A company is worth the present value of its future free cash flows +/- non-operating contingent assets/liabilities -- no more, no less. However, an investor can pay more or less than a company's intrinsic value. If the present value of a company's free cash flows are less than its stock price, the stock is overpriced. If the present value of a company's free cash flows are more than its stock price, the stock is underpriced. It has good value. Let's calculate Philip Morris International's (NYSE:PM) intrinsic value and compare it to its share price. Is it overvalued, or is it undervalued?
Philip Morris International's Investment Considerations
Philip Morris International Investment Highlights
• Philip Morris' business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively. The company has a very attractive Economic Castle.
• Philip Morris benefits from its exposure to faster-growing regions of the world, including Asia and EEMA. Still, it remains exposed to regulatory risk and excise price shocks that may impact demand for tobacco in certain countries. Currency fluctuations can pose stiff earnings headwinds at times.
• Philip Morris 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 12.5% in coming years. Total debt-to-EBITDA was 1.9 last year, while debt-to-book capitalization stood at 139%.
• The firm's Marlboro brand continues its leading position in the EU region. The brand's share of the premium market in the EU has advanced steadily in recent years. In the EEMA region, its brand Parliament is gaining share in countries such as Kuwait, Kazakhstan and Turkey. The company's brand portfolio is solid.
• Pricing will be the main driver of Philip Morris' income growth. We like the company's ability to raise prices despite a challenging economic backdrop in several regions of the world. Productivity gains should help profits as well.
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. Philip Morris' 3-year historical return on invested capital (without goodwill) is 81.2%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the company 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. 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
Our discounted cash flow model indicates that Philip Morris' shares are worth between $69-$103 each. A company's intrinsic value is always going to be based on the future cash flows that it generates. The future is always unpredictable. The more unpredictable the cash flows in the future, the larger the fair value range for a company today. The margin of safety around our fair value estimate is driven by the company's LOW ValueRisk™ rating, which is derived from the volatility of key valuation drivers.
We estimate Philip Morris' intrinsic value to be $86 per share (the midpoint of the range), which represents a price-to-earnings (P/E) ratio of about 16.3 times last year's earnings and an implied EV/EBITDA multiple of about 11.3 times last year's EBITDA. Our valuation model reflects a compound annual revenue growth rate of 2.5% during the next five years, a pace that is lower than the company's 3-year historical compound annual growth rate of 43.3%. Our valuation model reflects a 5-year projected average operating margin of 18.5%, which is above Philip Morris's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Philip Morris, we use a 9.7% 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 $86 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 Philip Morris. We think the firm is attractive below $69 per share (the green line), but quite expensive above $103 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
Pro Forma Income Statement
In the spirit of transparency, we reveal the performance of the Valuentum Buying Index in the latest study. Please click here for more details.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.