How Much Is Illinois Tool Works Worth?

We may not be in a raging economic recovery, but the recovery has been enough to help industrial companies like Illinois Tool Works (NYSE: ITW) climb back out of the recessionary ditch that they'd stumbled into.

Illinois Tool works churns out an amazing number of products ranging from plastic film to cooking equipment, welding gear, and laminate flooring. In 2009, the company reported a near 20% decrease in revenue as the economy slumped. This year has looked substantially better, and the company just recently reaffirmed its full-year outlook that full-year earnings per share would come in between $2.82 and $3.08 -- a 53% gain over 2009 at the midpoint.

Is it time to start snatching up shares of Illinois Tool Works? Well, first we need to get an idea of what the company's shares are really worth.

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 Illinois Tool Works stacks up.

Source: Capital IQ, a Standard & Poor's company, and Yahoo! Finance.
Average excludes Illinois Tool Works.

Using each of those averages to back into a stock price for Illinois Tool Works, and then taking the average across those results, we can come up with an estimated price-per-share of right around $54. This would suggest that at $46, the shares could be undervalued right now.

A comparable company analysis like this can sometimes raise as many questions as it answers though. For instance, is the entire industry properly valued? A supposedly fairly valued stock in an undervalued industry may actually be an undervalued stock -- and vice versa.

Additionally, while these companies are comparable, they're certainly not all the same. For example, Caterpillar's primary focus is on heavy industrial equipment, and the business includes a big financing arm. And while others like Danaher, Ingersoll-Rand, and Parker-Hannifin are all industrial manufacturers with diversified product lines, none of the businesses are a perfect mirror image of Illinois Tool Works.

So with all 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 (DCF). 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 (aka, 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 Illinois Tool Works' DCF, I used the following assumptions:

Source: Capital IQ, a Standard & Poor's company, Yahoo! Finance, 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.

Additionally, I've included an estimate for acquisition spending along with capital spending in my cash flow projections. For some companies, like Illinois Tool Works, acquisitions are an important growth driver, so it's important to either account for the amount the company spends on acquisitions, or throttle back growth assumptions accordingly.

Based on the assumptions above, a simple DCF model spits out a per-share value of $48 for Illinois Tool Works' stock. This suggests that the stock is just slightly undervalued, if not fairly valued.

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 Illinois Tool Works' stock.

That said, with a price range of $48 to $54, the stock looks like it could be moderately attractive. At the midpoint of that range, the stock would be roughly 10% undervalued. Of course with an industrial player like Illinois Tool Works whose business is very closely tied to the overall economy, it's very important that economic recovery continues to justify these prices.

As a generally solid and -- I believe -- well-run company that pays a decent dividend, Illinois Tool Works has been on my radar recently. Ideally, though, I'd like to see a slightly better price before I get too excited.

Do you think Illinois Tool Works is a great opportunity right now? Head down to the comments section and share your thoughts.

Soberly valuing stocks before you make a buy or sell decision is a smart move. Listening to this advice isn't.