As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Republic Services' (RSG) case, we think the firm is materially undervalued. Specifically, we think it is fairly valued at $42 per share, significantly higher than where it is currently trading.
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Republic Services 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 22.8% from 21.8% during the next two years.
Tengentially, there have been some questions recently about what Valuentum considers to be the most important measure of a firm's ability to deliver value to shareholders. Here's an excerpt from our FAQ page:
What is the most important measure of return on invested capital (ROIC), in Valuentum's opinion?
We think return on new invested capital (RONIC) is the most important measure of whether a company is generating economic value for shareholders. Though we look at ROIC with goodwill and ROIC without goodwill (and each one is informative depending on a company's acquisition program), we view the capacity of a company to generate economic value in the future (RONIC) as the best indication of its ability to translate such business performance into equity price outperformance, all else equal.
Republic Services' 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: Waste Management (WM) and Waste Connections (WCN), etc. We are strongly considering adding to our position in the company in the portfolio of our Best Ideas Newsletter. In the spirit of transparency, we show the performance of our Best Ideas portfolio below:
Republic Services 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 13.7% in coming years. Total debt-to-EBITDA was 2.9 last year, while debt-to-book capitalization stood at 47.4%.
The firm sports a very nice dividend yield of 2.9%. We expect the firm to pay out about 44% of next year's earnings to shareholders as dividends. Our dividend-growth report on Republic can be found here.
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 with its weighted average cost of capital (GM:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Republic Services' 3-year historical return on invested capital (without goodwill) is 21.2%, which is above the estimate of its cost of capital of 8.4%. 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. Republic Services' free cash flow margin has averaged about 8.3% 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 about our fully-populated DCF valuation models, please visit our website here. At Republic Services, cash flow from operations increased about 27% from levels registered two years ago, while capital expenditures expanded about 13% over the same time period.
Our discounted cash flow model indicates that Republic Services' shares are worth between $32 and $53 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 $42 per share represents a price-to-earnings (P/E) ratio of about 26.9 times last year's earnings and an implied EV/EBITDA multiple of about 9.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 30.5%. Our model reflects a 5-year projected average operating margin of 20.8%, which is above Republic Services' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.5% for the next 15 years and 3% in perpetuity. For Republic Services , we use a 8.4% 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 $42 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 Republic Services. We think the firm is attractive below $32 per share (the green line), but quite expensive above $53 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 Republic Services' fair value at this point in time to be about $42 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 Republic Services' 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 $53 per share in Year 3 represents our existing fair value per share of $42 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
Additional disclosure: RSG is included in the portfolios of our Best Ideas Newsletter and Dividend Growth Newsletter.