As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Papa John's (PZZA) case, the high end of our fair value range is $44 per share, slightly below where it is now trading after earnings. We're not too eager to jump in at these levels.
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 (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):
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. Papa John's posts a VBI score of 7 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and bullish techinicals. We compare Papa John's to peers Darden Restaurants (DRI), McDonald's (MCD), Starbucks (SBUX) and Yum! Brands (YUM). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
Our Report on Papa John's
• Papa John's 's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• The firm is trading at attractive valuation multiples 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 firm's shares.
• Papa John's has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 5.9% in coming years. Total debt-to-EBITDA was 0.4 last year, while debt-to-book capitalization stood at 19.7%.
• The firm's technicals look very attractive. If current prices hold, the firm's moving averages could create a golden cross, a very bullish technical pattern (please view our links on the left sidebar for more information).
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. Papa John's 's 3-year historical return on invested capital (without goodwill) is 36%, which is above the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation rating of EXCELLENT. In the chart, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray 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. Papa John's 's free cash flow margin has averaged about 6% 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. At Papa John's, cash flow from operations decreased about 5% from levels registered two years ago, while capital expenditures fell about 13% over the same time period.
Our discounted cash flow model indicates that Papa John's 's shares are worth between $30.00 - $44.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $37 per share represents a price-to-earnings (P/E) ratio of about 16.8 times last year's earnings and an implied EV/EBITDA multiple of about 8.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.5%. Our model reflects a 5-year projected average operating margin of 7.8%, which is above Papa John's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.9% for the next 15 years and 3% in perpetuity. For Papa John's, we use a 10.5% 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 $37 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 above, we show this probable range of fair values for Papa John's. We think the firm is attractive below $30 per share (the green line), but quite expensive above $44 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.
We strive to answer a few questions that investors often ask: 1) What are the chances of a total loss of investment in this company? and 2) What is the chance that the company is really worth twice what I paid for it? The probability (fair value < 0) strives to answer the first question. It indicates the chance that the firm may encounter insolvency based on the characteristics of its cash flow stream, capital structure and risk profile. The probability (fair value > 2x current share price) strives to answer the second question. It is our best estimate of whether investors are participating in a half-off sale by buying the company's shares at current prices.
Future Path of Fair Value
We estimate Papa John's 's fair value at this point in time to be about $37 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of Papa John'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 $50 per share in Year 3 represents our existing fair value per share of $37 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