By Valuentum Analysts
Do you believe that stock prices actually mean something? We do. As part of our stock-selection process, we build a discounted cash-flow model where we estimate the intrinsic value per share of companies. This may be slightly different than you might be used to with respect to valuation multiple analysis, where one might buy a stock because its multiple looks cheap relative to peers or relative to history, or something else.
But there’s a reason why a company like FedEx Corporation (FDX) has a market cap in the tens of billions while other stocks are penny stocks. By adding the net cash on a company’s balance sheet to the present value of its future expected free cash flows and then dividing that sum by shares outstanding, one arrives at the value of a company on a per-share basis. The market buys and sells based on an estimate of the company’s value. Where some small penny stocks may be burning through cash, FedEx has the capacity for tremendous free cash flow generation.
After calculating the value per-share of the company – which includes an analysis of net cash on the balance sheet and future expected free cash flows – and then comparing this value per-share to FedEx’s price per share, we can make an informed judgment about whether the stock is a good deal or not. The higher the value relative to the price, the better the deal! Think of it as getting a discount at the grocery store. As Warren Buffett once said, “Whether socks or stocks, I like buying quality merchandise when it is marked down.” In our discounted cash-flow process, we think FedEx is worth $295 per share, and this is well above where shares are currently trading (~$256 per share).
Our valuation model of FedEx reflects a compound annual revenue growth rate of 4.8% during the next five years, a pace that is lower than the company’s 3- year historical compound annual growth rate of 8.7%. We’re expecting some slowdown as pandemic-driven e-commerce proliferation (and the shipments) normalizes. Our valuation model of FedEx reflects a 5-year projected average operating margin of 9.1%, which is above FedEx’s trailing 3-year average (we think FedEx will eke out some operating efficiencies and drive some serious price increases in coming years). Beyond year 5, we assume free cash flow will grow at an annual rate of 5.5% for the next 15 years and 3% in perpetuity. We think these are reasonable normalized assumptions. For FedEx, we use a 9% weighted average cost of capital to discount future free cash flows.
These summary assumptions translate into a build to arrive at the value-derived market capitalization for FedEx, as shown in the image below. The free cash flows generated during the first five years are discounted back to the present value today (that’s the first grey bar on the left in the image below). The free cash flows from years 6 through 20 are discounted cash to the present value today, too (that’s the second grey bar from the left in the image below). The third grey bar from the left is the perpetuity value (this is the value assigned to all those cash flows FedEx will generate beyond year 20). The fourth grey bar from the left is FedEx’s net debt position, which is subtracted because equity owners own that money to bond holders. Had this been a net cash position, we would have added it because that excess cash belongs to the owners. The value-derived market capitalization (the blue bar all the way to the right) is then divided by diluted shares outstanding to arrive at the $295 per share fair value estimate of shares.
FedEx’s Investment Highlights
FedEx provides customers and businesses worldwide with a broad portfolio of transportation, e-commerce and business services. The proliferation of ecommerce supports its growth outlook. FedEx operates under various segments including: FedEx Express, FedEx Ground, FedEx Freight, and FedEx Services. It was founded in 1971 and is based in Memphis.
FedEx’s acquisition of TNT Express gives it access to TNT’s European distribution network. Integration costs have come in higher than projected, but it is on track to achieve material pre-tax synergies, which will help drive incremental operating profit.
FedEx’s operations are capital intensive, characterized by significant investments in aircraft, vehicles, technology, facilities, and equipment. Capital expenditures are generally 7%-9% of sales. While FedEx is a tremendous generator of operating cash flow, its free cash flow performance is rather volatile (as the above analysis has shown), and the firm has a large net debt load.
FedEx’s outlook is supported by its impressive pricing strength and future price increases should be expected. However, FedEx is also contending with major inflationary pressures, with an eye towards rising labor and fuel expenses. It will take time for recent pricing increases to be fully reflected in its financials.
FedEx has significantly grown its dividend in recent years. Management remains committed to rewarding shareholders. During the COVID-19 pandemic, FedEx’s business model has proven to be resilient even in the face of serious operational hurdles. Shares yield ~1.2%.
FedEx’s 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. FedEx’s 3-year historical return on invested capital (without goodwill) is 13.9%, which is above the estimate of its cost of capital of 9%.
As such, we assign the firm strong value-creation rating. 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. We like to think in terms of ranges of probable fair value outcomes, and ROIC in no different.
FedEx’s 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 FedEx’s fair value at about $295 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers such as 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.
This is a good way to think about the markets and what causes market volatility. For example, if future expectations change, the value of the company will change, and therefore so will the buying and selling decisions that drive the price. This is, in part, why we think stocks will eventually converge to a reasonable estimate of their intrinsic value.
Our risk 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 FedEx. We think the firm is attractive below $236 per share (the green line), but quite expensive above $354 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. With shares trading at ~$256 each, we think there is more upside potential than downside risk at FedEx at this time.
Future Path of Estimated Fair Value
We estimate FedEx’s fair value at this point in time to be about $295 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 FedEx’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 $380 per share in Year 3 represents our existing fair value per share of $295 increased at an annual rate of the firm’s cost of equity less its dividend yield. The upside and downside…
Read More: FedEx: Stock Cheap And FCF On The Mend (NYSE:FDX)