In this article, I will share the work I have been doing this week to see if the market is valuing Caterpillar (CAT) correctly.
Discounted Cash Flow Valuation
The methods I used are widely used in finance; the first one is the Discounted Cash Flow Valuation, which uses projections of future cash flows that the company will receive discounted at present value by the Weighted Average Cost of Capital (WACC).
Since this requires some guess-work and can vary depending on your expectations of the company and macro-economic factors, I will be happy to share in the comment section the inputs used for the value I arrived at using the DCF method.
The main variables used in DCF valuation were:
The WACC was used as the discount rate (10% as of this writing, according to the company)
Long-term sustainable growth rate was assumed at 3%.
The resulting value by the DCF valuation method was $98.77 per share.
The Graham Formula
The second method used was the Graham Formula, used by Benjamin Graham in The Intelligent Investor to determine true value of shares.
Most of the weight of this formula is on EPS, P/E and a smaller part on growth.
Current EPS for Caterpillar is $8.34, and 2012 EPS is expected at $11.52, a 38.1% increase.
The value of shares according to this formula is $89.57
There are two more methods used to determine price ranges for this security that I used:
A very popular method used when quickly trying to determine an approximate company´s value. This assumes that you would wait 7 years to get your investment back if you bought the company, this assumes no growth or decline in EBITDA during that period.
This method is more commonly used for private companies, and the values range from 6x EBITDA to 8x or more, so I considered using 7x EBITDA a conservative measure. The share price that this method implies is $114.02, by far the loftiest of the methods.
The last method used was Price/Sales, which takes into account market capitalization (currently $55.9 billion), and dividing it by the company´s revenue ($60.1 billion in 2011).
The ratio is 0.93, which means the market is not even valuing the company at its yearly revenues, this should be around 1. If it were 1, the share price should be $91.19
Using these four methods, the average price per share was $98.39, giving shares a potential 16.1% upside.
The price ranges for these past 3 years have been wild, from around $25 during the steepest decline of the financial crisis to above $115 several times during the past 2 years.
Do consider that since September 2010, prices have oscillated between $70 and $115.
I would like to emphasize that using all these methods, you could trade this stock within the ranges given by the valuations, buying when the price is at or below $89.57, and selling when it goes into the higher end of the range, conservatively you could sell (or short) at $98.39, or wait for price to go even higher if you like some adrenaline with your long position.
The bottom line is, right now shares of are undervalued at $84.96, and both traders and investors should look to get on the long side of this stock while also avoid shorting, since risk/reward is tilting heavily towards the long side right now.
In my next article I will be analyzing (DE), which should be interesting considering they are both in the same sector.
Additional disclosure: Also short SPY call spreads.