Avon Has Substantial Upside, Boasts Excellent Yield

| About: Avon Products, (AVP)
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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In the case of Avon Products's (NYSE:AVP), we think the company is significantly undervalued at today's prices. We think it's fair value is $26 per share (our report on Avon Products and hundreds of other companies can be found here).

For some background, we think a comprehensive analysis of a company's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Avon Products scores a 6 on our scale (reflecting its undervaluation, but bearish technicals). Given Avon's attractive valuation, we are strongly considering adding it to the portfolio in our Best Ideas Newsletter.

Our Report on Avon Products


Investment Considerations

Investment Highlights

Avon Products earns a ValueCreation™ rating of Excellent, the highest possible mark on our scale. The company has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 45.5% during the past three years.

Avon Products's valuation is compelling at this time. The company is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The company's forward earnings multiple and PEG ratio also look attractive versus peers.

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

The company sports a very nice dividend yield of 5.5%. We expect the company to pay out about 51% of next year's earnings to shareholders as dividends.

Economic Profit Analysis

The best measure of a company'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 company's economic profit spread. Avon Products's 3-year historical return on invested capital (without goodwill) is 45.5%, which is above the estimate of its cost of capital of 9%. 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.

Cash Flow Analysis

companys that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Avon Products's free cash flow margin has averaged about 3.8% during the past 3 years. As such, we think the company'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 www.valuentum.com. At Avon Products, cash flow from operations decreased about 8% from levels registered two years ago, while capital expenditures fell about 13% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Avon Products's shares are worth

between $20.00 - $33.00 each. The margin of safety around our fair value estimate is driven by the company's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $26 per share represents a price-to-earnings (P/E) ratio of about 18.9 times last year's earnings and an implied EV/EBITDA multiple of about 10.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 2.2% during the next five years, a pace that is lower than the company's 3-year historical compound annual growth rate of 3%.Our model reflects a 5-year projected average operating margin of 10.9%, which is above Avon Products's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.1% for the next 15 years and 3% in perpetuity. For Avon Products, we use a 9% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each company on the basis of the present value of all future free cash flows. Although we estimate the company's fair value at about $26 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 Avon Products. We think the company is attractive below $20 per share (the green line), but quite expensive above $33 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 company, in our opinion.

Future Path of Fair Value

We estimate Avon Products's fair value at this point in time to be about $26 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 company's current share price with the path of Avon Products'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 company's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the company's future cash flow potential change. The expected fair value of $30 per share in Year 3 represents our existing fair value per share of $26 increased at an annual rate of the company'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.