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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Allegheny Technologies' (NYSE:ATI) case, we think the firm is fairly valued at $47 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. The framework of the Valuentum Buying Index is backed up by extensive academic analysis revealing the significant benefits of a combined value-momentum portfolio versus other strategies (namely value, growth, and momentum alone). Our white paper can be downloaded here.

In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

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. Allegheny Technologies posts
a VBI score of 5 on our scale, reflecting our 'fairly valued' DCF assessment of the company, attractive relative valuation versus peers, and neutral technicals. Allegheny Technologies is at the top of its peer group that includes Alcoa (NYSE:AA), Aluminum Corp of China (NYSE:ACH), Century Aluminum (NASDAQ:CENX), and Titanium Metals (TIE) for our peer group analysis.

Our Report on Allegheny Technologies

In the spirit of transparency, our report on Allegheny Technologies and hundreds of other companies can be found here.

click to enlarge images

Investment Considerations

Investment Highlights

Allegheny Technologies' average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits
through the course of the economic cycle. We think there are better quality firms out there.

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.

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 $24, we'd take a closer look at adding it to the market-beating portfolio of our Best Ideas Newsletter. In the spirit of transparency, we show the performance of our Best Ideas Newsletter below:

We're not too fond of Allegheny Technologies' weak cash flow generation and high financial leverage. Although this combination does not guarantee financial problems down the road, it could potentially
be a recipe for disaster during tough economic times.

The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.

Business Quality

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. Allegheny Technologies' 3-year historical return on invested capital (without goodwill) is 4.5%, which is below the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of POOR. 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. Allegheny Technologies' free cash flow margin has averaged about -3.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. 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 Allegheny Technologies, cash flow from operations increased about 36% from levels registered two years ago, while capital expenditures fell about 33% over the same time period.

Valuation Analysis

We think Allegheny Technologies' shares are worth $47 each, which represents a price-to-earnings (P/E) ratio of about 25 times last year's earnings and an implied EV/EBITDA multiple of about 10.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -0.8%. Our model reflects a 5-year projected average operating margin of 12.1%, which is above Allegheny Technologies' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5% for the next 15 years and 3% in perpetuity. For Allegheny Technologies, 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 $47 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 Allegheny Technologies. We think the firm is attractive below $24 per share (the green line), but quite expensive above $71 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 Allegheny Technologies' fair value at this point in time to be about $47 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 Allegheny Technologies' 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 $63 per share in Year 3 represents our existing fair value per share of $47 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

Source: Why Allegheny's Shares Have Valuation Upside