As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Dell's (DELL) case, we think the firm is cheap. We think it is fairly valued at $25 per share, significantly higher than where it is currently trading.
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, 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. Dell posts a VBI score of 9 on our scale, reflecting our 'undervalued' DCF assessment of its shares, its attractive relative valuation versus peers, and bullish techinicals. Dell leads this peer group with a VBI score of 9, followed by IBM, Apple (AAPL), Hewlett-Packard (HPQ), and Research in Motion (RIMM).
Our Report on Dell
click to enlarge images
Dell earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 133% from 131.2% during the next two years.
Dell 's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.
Dell has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 5.7% in coming years. Total debt-to-EBITDA was 1.7 last year, while debt-to-book capitalization stood at 50.9%.
The firm's shares have underperformed the market benchmark during the past quarter. Although Dell 's valuation appears attractive, the company is currently exhibiting characteristics of a potential value trap, and we'd still be cautious at these levels. There may be a better entry point yet.
The firm experienced a revenue CAGR of about 0.5% during the past 3 years. We expect its revenue growth to be below that of its peer median during the next five years.
Most Recent Quarterly Results
Dell reported disappointing fiscal fourth-quarter results. Revenue for the quarter advanced only 2%, to $16 billion, as a 6% jump in services revenue offset roughly flat product revenue. The firm continues to expand its mix of revenue and earnings, and services revenue growth outpaced products revenue advancement in the quarter, which we view positively. Non-GAAP operating income fell 11% in the period, while non-GAAP net income dropped 10% as the company faced higher disk drive costs due to the well-known supply constraints from the recent flooding in Thailand. Share buybacks, however, mitigated the decline in earnings per share, which fell 4% from the same period a year ago, to $0.51 (consensus was at $0.52 per share).
Looking ahead, Dell said it is focused on operating income and cash flow, important targets, though we prefer a focus on return on new invested capital (which may prevent a reckless acquisition). For 2013, the company expects non-GAAP earnings per share to exceed the record $2.13 per share it achieved during fiscal 2012 and excellent net income conversion to cash flow. Though we like its full-year outlook, the company guided revenue in its fiscal first quarter to decline 7% on a sequential basis, lower than what consensus was expecting. However, we think the launch of Windows 8, which will be offered on Dell's products, will serve as a nice catalyst for the company's shares to converge to our fair value estimate, despite intense competition from the tablet market, namely Apple's iPad portfolio. Given the firm's valuation, we are strongly considering it in the portfolio of our Best Ideas Newsletter.
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. Dell 's 3-year historical return on invested capital (without goodwill) is 117.2%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm 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
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Dell 's free cash flow margin has averaged about 6.7% during the past 3 years. As such, we think the firm'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 Dell, cash flow from operations increased about 42% from levels registered two years ago, while capital expenditures expanded about 84% over the same time period.
Our discounted cash flow model indicates that Dell 's shares are worth between $18.00 - $33.00 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 $25 per share represents a price-to-earnings (P/E) ratio of about 13.3 times last year's earnings and an implied EV/EBITDA multiple of about 7.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 0.5%. Our model reflects a 5-year projected average operating margin of 7.5%, which is above Dell 's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 0.8% for the next 15 years and 3% in perpetuity. For Dell, we use a 10.2% 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 $25 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 Dell. We think the firm is attractive below $18 per share (the green line), but quite expensive above $33 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 Dell's fair value at this point in time to be about $25 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 Dell'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 $35 per share in Year 3 represents our existing fair value per share of $25 increased at an annual rate of the firm'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