’t use debt, when calculating FCFE and management options, when calculating value of equity, purposely. If I’ll add them, a few metrics will be changed, but overall picture will remain the same and will have the same bullish thesis. Sources: sec.gov, Company fillings, Bloomberg, YY Charts, pages.stern.nyu.edu/~adamodar.