By The Valuentum Team
Understanding the Flaws of Selecting Peers in Relative Valuation Analysis
There sometimes isn't a great peer, rival, or business model to use in relative valuation analysis, but we cover a large number of equities in the management services industry and the median forward metrics seek to be representative of this sprawling group. Even in the case of a near perfect peer, rival or business model, there are still myriad potential pitfalls of using any relative valuation approach, which is why our research and analytical work is grounded instead (or in addition to) in discounted cash-flow analysis and a firm-specific fair value estimate based on the intrinsic qualities of the actual firm being valued.
Many investors may feel that multiple analysis or relative value analysis is the only way to view equity valuation. It's possible that a lot of investors may not know the benefits of the DCF above any other valuation process. The DCF focuses on the intrinsic qualities of the firm to arrive at a firm-specific fair value. Using a variety of different valuation approaches, including relative valuation, remains the cornerstone of the Valuentum process, but with any relative valuation assumption, the very idea of comparing it to another firm will always be imperfect (no two firms are ever the same). Before reading this article on Booz, let's talk about this topic a little more and then come back.
Booz Allen Investment Thesis
Booz Allen Hamilton (NYSE:BAH) provides management and technology consulting and engineering services around the globe. The firm reported a strong quarter in the first quarter of its fiscal 2017 (ends March 2017). Both revenue and net income advanced more than 5% on a year-over-year basis in the period as the company continues to benefit from technology changing and developing faster than any other point in time. Most importantly, Booz Allen Hamilton's backlog leapt nearly 30% from the year-ago period to $12 billion, offering visibility into its future performance.
A fundamental driver of Booz Allen Hamilton's success is its strategic partnerships and alliances, which help it deliver the most technologically-advanced solutions and serve as a translator of cutting edge technology to clients. We like its combination of consulting expertise, domain knowledge, and technical capabilities, all of which are differentiating factors. The firm's first quarter report evidenced that it is on track for sustainable growth.
Looking ahead to the rest of fiscal 2017, Booz Allen Hamilton has prioritized the improvement of organic growth while executing with agility and efficiency. The operationalization of its past investments in advanced capabilities and talents will aid in such an initiative. Management is expecting revenue to be 2%-5% higher than fiscal 2016 in the year, while adjusted diluted earnings per share guidance comes in a range of $1.65-$1.75.
Booz Allen's Investment Considerations
• Booz Allen is a provider of management and technology consulting services. The firm's largest client is the US Army. Examples of its work includes rapid prototyping of equipment to protect soldiers on the battlefield and the design of wireless military communications.
• Backlog trends appear to be turning in the right direction. At the end of fiscal 2016, Booz Allen's total backlog totaled $11.8 billion, compared to $9.4 billion at the end of fiscal 2015. The driver was a ~45% jump in priced options backlog. The duration and timing of newly awarded contracts can adversely impact reported backlog.
• Management is expecting revenue growth in the low to-mid single digits for fiscal 2017 thanks in part to backlog growth, which has been pushed higher by increased investments in bid and proposal activity as the government contracting environment stabilizes. Adjusted diluted earnings per share are expected to be in a range of $1.65-$1.75.
• The company's book-to-bill has been volatile. For example, In the second quarter of fiscal 2016 it reached 3.49, compared to 0.92 in the previous quarter. The full year measure came in at a six-year high of 1.45x.
Economic Profit Analysis
In our opinion, 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. Booz Allen's 3-year historical return on invested capital (without goodwill) is 64.8%, which is above the estimate of its cost of capital of 10%. 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.
Understanding the Risk Free Rate and the Cost of Debt
Q: Can you explain why you use the risk-free rate you use in your valuation model? Why do you use a risk free rate assumption of 4.25% when the current spot rate of the 10-year Treasury is about 2%?
A: In our discounted cash-flow models that we use to value every non-financial operating company in our coverage universe, we match the duration of future free cash flows (from year 1 to perpetuity) with expectations of the average discount rate over this forecast horizon (from year 1 to perpetuity). We think the best way to achieve expectations of the long-term future average rate of the 10-year Treasury (risk free rate) is to use the weighted average of the historical 10-year Treasury and the current spot rate.
The goal of using a weighted average risk free rate in our DCF process is to achieve balance with respect to the duration of future cash flows. For example, discounting a cash flow in Year 20 at the current spot rate doesn't make much sense to us. Other methods consider the yield curve in discounting future free cash flows, or use a long-term average of the risk free rate without considering near-term changes in the 10-year Treasury rate. We think the use of the spot rate on the 10-year Treasury as the risk free rate in any valuation model would not only cause significant fair-value volatility but also result in a systematic overvaluation of companies relative to their true long-term intrinsic worth.
Source: Valuentum Securities
Q: Can you explain how you arrived at the after-tax cot of debt?
A: The credit spread is added to the risk free rate assumption in arriving at a company's pre-tax cost of debt. In the same light as to the rationale deriving the long-term risk-free-rate assumption, we use a fundamental assessment of credit quality to derive our own estimate of a company's credit spread, not a spot representation or recent debt issuance spreads (as might be found in an SEC filing, for example). We call our derivation the "synthetic credit spread."
In situations as in the current credit markets, which may underestimate a firm's true cost of borrowing in the financial valuation context, we feel a synthetic credit spread is more appropriate in matching a long-term estimate of the cost of borrowing with our forecast duration, which expands through 20 years and beyond. The pre-tax cost of debt is tax-effected to capture the interest tax shield that corresponds to the application of an enterprise free cash flow model applying earnings before interest, after taxes.
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. Booz Allen's free cash flow margin has averaged about 4.8% 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. At Booz Allen, cash flow from operations decreased about 25% from levels registered two years ago, while capital expenditures expanded about 219% over the same time period.
We think Booz Allen is worth $25 per share with a fair value range of $20-$30.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 3.7% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of -0.4%.
Our model reflects a 5-year projected average operating margin of 8.3%, which is below Booz Allen's trailing 3- year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Booz Allen, we use a 10% weighted average cost of capital to discount future free cash flows, which is based on the firm's capital structure being split by ~73.5% equity and ~26.5% debt along with a cost of equity assumption of 10.8% and an after-tax cost of debt assumption of 7.5%.
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 $25 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 were 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 above, we show this probable range of fair values for Booz Allen. We think the firm is attractive below $20 per share (the green line), but quite expensive above $30 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 Booz Allen's fair value at this point in time to be about $25 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Booz Allen'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 $32 per share in Year 3 represents our existing fair value per share of $25 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.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.