Some time ago, a particularly Foolish reader recommended that I take a good look at medical-device manufacturer Medtronic (NYSE: MDT ) . Why? The company is a leader in its industry, it has a rapidly growing dividend (it's more than doubled in the past five years), and the stock looks darn cheap.
Sounds good to me, but is the stock actually cheap? Let's take a closer look.
It's a beautiful day in the neighborhood
One way to get an idea of what a stock might be worth is to check out how similar companies are valued. So let's take a look at how Medtronic stacks up.
Total Enterprise Value / Trailing Revenue
Next Twelve Months Price-to-Earnings Ratio
Total Enterprise Value / EBITDA
Trailing Twelve Months PEG
|Baxter International (NYSE: BAX )||2.4||11.9||9.0||1.9|
|Becton, Dickinson (NYSE: BDX )||2.6||15.2||8.6||1.7|
|Boston Scientific (NYSE: BSX )||2.1||18.2||8.6||NM|
|St. Jude Medical (NYSE: STJ )||3.1||13.3||9.6||1.2|
|Stryker (NYSE: SYK )||2.7||15.6||8.3||1.5|
|Zimmer Holdings (NYSE: ZMH )||2.7||12.2||7.5||1.6|
Sources: Capital IQ, a Standard & Poor's company, and Yahoo! Finance.
Average excludes Medtronic.
NM = Not meaningful. Boston Scientific was unprofitable over the past 12 months.
Using each of those averages to back into a stock price for Medtronic and then taking the average across those results, we can come up with an estimated price-per-share of roughly $41. This would suggest that the recent price of $37.58 is undervalued.
A comparable company analysis like this can sometimes raise as many questions as it answers, though. For instance, is the entire group properly valued? A supposedly fairly valued -- or even overvalued -- stock among a bunch of other undervalued stocks may actually be an undervalued stock and vice versa.
While these are all medical equipment companies, their businesses are certainly not all the same. Boston Scientific and St. Jude may be the most comparable of the group, but neither has the scale of Medtronic, and Boston Scientific has been dealing with messy restructuring and impairments for years. Meanwhile, Zimmer and Stryker deal largely with orthopedic products, and Baxter and Becton, Dickinson offer an array of other medical gear including syringes, drug delivery devices, renal care equipment, and scalpels. That means that these businesses won't necessarily move in lockstep.
So with that in mind, it's best to combine comparable company analysis with another valuation technique.
Collecting the cash flow
An alternate way to value a stock is to do what's known as a discounted cash flow. Basically, this method projects free cash flow over the next 10 years and discounts the tally from each of those years back to what it would be worth today (since a dollar tomorrow is worth less to us than a dollar today).
Because a DCF is based largely on estimates (i.e., guesses) and it attempts to predict the future, it can be a fickle beast, and so its results are best used as guideposts rather than written-in-stone answers sent down from Mount Olympus.
For Medtronic's DCF, I used the following assumptions:
|Fiscal 2011 Unlevered Free Cash Flow||$3 billion|
|FCF Growth 2011-2015||9.5%|
|FCF Growth 2015-2020||4.8%|
|Market Equity as a Percentage of Total Capitalization||80.0%|
|Cost of Equity||12.0%|
|Cost of Debt||3.1%|
|Weighted Average Cost of Capital||10.1%|
Sources: Capital IQ, a Standard & Poor's company, Yahoo! Finance, and author's estimates.
While most of this is pretty standard fare when it comes to DCFs, the academically inclined would probably balk at the way I set the cost of equity. In a "classic" DCF, the cost of equity is set based on an equation that uses beta -- a measure of how volatile a stock is versus the rest of the market -- and a few other numbers that I tend to thumb my nose at.
But when you get right down to it, the cost of equity is the rate of return that investors demand to invest in the equity of that company. So I generally set the cost of equity equal to the rate of return that I'd like to see from that stock.
Based on the assumptions above, a simple DCF model spits out a per-share value of roughly $47 for Medtronic's stock. That not only confirms the undervaluation above but makes it look as though Medtronic's stock may be even cheaper than we originally thought.
Interestingly, we get this result even though my free-cash-flow numbers assume that Medtronic continues to spend a very significant portion of its cash flow on acquisitions. Obviously, a toning-down of the company's acquisition program would have an impact on the company's growth, but it would boost cash flow significantly.
For sake of comparison, if I assumed that Medtronic stopped making acquisitions and, as a result, its growth rate fell to a flat 3% forever, the DCF result would actually go up to $55. Of course, while this could be considered an upside scenario, we also have to consider the possibility that management could make some large, overpriced acquisitions that impair the company's value to something less than the $47.
Do we have a winner?
The valuations that we've done here are pretty simple and, particularly when it comes to the DCF, investors would be well-advised to play with the numbers further before making a final decision on Medtronic's stock.
However, with a valuation range of $41 to $47, I feel pretty comfortable that this is an undervalued stock. At the midpoint of that range, the stock would be worth 17% more than today's price.
Combine that valuation with a solid underlying business that should benefit from demographic trends and a management team that is cutting investors in on the company's success through share buybacks and dividends, and we've got a stock that I'm excited to put on the short list to add to my personal portfolio.
I'm digging Medtronic, but Warren Buffett scooped up shares of one of the other companies listed above. Find out which one in this free special report.