Moody's Boasts A Highly Rated Economic Castle

| About: Moody's Corporation (MCO)
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One of the most recent break-throughs in finance is the definition of an Economic Castle.

Many investors have heard about Warren Buffett's economic moat concept, but very few investors are aware of the pitfalls of such a process.

Business owners want companies to generate the most economic profit, not the longest economic profit stream. At the core, this is the difference between a castle and a moat, respectively.

Let's take a look at Moody's investment prospects and understand why it has a highly-rated Economic Castle.

One of the most recent break-throughs in all of finance has been the development of Economic Castle ratings. These ratings assess the magnitude of the economic profit that a company will generate in the future and correct for the pitfalls of the economic moat concept, which is interested more in duration than magnitude. In this article let's talk about Moody's (NYSE:MCO) highly-rated economic castle, address a number of its investment considerations, and derive its intrinsic value.

Moody's Investment Considerations

Investment Highlights

• Moody's 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 firm garners one of the highest-rated Economic Castles in Valuentum's coverage universe.

• Moody's provides credit ratings, research, tools and analysis to the financial markets. The firm's ratings and analysis track debt covering more than 115 countries, 10,000 corporate issuers, 22,000 public finance issuers, and 82,000 structured finance obligations.

• Moody's 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 29.6% in coming years. Total debt-to-EBITDA was 1.6 last year, while debt-to-book capitalization stood at 86.2%. The operating margins on Moody's business are simply fantastic.

• Moody's has robust opportunities for growth: 1) economic activity will drive debt market issuance, 2) disintermediation of credit markets will increase new product demand, and 3) the firm retains pricing power. Management believes low-double-digit average annual growth is sustainable. Historically, rising interest rates have not significantly impacted revenue.

• Moody's has a nice recurring revenue base across much of its portfolio, with Moody's Analytics accounting for the majority of this revenue stream. Recurring revenue has consistently grown at a high single-digit pace.

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 with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Moody's 3-year historical return on invested capital (without goodwill) is 217.8%, which is above the estimate of its cost of capital of 10.2%. 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. Moody's free cash flow margin has averaged about 30.2% 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 At Moody's, cash flow from operations increased about 15% from levels registered two years ago, while capital expenditures fell about 38% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Moody's shares are worth between $69-$103 each. Shares are trading at just under $100 per share, so they are not necessarily cheap at present levels. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.

The estimated fair value of $86 per share represents a price-to-earnings (P/E) ratio of about 23.9 times last year's earnings and an implied EV/EBITDA multiple of about 14.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 13.5%. Our model reflects a 5-year projected average operating margin of 44.5%, which is above Moody's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4.6% for the next 15 years and 3% in perpetuity. For Moody's, we use a 10.2% weighted average cost of capital to discount future free cash flows.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Moody's to peers Morningstar (NASDAQ:MORN) and McGraw-Hill (MHFI).

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 Moody's. 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

We estimate Moody's fair value at this point in time to be about $86 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 Moody'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 $113 per share in Year 3 represents our existing fair value per share of $86 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

In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance. Thank you for reading!

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.