As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In DuPonts' (NYSE:DD) case, we think the firm is fairly valued at about $65 per share, and it is currently trading at the low end of our fair value range.
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. DuPont posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We compare Dupont to peers Airgas (ARG), Dow Chemical (NYSE:DOW), Praxair (NYSE:PX), and Sigma-Aldrich (NASDAQ:SIAL). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
Our Report on DuPont
• DuPont 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 18.8% from 17.9% during the next two years
• The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $49, we'd take a closer look.
• DuPont 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 9.5% in coming years. Total debt-to-EBITDA
was 2.2 last year, while debt-to-book capitalization stood at 59.6%.
• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.
• The firm sports a very nice dividend yield of 3.1%. We expect the firm to pay out about 38% of next year's earnings to shareholders as dividends. Though we're near fully invested, DuPont is a name we may consider for addition to the portfolio in our Dividend Growth Newsletter.
<< Our Dividend Report on DuPont -- free
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 (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. DuPont's 3-year historical return on invested capital (without goodwill) is 15.8%, which is above the estimate of its cost of capital of 9.7%. 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. DuPont's free cash flow margin has averaged about 10.1% 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 DuPont, cash flow from operations increased about 9% from levels registered two years ago, while capital expenditures expanded about 41% over the same time period.
Our discounted cash flow model indicates that DuPont's shares are worth between $49.00 - $81.00 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 $65 per share represents a price-toearnings
(P/E) ratio of about 18.2 times last year's earnings and an implied
EV/EBITDA multiple of about 13.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 9.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 3.7%. Our model reflects a 5-year projected average operating margin of 12%, which is above DuPont's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.7% for the next 15 years and 3% in perpetuity. For DuPont, we use a 9.9% 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 $65 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. We think the firm is attractive below $49 per share, but quite expensive above $81 per share. The prices in between, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.