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With Nabors Industries (NYSE:NBR) well off its recent highs achieved in February, we thought it important to reiterate our valuation assessment and walk through why the company fits the Value-Momentum style of investing.

Our Report on Nabors Industries

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Investment Considerations

Investment Highlights

Nabors Industries' scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return
on invested capital (excluding goodwill) has averaged 9.9% during the past three years.

Nabors Industries' valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers. We are strongly considering opening up a position in the portfolio of our Best Ideas Newsletter (please see our links on our left sidebar for more info).

Nabors Industries' cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.

The firm's shares have underperformed the market benchmark during the past quarter. Although Nabors Industries' valuation appears attractive, the company is currently exhibiting characteristics of a potential value trap, and we'd still be cautious at these levels. There may be a better entry point yet.

The firm's PEG ratio is not only below 1, but it also falls below the median of its peer group. This provides additional support for the firm's attractive valuation on a DCF basis.

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. Nabors Industries' 3-year historical return on invested capital (without goodwill) is 9.9%, which is above the estimate of its cost of capital of 7.8%. As such, we assign the firm a ValueCreation™ rating of GOOD. 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. Nabors Industries' free cash flow margin has averaged about 3.8% during the past 3 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 Nabors Industries, cash flow from operations decreased about 4% from levels registered two years ago, while capital expenditures expanded about 87% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Nabors Industries' shares are worth between $16.00 - $26.00 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 $21 per share represents a price-to-earnings (P/E) ratio of about 18 times last year's earnings and an implied EV/EBITDA multiple of about 5.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 6.7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 5%. Our model reflects a 5-year projected average operating margin of 15.1%, which is above Nabors Industries' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.8% for the next 15 years and 3% in perpetuity. For Nabors Industries, we use a 7.8% 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 $21 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 Nabors Industries. We think the firm is attractive below $16 per share (the green line), but quite expensive above $26 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 Nabors Industries' fair value at this point in time to be about $21 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 Nabors Industries' 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 $29 per share in Year 3 represents our existing fair value per share of $21 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: Rebecca Freese constructed the article. The opinions and analysis of the firms mentioned in this article reflect that of The Valuentum Team. We did not receive compensation from companies mentioned in this article, and we have no business relationship with any company whose stock is mentioned in this article.

Source: Why Nabors Is A Value-Momentum Stock