As savvy investors know, valuation is a range of potential outcomes as opposed to a specific point estimate. That's why we like to use a fair value range in our analysis. No one, and we repeat no one, can tell you the exact value of a company. Why? Because value is based on the future cash flow and earnings of a company, and these are inherently unpredictable. No one can know the future with certainty. However, using a range and identifying when stock prices fall outside that range, is the secret to finding undervalued or overvalued firms. Though in Valero Energy's (NYSE:VLO) case, we think the firm is fairly valued (its price falls within our fair value range), the firm has yet to reach the high end of the range ($53). We would not be surprised if its upward advance beginning early 2012 continues.
Our Report on Valero Energy
• Valero Energy's 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.
• Valero Energy's 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.
• 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.
• Valero's petroleum refineries are located in the US, Canada, UK, and Aruba and produce conventional gasoline and other refined products. The company's performance remains heavily tied to refining margins, which remain highly volatile.
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 (NASDAQ: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. Valero Energy's 3-year historical return on invested capital (without goodwill) is 9%, which is below the estimate of its cost of capital of 10.5%. 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. Valero Energy's free cash flow margin has averaged about 2.9% 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. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Valero Energy, cash flow from operations increased about 17% from levels registered two years ago, while capital expenditures expanded about significantly over the same time period.
Our discounted cash flow model indicates that Valero Energy's shares are worth between $23.00 - $53.00 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $38 per share represents a price-to-earnings (P/E) ratio of about 10.3 times last year's earnings and an implied EV/EBITDA multiple of about 5.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 0.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 1.9%. Our model reflects a 5-year projected average operating margin of 3.8%, which is above Valero Energy's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.4% for the next 15 years and 3% in perpetuity. For Valero Energy, we use a 10.5% 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 $38 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 Valero Energy. We think the firm is attractive below $23 per share (the green line), but quite expensive above $53 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 Valero Energy's fair value at this point in time to be about $38 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 Valero Energy'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 $52 per share in Year 3 represents our existing fair value per share of $38 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. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.