As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Precision Castparts' (NYSE:PCP) case, we think the firm is undervalued. We think it is fairly valued at $217 per share. Our report on Precision Castparts and hundreds of other companies can be found here.
For some background, we think a comprehensive analysis of a firm'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 (click here for more info on our methodology), 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. Precision Castparts posts a VBI score of 7 on our scale, reflecting our 'undervalued' DCF assessment of the company, its neutral relative valuation versus peers, and bullish techinicals. Precision Castparts is at the top of this group, which includes Spirit AeroSystems (NYSE:SPR), Goodrich (NYSE:GR), Rockwell Collins (NYSE:COL), and Hexcel Corp (NYSE:HXL).
Our Report on Precision Castparts
Precision Castparts' 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.
Although we think the firm's DCF valuation indicates a potential attractive investment opportunity, we'd be most comfortable investing in the firm if it was more attractively priced on a relative basis versus peers as well. However, because we think Precision Castparts represents the best fundamental play without the aerospace supply chain, we hold the name in the portfolio of our Best Ideas Newsletter and expect upside beyond $200 per share. In the spirit of transparency, we disclose the performance of our Best Ideas Newsletter below:
Precision Castparts has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 14.2% in coming years. Total debt-to-EBITDA was 0.1 last year, while debt-to-book capitalization stood at 3.2%.
The firm experienced a revenue CAGR of about -3.2% during the past 3 years. However, we expect its revenue growth to be better than its peer median during the next five years.
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 (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Precision Castparts' 3-year historical return on invested capital (without goodwill) is 37.4%, which is above the estimate of its cost of capital of 10.7%. 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. Precision Castparts' free cash flow margin has averaged about 13.8% 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, we are the only firm that makes available fully-discounted cash flow models to our financial advisor clients. At Precision Castparts, cash flow from operations decreased about 6% from levels registered two years ago, while capital expenditures fell about 41% over the same time period.
Our discounted cash flow model indicates that Precision Castparts' shares are worth between $174 and $260 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 estimated fair value of $217 per share represents a price-to-earnings (P/E) ratio of about 30.9 times last year's earnings and an implied EV/EBITDA multiple of about 18.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 15.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -3.2%. Our model reflects a 5-year projected average operating margin of 25.2%, which is above Precision Castparts' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 7.6% for the next 15 years and 3% in perpetuity. For Precision Castparts, we use a 10.7% 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 $217 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 Precision Castparts. We think the firm is attractive below $174 per share (the green line), but quite expensive above $260 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 Precision Castparts' fair value at this point in time to be about $217 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 Precision Castparts' 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 $295 per share in Year 3 represents our existing fair value per share of $217 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
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: PCP is included in our Best Ideas portfolio.