With earnings season still a few weeks away, and most companies relatively quiet on the news front, it's a good time to check up on existing holdings and make sure that competitive positions and valuation still make sense. Up for review in my portfolio today is Canon
Canon, which is well-known for all things imaging, continually innovates with new products and manages its financial health quite well. However, the stock has been sitting at its highs lately, and today it's hitting another 52-week high. That doesn't make it automatically overvalued, but when I originally purchased the shares, I had valued the company around the current price of $66 per share.
Competitively, I like how the company is positioned in its printer, copying, and digital camera businesses. I also believe that Canon will continue to gradually improve its bubblejet printing offerings and gain share. However, these are all very competitive industries, and rivals Hewlett-Packard
The largest concern is one of valuation. Over the past five years, Canon has generated 224.6 billion yen ($1.9 billion) in average annual free cash flow. In comparison, the company generated 384 billion yen ($3.3 billion) in net income last year, and wants to generate 550 billion yen in net income within five years, which is 7.4% compound annual growth. That level of growth is not too shabby, but assuming free cash flow grows at a similar 7.4% rate for the next five years, and using a discount rate of 10%, I see a company that is fairly valued to slightly overvalued right now.
It's not all that simple. From 2002 to 2004, the company generated more in free cash flow each year than in 2005, and 2001 is abnormally low -- only 98 billion yen ($845 million) in free cash flow. Throwing out the 2001 data, and using the average rate of free cash flow for the last four years -- 256.3 billion yen ($2.2 billion) -- shows that the company may still be slightly undervalued. This level is probably more appropriate, but I believe that Canon will see higher-than-normal capital expenditures for the next few years as it moves to further automate its manufacturing. Automation is a smart move for the long term, given the demographic shift that is occurring in Japan's population, but not one that comes for free.
Canon is a healthy company, and certainly not fully developed. It should still have several years of growth ahead. At least some of that growth is priced in; my more conservative valuations now show that the company is either fully valued or fairly close at $66 per share. This exercise just goes to show how "flexible" valuations are. The calculations are concrete, but the inputs and the accuracy of the assumptions behind them can make a huge difference in the final result. With that said, I have some work to do on double-checking my assumptions for Canon over the next week -- and deciding whether to sell or hold.
For more Canon-related Foolishness: