Every non-defunct company is worth something to shareholders, even companies that are marked for dead. They still have option value to turn things around. President of Valuentum's Equity Research, Brian Nelson, spends a lot of time talking about how investing is not about just owning a fantastic company at any price, but instead, it is about owning a fantastic company at a great price. (We recently posted a video on this topic.)
To determine whether Caterpillar (NYSE:CAT) is worthy of investment, for example, investors should not be asking whether CAT is a good company, but instead, whether the share price of Caterpillar reflects its intrinsic value, and whether the share price reflects the view that CAT is a good company. There is a big difference between a good company and a good stock. In this piece, let's address the concept of price vs. value with respect to Caterpillar.
Caterpillar's Investment Considerations
• Caterpillar'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. Caterpillar has an attractive Economic Castle rating, but results are not immune to geopolitical risks.
• Caterpillar makes construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The company also owns Caterpillar Financial Services (Cat Financial). Operations are tied to cyclical end markets.
• Caterpillar 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 8.4% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 64.5%.
• Cat's dealer network is a significant competitive advantage. The company's reach is phenomenal, with about 50 dealers in the US and over 140 outside of the US (serving 180+ countries). We like the firm's proficiency in lowering costs, improving cash flows and continued execution of lean manufacturing initiatives.
• Near-term trends aren't favorable. Industry surveys indicate that total mining capital expenditures will fall another 20% in 2014 from 2013 levels, which were ~10% below 2012 spending. Mining equipment sales remain tied to expectations of commodity prices.
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. Caterpillar's 3-year historical return on invested capital (without goodwill) is 30.3%, which is above the estimate of its cost of capital of 9.6%. 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. Caterpillar's free cash flow margin has averaged about 10.2% 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. At Caterpillar, cash flow from operations increased about 46% from levels registered two years ago, while capital expenditures expanded about 37% over the same time period.
We think Caterpillar's shares are worth between $76-$114 each. 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 midpoint of the range, $95 per share, is our estimate of Cat's intrinsic value.
Our model reflects a compound annual revenue growth rate of 1.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 9.3%. Our model reflects a 5-year projected average operating margin of 13.1%, which is below Caterpillar's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For Caterpillar, we use a 9.6% weighted average cost of capital to discount future free cash flows.
What does all of this mean in laymans' terms? Well, the CAT is out of the bag! Our fair value estimate is roughly in line with where shares are trading, so we don't expect much return from price-to-fair value convergence. Investors should expect a market return from Cat from these levels. If shares were to get cheaper (the share price were to fall), we'd grow much more interested in the company.
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 Caterpillar to peers AGCO Corp (NYSE:AGCO) and Deere (NYSE:DE).
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 $95 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 Caterpillar. We think the firm is attractive below $76 per share (the green line), but quite expensive above $114 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 Caterpillar's fair value at this point in time to be about $95 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 Caterpillar'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 $120 per share in Year 3 represents our existing fair value per share of $95 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.