As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Caterpillar's (CAT) case, we think the firm is significantly undervalued. In this article, we walk through why.

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. Caterpillar posts a VBI score of 3 on our scale, reflecting our 'undervalued' DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. We compare Caterpillar to peers Deere (DE), Joy Global (JOY), AGCO Corp (AGCO), and CNH Global (CNH). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

**Our Report on Caterpillar**

**Investment Considerations**

**Investment Highlights**

â€¢ Caterpillar earns a ValueCreationâ„¢ 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 47.5% from 44.1% during the next two years.

â€¢ Caterpillar 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 7.8% in coming years. Total debt-to- EBITDA was 1.3 last year, while debt-to-book

capitalization stood at 72.9%.

â€¢ The firm sports a very nice dividend yield of 2.5%. We expect the firm to pay out about 22% of next year's earnings to shareholders as dividends.

**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. Caterpillar 's 3-year historical return on invested capital (without goodwill) is 33.4%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreationâ„¢ 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. Caterpillar 's free cash flow margin has averaged about 11.8% 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 www.valuentum.com. At Caterpillar , cash flow from operations increased about 11% from levels registered two years ago, while capital expenditures expanded about 46% over the same time period.

**Valuation Analysis**

Our discounted cash flow model indicates that Caterpillar 's shares are worth between $92.00 - $154.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRiskâ„¢ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $123 per share represents a price-to-earnings (P/E) ratio of about 16.6 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 7.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 5.4%. Our model reflects a 5-year projected average operating margin of 14.7%, which is above Caterpillar 's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Caterpillar , we use a 10.2% 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 $123 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 ValueRiskâ„¢ 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 Caterpillar . We think the firm is attractive below $92 per share (the green line), but quite expensive above $154 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 Caterpillar 's fair value at this point in time to be about $123 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 Caterpillar '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 $160 per share in Year 3 represents our existing fair value per share of $123 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**

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.