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With Halliburton (NYSE:HAL) falling significantly from its recent highs set in July of last year, we though it important to share our thoughts on the firm's valuation and whether it exhibits both value and momentum characteristics, two qualities that -- when combined -- have a solid possibility of generating alpha.

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Investment Considerations

Investment Highlights

Halliburton 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. Return on invested capital (excluding goodwill) has averaged 19.1% during the past three years.

The company looks fairly valued at this time (it is trading within our fair value range). We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $32, we'd take a closer look at adding it to the market-beating portfolio of our Best Ideas Newsletter. However, based on our fair value point estimate, we see upside to the mid-$40s.

Halliburton's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 2.6% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.

Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company. Halliburton scores a 6 on our Valuentum Buying Index, which considers that it is trading within our fair value range on bullish technicals.

The firm experienced a revenue CAGR of about 10.7% during the past three years. We expect its revenue growth to be below that of its peer median during the next five years.

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. Halliburton's three-year historical return on invested capital (without goodwill) is 19.1%, which is above the estimate of its cost of capital of 9.9%. 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. Halliburton's free cash flow margin has averaged about 2.6% during the past three years. As such, we think the firm's cash flow generation is relatively medium. 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 Halliburton, cash flow from operations increased about 59% from levels registered two years ago, while capital expenditures expanded about 58% over the same time period.

Valuation Analysis

We think Halliburton is worth $45 per share, which represents a price-to-earnings (P/E) ratio of about 13.8 times last year's earnings and an implied EV/EBITDA multiple of about 7.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8.7% during the next five years, a pace that is lower than the firm's three-year historical compound annual growth rate of 10.7%. Our model reflects a five-year projected average operating margin of 16.4%, which is below Halliburton's trailing three-year average. Beyond year five, we assume free cash flow will grow at an annual rate of 4% for the next 15 years and 3% in perpetuity. For Halliburton, 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 $45 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 Halliburton. We think the firm is attractive below $32 per share (the green line), but quite expensive above $59 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 Halliburton's fair value at this point in time to be about $45 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 Halliburton'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 three 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 $59 per share in year three represents our existing fair value per share of $45 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 Halliburton Has Upside To The Mid-$40s