It's little wonder that Automatic Data Processing
But a solid underlying business is only part of the math of a good investment. Even the best companies can be lousy investments if the price is too high.
So is ADP worth buying? Well, first we need to get an idea of what its 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 ADP stacks up.
Total Enterprise Value / Trailing Revenue
Price / Forward Earnings
Total Enterprise Value / Trailing EBITDA
Fidelity National Informational Services
Sources: Capital IQ, a Standard & Poor's company, and Yahoo! Finance. Average excludes ADP.
Using each of those averages to back into a stock price for ADP, and then taking the average across those results, we can come up with an estimated price per share of right around $46. This would suggest today's price of $42 leaves the stock somewhat undervalued.
However, a comparable company analysis like this can sometimes raise as many questions as it answers. 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.
Additionally, while these companies are comparable, they're certainly not all the same. All of the names above are involved in business and specialty financial services, but many of them are riding very different business drivers. Visa and MasterCard, for example, are being driven by the growth in electronic payments, while Western Union is banking on the growth in money transfers around the world.
So with all that in mind, it's best to combine comparable company analysis with another valuation technique.
Collecting the cash flow
An alternative 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 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 ADP's DCF, I used the following assumptions:
|2011 Unlevered Free Cash Flow||$1.1 billion|
|FCF Growth 2011-2015||10.6%|
|FCF Growth 2015-2020||5.3%|
|Market Equity as a Percentage of Total Capitalization||99.8%|
|Cost of Equity||12%|
|Cost of Debt||0.75%|
|Weighted Average Cost of Capital||12%|
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.
In addition, I've included acquisitions along with ADP's capital spending. Some companies, like ADP, use acquisitions as a consistent part of their growth strategy. When this is the case, a reasonable valuation will either include the cash flow impact of the acquisition strategy or throttle back the growth rate.
Based on the assumptions above, a simple DCF model spits out a per-share value of $37 for ADP's stock. This seems to suggest that the stock could actually be overvalued.
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 ADP's stock.
That said, with a price range of $37 to $46, we're left with a pretty muddled view of ADP's current price. At the midpoint of that range, though, we'd peg the stock's fair value at $41.50, which nearly hits the current price right on the nose.
As an owner of ADP myself, I'm not particularly anxious to put in a sell order -- the stock doesn't look particularly overvalued, and the company has a great underlying business and is paying investors 3.2% just to hang around. That said, I'm also not itching to add to my position either.
So in Wall Street parlance, I'd call ADP a "hold" right now. But I want to know what you think. Do you agree that ADP is a hold? Head down to the comments section and share your thoughts.
This exercise would be completely meaningless if stock picking were dead. Of course, I don't believe stock picking is even close to dead.
Paychex and Western Union are Motley Fool Inside Value recommendations. Western Union is a Motley Fool Stock Advisor pick. Automatic Data Processing is a Motley Fool Income Investor recommendation. Paychex is a former Income Investor recommendation. Motley Fool Options has recommended a write covered strangle position on Western Union. The Fool owns shares of Fiserv. Try any of our Foolish newsletter services free for 30 days.
True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.
Fool contributor Matt Koppenheffer owns shares of ADP, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his Motley Fool CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookies were harmed in the making of this article.