Quick Overview - Hannover Re Stock Analysis

Investment Thesis

Reinsurers are an essential part of the insurance industry, providing financial protection to insurance companies, also known as primary insurers, by underwriting a portion of the risks these companies take on. This partnership significantly contributes to the risk management strategy by mitigating the impacts of major events such as natural disasters and terrorist attacks. By taking on these portions of risk, reinsurers help stabilise the insurance market and minimise fluctuations and uncertainties within the sector. Although this cooperation between primary and reinsurers exists, it does not directly affect the existing insurance contracts with the end customers. Instead, it enables primary insurers to receive partial or full compensation from reinsurers in the event of a claim, depending on the terms of the reinsurance agreement.

A Leading Reinsurer with Solid Growth and High Returns for Value Investors: Hannover Re is the third-largest reinsurer globally, specialising in risk coverage for primary insurers, enabling them to minimise risks and generate stable profits. With an annual market growth of 3%, the sector ranks among the fastest-growing in the insurance industry. The company focuses on property damage reinsurance and benefits from the increase in natural disasters by regularly renewing contracts and raising premiums.

Is Hannover Re stock undervalued? Hannover Re is seen as an attractive investment opportunity, especially for value investors. The company is distinguished by its focused approach to the insurance market and a dynamic growth strategy, while still being considered fairly valued. It boasts great revenue growth, an excellent return on equity, an impressive dividend, and a solid balance sheet within the industry. Is there still more strength in the Hannover Re stock, or should investors wait to buy in despite the fair valuation?

Where is the fair value, and how much potential is actually still in the stock? That's what I want to work out step by step in the following company analysis. Let's get started!

Company - Hannover Re

History

Industry

Reinsurers play a crucial role in the insurance industry by insuring insurance companies (primary insurers), thus helping to manage the financial risks from natural disasters, terrorist attacks, and other major events. By taking on parts of the risks from primary insurers, reinsurers enable a stabilisation of the insurance market, leading to less turbulence and uncertainty within the sector. The cooperation between primary insurers and reinsurers does not directly affect the original insurance contracts with the insured. It allows primary insurers to be reimbursed for a part or the entire amount of claims from the reinsurers, depending on the agreed coverage.

The tasks and offerings of reinsurers have significantly expanded over time to respond to the increasingly complex and diverse risks. This evolution has led to an interdisciplinary approach to work, involving experts such as lawyers, geologists, engineers, underwriters, actuaries, client managers, and risk managers working together to better assess and manage risks.

The history of reinsurance dates back to the mid-19th century, with the establishment of the first reinsurance company in Cologne, Germany. Companies like Swiss Re and Munich Re began their reinsurance operations in the latter half of the 19th century, and today, reinsurance is a globally oriented sector that works closely with companies operating on an international scale.

Munich Re

Munich Reinsurance Company (Munich Re) is one of the world's largest reinsurers, headquartered in Munich, Germany. It offers a broad spectrum of reinsurance services to insurance companies globally, operating across all reinsurance divisions. Munich Re is renowned for its extensive risk assessment expertise and for creating innovative solutions tailored to the specific needs of its clients. The firm places a strong emphasis on sustainability and risk management as part of its business strategy.

Swiss Re

Headquartered in Zurich, Switzerland, Swiss Re is another leading player in the global reinsurance market, offering a comprehensive portfolio of reinsurance and insurance solutions across a worldwide network. Swiss Re is known for its financial strength, capability for innovation, and for developing solutions based on thorough data analysis and research. The company focuses heavily on addressing global challenges such as climate change and increasing urbanisation.

Berkshire Hathaway

Led by Warren Buffett, Berkshire Hathaway is a diversified conglomerate with significant investments and direct ownership in various industries, including insurance and reinsurance operations. Its insurance division includes companies like GEICO, General Re (Gen Re), Berkshire Hathaway Reinsurance Group, among others. Berkshire Hathaway is distinguished by its exceptional capital strength, enabling the company to undertake very large and complex risks. Moreover, the insurance operations benefit from Buffett's expertise in capital investment, giving Berkshire Hathaway a unique advantage in the industry.

Business Model

Let's have a closer look at the business model of the Hannover Re. Hannover Re is a leading reinsurer that supports insurance companies by providing reinsurance solutions to reduce their risk exposure. 

The company focuses on two main business areas: Property & Casualty Reinsurance, which covers a wide range of risks such as natural disasters and accidents, and Life & Health Reinsurance, dealing with risks associated with life, health, and annuity insurance products. Additionally, Hannover Re offers capital market products and structured reinsurance solutions to assist insurers in risk management and capital optimisation. Hannover Re's strength lies in its tailored risk assessment and management, which it offers to its client.

Let's delve into the details.

Which services are offered?

Hannover Re offers a wide range of services in the areas of property and casualty reinsurance and life and health reinsurance. Their services cover both traditional and innovative solutions to meet the diverse needs of their clients:

Property and Casualty Reinsurance

In property and casualty reinsurance, Hannover Re provides solutions covering areas such as:

Life and Health Reinsurance

In life and health reinsurance, Hannover Re focuses on reinsurance of risks associated with life, death, illness, and other biometric risks:

Through these services, Hannover Re enables its clients to more effectively manage and diversify their risks. The company works closely with its partners to develop customised solutions that meet the specific requirements and challenges in the market.

Who are the customers?

Hannover Re's clients come from various segments of the insurance industry and include:

Hannover Re serves a broad range of clients globally, offering tailored reinsurance solutions that are customised to the specific needs and requirements of each client. The exact names of specific clients of Hannover Re are generally not publicly disclosed, as this information is confidential and part of the business relations between the companies.

How is the income realised?

Hannover Re generates income primarily through:

These sources of income allow Hannover Re to maintain a diversified income portfolio and ensure long-term financial stability.

Company Strategy

Hannover Re is pursuing a three-part strategy (Focus, Grow, Accelerate) aimed at strengthening its capital-efficient reinsurance business and promoting profitable growth. Key points include the optimisation of cycle management and portfolio steering, enhancing operational efficiency and automation, and utilising data to improve risk analysis. The company also values diversity, equality, inclusion, and is investing in its workforce.

Hannover Re aims to achieve a leading position in profitability and earnings growth, with specific targets such as a return on equity of over 14% and an increase in EBIT of more than 5% annually over a three-year strategy cycle. The dividend strategy remains stable, with the expectation of rising basic dividends supported by potential special dividends, based on the capital equipment and the need for future growth.

Shareholders

The shareholder structure of Hannover Re is already quite clear. In February 2004, the Talanx AG, the third-largest German insurer, acquired a 50.2% stake in Hannover Re, thereby becoming the principal shareholder of the third-largest reinsurance company in the world.

The remaining shares of Hannover Re are distributed among institutional investors such as BlackRock and Deutsche Asset Management Investment GmbH, as well as private investors.

Management / Salary

Jean-Jacques Henchoz, born in 1964 in Switzerland, has been serving as the Chief Executive Officer (CEO) of Hannover Re SE since 8 May 2019. He succeeded Ulrich Wallin in this prestigious role, bringing with him a wealth of experience from his previous position at industry rival Swiss RE. Henchoz is distinguished by his profound expertise and extensive network within the insurance sector.

Historical Financial Performance

Share Price

The Hannover Re share was first listed on the stock exchange in 1994 and has since shown remarkable growth. Especially after the financial crisis, it has grown by 1,254.58% to date.

The majority shareholder of Hannover Re is Talanx AG, holding 50.2% of the voting rights. The remaining shares are held by institutional or private investors, including those who particularly focus on sustainability criteria.

Since March 21, 2022, Hannover Re shares have been part of the DAX. Previously, they were listed on the MDAX.

Financial Statements

Income Statement

The income statement of Hannover Re for the year 2022 reveals significant trends that underscore the financial performance of the company over a decade. With an impressive average annual revenue growth of 10.1%, Hannover Re has demonstrated its ability to continuously grow in the highly competitive insurance market. This growth rate reflects the strategic efforts of the company to adapt to changing market conditions and to seize new business opportunities.

However, despite this impressive revenue growth, the company faces a challenge in the form of a below-average net margin of 6.2%, which falls below the industry benchmark of 10%. This could be attributed to higher operating costs, claims payments, or investments in business expansion that might impact profitability in the short term but could strengthen market position in the long term.

Nevertheless, the average net income growth of 7.8% in recent years shows that Hannover Re is capable of effectively increasing its profits and maintaining financial stability. This stability suggests that Hannover Re has developed or is developing a sustainable competitive advantage over a long period, which is a positive sign for investors and stakeholders. Overall, the financial performance of Hannover Re reflects the strengths and challenges of the company in a dynamic market environment.

Balance Sheet

The balance sheet of Hannover Re does not list any fixed assets, which is not uncommon for an insurance company. Insurance companies typically demonstrate their assets through financial investments. Hannover Re invests its customers' premiums in stocks, funds, infrastructure projects, or other alternative investments.

In the last decade, Hannover Re has showcased remarkable financial stability by maintaining a steady equity ratio of approximately 14.3%, significantly surpassing the Basel III recommended minimum of 9%. Furthermore, with an average return on equity of 12.5%, the company greatly exceeds the benchmark of 10%, indicating efficient utilization of retained earnings. This high level of financial performance highlights the management's ability to profitably allocate shareholders' capital, thereby bolstering investor confidence in the company.

Cash Flow Statement

The cash flow statement of Hannover Re, a company within the insurance sector, reveals key insights into its financial health and strategy. A notable observation is the positive trend in operating cash flow, indicating that the company is efficiently managing its revenues and expanding its operations. Unlike many other firms outside the insurance industry, Hannover Re, however, shows no capital expenditure (Capex), reflecting the specific nature of the insurance business, which is less capital-intensive in physical assets.

The analysis of capital allocation, derived directly from the cash flow statement, is particularly illuminating for understanding how the company utilises its resources to create value in the long term and potentially secure a sustainable competitive advantage. The increasing cash reserve is another positive sign, underscoring the financial stability and the ability of the company to capitalise on future opportunities.

Capital Allocation

In the long-term return on an equity investment, the efficient use of the operating cash flow generated plays a decisive role. This is determined by capital allocation, which refers to the strategic distribution of cash flow to different areas. There are three main areas that I pay particular attention to: CapEx, dividends and share buybacks.

Investing activities & Capital expenditures (CapEx)

Insurance companies typically do not make significant capital expenditures, except when acquiring other businesses. Instead, they invest primarily in areas such as human capital, marketing, and ongoing operational expenses, which are directly included in their financial forecasts.

Dividends

Hannover Re pays out a dividend once a year, typically in May. For the past 14 years, shareholders have regularly received a dividend, except during the financial crisis when none was paid out. The dividend yield stands at 3.23%, equating to a dividend of €5. Additionally, it is not uncommon for a special dividend ranging from €1 to €1.5 per share to be paid out.

Share Buybacks & Shares Outstanding 

Hannover Re has not initiated a share buyback program in its history and does not intend to do so in the foreseeable future. Since the last capital increase in 2003, the number of outstanding shares has remained unchanged at 120,597,134.

Return On Invested Capital

I personally place great importance on the return on invested capital (ROIC) of a company. It indicates how well a company is able to generate higher cash flows from the capital reinvested into the business.

The consistently remarkable aspect is that all 4 reinsurers consistently have a return on invested capital (ROIC) that exceeds the benchmark of 10%. Especially Hannover Re with an ROIC of 22% far ahead of the other 3. This means they consistently generate higher cash flows with the reinvested capital. This is an extremely positive attribute and underscores the efficiency and profitability of these companies in managing their capital resources.

Valuation

After conducting a thorough analysis of the financial statements, we now turn our attention to the valuation of Hannover Re. For this valuation, we will utilise three different methods: the Discounted Cash Flow (DCF), Owner Earnings, and the Equity Bond method. However, before we proceed with these, we will first examine the valuation multiples of the world's fourth-largest reinsurer.

The financial metrics of Hannover Re have painted a consistently positive picture for over ten years. Particularly noteworthy are the four main ratios: The price-to-cash flow ratio stands at 4.33, the price-to-sales ratio at 0.7, the price-to-book value ratio at 2.56, and the price-to-earnings ratio at 15.91. These figures suggest that Hannover Re's stock can be considered a so-called value stock, meaning it could be undervalued and thus presents an attractive investment opportunity.

Let's see what the 3 valuation methods will tell us.

Discounted Cash Flow Model

We commence with the analysis of the Discounted Cash Flow (DCF) model to ascertain the present value of Hannover Re by discounting future cash flows to the current date.

The analysis reveals that the calculated intrinsic value of a Hannover Re share, according to the Discounted Cash Flow (DCF) model at the time of report generation, stands at an impressive €453.32. This calculation suggests that Hannover Re shares, with a current share price of approximately €221.70, appear to be significantly undervalued according to the DCF model.

It remains to be seen what insights the other two valuation methods will provide.

Owner Earnings Method

The Owner Earnings method provides an in-depth analysis of a company's actual earning power by considering not only the net profit but also depreciation, changes in working capital, and necessary investments. This approach allows for a more accurate assessment of financial performance and sustainable profitability of Hannover Re, by highlighting the quality of cash flow.

The use of owner earnings instead of free cash flow in the Discounted Cash Flow model indicates that the estimated intrinsic value per share of Hannover Re is an impressive €406.10. This suggests that Hannover Re's shares, with a current share price of approximately €221.70, are significantly undervalued.

A final, last method to be sure.

Equity Bond Method

The Equity-Bond method is a valuation approach used by investors like Warren Buffett to estimate the intrinsic value of a share. It is based on the concept that a share can be viewed similarly to a bond, by considering regular income through dividends and the growth potential of the company. To perform the calculation, only five key values are required: the equity per share, the earnings per share, the dividend payout ratio, the current share price, and the average price-to-earnings ratio (P/E ratio) over the last ten years. This method allows investors to determine the actual value of the shares and calculate the expected average annual return, aiding in making an informed investment decision.

Let's check how it looks by Hannover Re.

By applying the Equity-Bond method, the estimated intrinsic value per share of Hannover Re was calculated to be an impressive €467.63. This analysis suggests that the company's shares could be significantly undervalued, especially when considering the current market price of approximately €221.70.

All three methods estimate the intrinsic value of Hannover Re to be between approximately €400 and €460.

Expected Return

At a current share price of €221.70, we anticipate annual returns between 12.5% and 16.8%. This expectation is grounded in Hannover Re's historical performance, achieving such a range of returns in recent years. 

Hannover Re's proven capability to consistently generate high returns bolsters confidence in its strong market position and future prospects. Compared to an ETF, which typically offers an average return of around 10%, Hannover Re emerges as a particularly attractive investment opportunity. 

Final Thoughts

Hannover Re is a leading company in the reinsurance sector, acting as the third-largest player globally. The core competency of Hannover Re lies in providing risk coverage for primary insurers, thereby enabling them to minimise their own risk exposure. This allows insurance companies to grow faster and generate more stable profits. With an annual market growth of 3%, the sector is among the fastest-growing within the insurance industry.

Hannover Re focuses primarily on reinsurance for property damage and covers a wide range of insurance segments – from property and vehicle insurance to personal liability insurance. Given the increasing frequency of natural disasters and rising sums of damages, the company can regularly conclude new contracts and raise insurance premiums. 

Thanks to an efficient corporate structure and a solid investment portfolio, Hannover Re achieves high returns. The company's stock is considered relatively inexpensive due to solid annual growth of around 7.8%, a price-earnings ratio of 15 for the year 2022, and an attractive dividend yield of 3.23%. With an expected return between 12.5% and 16.8% per year, Hannover Re is seen as an attractive investment opportunity, especially for value investors. The company is distinguished by its focused approach to the insurance market and a dynamic growth strategy, while still being considered fairly valued.

Reference

Berkshire Hathaway

Hannover Re History

Hannover Re Remuneration Report

Hannover Re Results and Reports

Munich Re

Simply Wall St

Swiss Re

Yahoo Finance

Holdings Disclosure
I hold a position in Hannover Re.
This article is not intended to be a solicitation for you, the reader, to buy or sell the stock. I wrote this article myself, and it reflects my personal views and opinions. I do not receive any remuneration nor do I have any business relationship with any company whose shares are mentioned in this article.

Legal Disclaimer
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Quick Overview - Wise Stock Analysis

Investment Thesis

Today, the online money transfer market plays a decisive role in the digital financial and economic world: With the increasing trend towards digital financial services and the globalization of the economy, the demand for efficient and cost-effective online money transfer services has risen significantly. These services allow individuals and businesses to transfer money quickly and securely across international borders, leading to accelerated financial integration and improved access to financial services worldwide. Competition in this market is intense as companies constantly strive to offer innovative solutions to meet the evolving needs of consumers.

Wise plc, the best alternative to PayPal?!: Wise plc has successfully evolved into a leading online money transfer service. In contrast to PayPal, which primarily focuses on facilitating payments in electronic commerce, Wise concentrates on providing cost-effective and transparent cross-border money transfers for individuals and businesses. In terms of innovation and cost structures, I would say that Wise surpasses PayPal. Nevertheless, PayPal continues to play a significant role in online payment processing.

Is Wise plc stock undervalued? Wise plc is an emerging British fintech company that is revolutionizing global online money transfers with its range of services. Notably, it has not posted any losses since its IPO and is also solidly financed. However, is this a reason to buy the stock now, or should investors wait despite the positive growth prospects?

Where is the fair value, and how much potential is actually still in the stock? That's what I want to work out step by step in the following company analysis. Let's get started!

Company - Wise plc

History

Industry

The fintech industry (financial technology) has brought about significant changes in the way financial services are delivered in recent years. A focus within this sector is on online money transfer services. These services enable users to transfer money electronically from one location to another without relying on traditional banking services.

In brief, online money transfer services in the fintech industry provide the opportunity to conduct financial transactions quickly, securely, and cost-effectively. Unlike traditional bank transfers, users can often utilize these services through mobile apps or websites. These platforms leverage innovative technologies, including blockchain and other digital payment technologies, to make transactions more efficient.

Many online money transfer services have also revolutionized international transfers by minimizing traditional barriers such as high fees and slow processing times. This has brought significant benefits, especially for individuals who need to make cross-border transfers.

Well-known companies in this sector include PayPal, Wise, Revolut, Square Cash, and many more. The constant innovation and integration of new technologies make online money transfer services a significant area within the fintech industry.

Western Union

Western Union is an internationally recognized provider of money transfer services that enables people to send and receive money worldwide. The Western Union service includes both physical locations and an online platform for money transfers.

It is important to note that while Western Union has a traditional approach to money transfers, it also leverages various technologies to make the service more efficient and secure. The service has been in existence since 1871 and remains a relevant force in the field of international money transfers.

OFX

OFX is an online money transfer service that allows users to transfer money electronically from one location to another. The company is headquartered in Sydney, Australia, and provides services for international money transfers.

OFX's platform enables customers to trade currencies online and make transfers to various countries. The company uses modern technologies to ensure the transfer process is secure and transparent. OFX caters to both individuals and businesses that need to make international payments.

Remitly

Remitly is an online money transfer service headquartered in Seattle. Founded in 2011, the company specializes in facilitating international transfers efficiently, securely, and cost-effectively, particularly for individuals sending money to their home countries.

The company utilizes technologies like artificial intelligence and mobile applications to offer fast and transparent transfer services. It also enables users to track the progress of their transfers and make real-time payments.

PayPal

PayPal is a leading online money transfer service headquartered in San Jose, California. Established in 1998, PayPal has become one of the most well-known and widely used payment service providers in e-commerce. The company allows users to send and receive money electronically, make online purchases, and conduct transactions securely and conveniently.

One significant advantage of PayPal is that sensitive financial information doesn't need to be exchanged directly between buyers and sellers, enhancing the security of transactions. Additionally, through acquisitions and strategic partnerships, PayPal has expanded its range of services to include other financial offerings, such as lending and mobile payment solutions.

The platform is utilized globally and has become an integral part of the digital payment ecosystem, with millions of individuals and businesses relying on PayPal to handle their financial transactions.

Business Model

Wise plc is a leading online money transfer service headquartered in London, United Kingdom. The company was founded in 2011 by two Estonians, Taavet Hinrikus and Kristo Käärmann. Wise's business model focuses on providing cost-effective and transparent cross-border money transfers for individuals and businesses. Here are some features of the business model:

What is the service?

Wise plc offers a variety of services in the international financial transactions sector. The main offerings include international money transfers in various currencies, with the company using low and transparent fees as well as the real foreign exchange mid-market rate to ensure fair exchange rates. In addition to individual transfers for individuals, Wise also allows the opening of bank accounts for individuals, linked with a Debit Mastercard.

For businesses, Wise provides specific services under the name "Wise Business," including bank accounts and Debit Mastercards. This enables companies to handle international transactions more efficiently and cost-effectively. Additionally, Wise offers an API (Application Programming Interface) that allows other businesses and banks to integrate Wise services into their own platforms. This Wise API facilitates the seamless incorporation of Wise services into various business applications and financial systems.

Who are the customers?

Wise plc caters to a diverse range of customers, spanning from individuals to businesses. The primary clientele of Wise typically includes individuals and companies needing to make international money transfers or exchange currencies. Here are some examples:

Overall, Wise's services cater to a broad spectrum of customers, all of whom can benefit from the company's transparent and competitive approach to international money transfers and currency exchange.

How is the income realised?

As mentioned earlier, Wise charges significantly lower fees for international money transfers compared to traditional banks. According to Wise's 2023 annual report, the company has a customer base of over 10 million and processed transactions worth more than £105 billion in the same year. However, how does the company generate profits to be economically successful? Here, I will provide an overview of Wise's various revenue streams.

Transaction Fee

The primary source of revenue for the app comes from the fees it charges for money transfers. Users can visit the Wise website, enter the amount they want to transfer, and see how much Wise would charge for their specific transaction. To avoid uncertainties, the app locks in the exchange rate for up to 4 days. The fee varies depending on the transaction currency and starts at 0.43%.

Wise for Business

For business owners who frequently handle payments in various currencies, Wise offers a business account. In addition, physical payments can be processed with a MasterCard. Other features of the Wise business account include account balance tracking, invoice management, and an API for payment automation.

Users do not have to pay for an account, except for a registration fee of £45 (50 euros). However, they will be charged a fee for each cross-border transaction.

Borderless Bank Account

A borderless account with Wise allows users, much like businesses, to open a free bank account. Additionally, they can receive a complimentary MasterCard debit card. Wise generates revenue primarily through currency conversion fees charged to consumers. When users convert currencies while making payments with the debit card or within the account, they incur relevant fees.

Wise API

The Wise API is the backbone of the Wise platform. Companies or banks can choose to integrate Wise into their technical systems to facilitate cross-border payments for their businesses. Wise also earns revenue by licensing its software to other companies.

Wise optimizes its revenue by cleverly monetizing its platform and services, making it one of the most promising fintech startups globally.

Company Strategy

The corporate strategy of Wise plc aims to create an efficient and user-friendly platform for cross-border money transfer and management. The mission of Wise, articulated as "Money without Borders," underscores the objective of making financial transactions across country borders as seamless as possible. The strategy is based on the principles of "Min fees. Max ease. Full speed." – meaning minimal fees, maximum user-friendliness, and maximum speed.

Wise focuses on low and transparent fees to enable cost-effective international money transfers. The emphasis on maximum user-friendliness is reflected in the provision of easy-to-use platforms, both in the form of a mobile app and an online platform. Furthermore, the strategy highlights the speed of transactions, with Wise striving to process money transfers in the shortest possible time.

In summary, Wise's overall strategy aims to provide an innovative, transparent, and efficient solution for international money transfers, allowing individuals and businesses to move and manage funds across borders.

Shareholders

Wise plc has attracted significant investments from renowned tech investors, providing the company with impressive financial backing. Notable investors include Andreessen Horowitz with AH Capital Management LLC, Valar Ventures by Peter Thiel, the Norwegian sovereign wealth fund, as well as personalities like Richard Branson and Max Levchin, co-founder of PayPal, all of whom have invested in Wise Vision.

The major shareholders of Wise, alongside Andreessen Horowitz (8.629%), are the co-founders Kirsto Käärmann (18.23%) and Taavet Hinrikus (7.088%). Additionally, Taavet Hinrikus, through his venture capital firm OÜ Notorious, holds a further 5.726% stake in Wise.

Management / Salary

Since the resignation of Taavet Hinrikus in December 2021, the leadership structure of Wise plc has undergone a change. Kristo Käärmann now stands alone at the helm of the company as CEO, having previously served as Chairman alongside Hinrikus. This development marks a new phase in Wise's corporate leadership, with Käärmann as the sole CEO, taking on the responsibility for the strategic direction and management of the company.

An investigation has been initiated against CEO Kristo Käärmann on suspicion of tax evasion. Allegedly, he failed to settle a tax debt of £720,000 with the British government. This incident occurred in 2022, and to date, no conclusive judgment or any other outcome has been reached.

Historical Financial Performance

Share Price

On the 7th of July 2021, the British fintech giant Wise had a solid stock market debut, giving the company a market value of over £8 billion ($11 billion). Wise shares opened on a Wednesday morning at £8 per share and by the market close, they had risen by up to 10% to £8.88. A notable aspect of the money transfer company's IPO was its choice of a direct listing on the London Stock Exchange, a rare method of going public, similar to Spotify's approach in the US in 2018.

Since going public, Wise's stock has only known one direction – downwards. One of the reasons was that some Wise employees exercised their right to divest themselves of some of their shares. A much larger issue arose when, a year after the IPO, CEO Kristo Käärmann became the subject of a tax evasion investigation. He failed to settle a tax debt of £720,000 owed to the UK government. There was even speculation about whether he would be allowed to continue leading the company.

On the other hand, the stock price managed to recover in the fiscal years 2023 and 2024, thanks to a favourable business situation.

Let's have a closer look at the Financial Statements; they can provide insights into how well the company is performing.

Financial Statements

Income Statement

Wise plc has been able to demonstrate a remarkable annual revenue growth of an average of 44.1% since its initial public offering. Simultaneously, the high gross profit margin of over 50% suggests that the company may already possess a sustainable competitive advantage. This robust revenue growth indicates a strong market position and underscores the efficiency of Wise plc's business model.

The improvement in the ratio of interest payments to operating income is noteworthy. What's remarkable for a growth company is that Wise plc has yet to post a loss since its IPO, making it consistently profitable. This is relatively uncommon for young companies. The net margin has significantly increased from 5.0% in 2020 to 28.2% in the first half of the fiscal year 2024. This is another indicator that the company is evolving and building a substantial moat.

Let's now explore what the balance sheet of Wise plc can reveal to us.

Balance Sheet

Typically, for a financial company, Wise plc's balance sheet does not show any items such as inventories or significant investments in property, plant, and equipment (PPE). However, the solid ratio between current assets and current liabilities is striking, particularly due to a substantial cash position. This indicates that Wise is able to effectively cover its current liabilities with current assets, such as cash and cash equivalents.

When analysing the balance sheet of Wise plc, it is particularly noticeable that the company has minimal to no long-term debts. This is generally considered a positive sign, suggesting it could be a solid long-term investment opportunity. This observation is also supported by the Income Statement, notably the favourable ratio of interest payments to operating income.

Regarding the equity ratio, a slightly higher percentage, preferably above 10%, may be desirable for a financial company. Nevertheless, it is gratifying to note that the return on equity has increased from 7.6% to 19.8% over four years. This indicates that, despite its relatively young corporate history, Wise plc boasts a robust balance sheet. However, there are still some areas that could be considered for optimization, like the equity ratio for example.

Cash Flow Statement

Let's have a look at how money moves at Wise plc. The cash flow statement is an extremely useful source of information to determine whether the company has a sustainable competitive advantage (Moat). The analysis of capital allocation that can be derived from the cash flow statement is particularly revealing.

Capital Allocation

The long-term return on a capital investment is significantly influenced by the efficient use of generated operational cash flow. This efficiency, in turn, depends on capital allocation, which involves the strategic distribution of cash flow across three essential areas: capital expenditures, dividend payouts, and share buybacks. Diligent attention to these key aspects is crucial to ensure a sustainable and profitable yield for us as investors.

Investing activities & Capital expenditures (CapEx)

Wise plc benefits significantly from the fact that it requires minimal capital expenditures to sustain its profitable business model. These low investment requirements are not only extremely positive for investors, but also for the company itself. By avoiding substantial investments, Wise plc can allocate a considerable portion of its financial resources towards growth and expanding into new markets, including promising regions like China. This financial flexibility allows the company to implement strategic expansion plans and strengthen its presence in emerging markets.

Through the strategic investment in the company's growth, Wise will have the opportunity to attract an expanded customer base. This will result in increased utilization of the Wise system, leading to a heightened cash flow. The augmented transactions contribute to more financial resources flowing into Wise's coffers, thereby strengthening the company's financial stability.

And that's precisely what we as investors are looking for: a company that receives a steady flow of cash and can increase it. A true money-making machine that can also fill our investor pockets with cash, isn't it?

Dividends

The absence of a dividend payment could indeed be considered a challenge for potential investors in Wise plc. In the current scenario, the company does not distribute profits to its shareholders, but reinvests all earnings internally. This business strategy is quite positively viewed from an economic perspective. The decision to channel profits back into the company allows Wise to pursue further growth and increase returns in the long term. Although this may be less appealing to investors reliant on regular dividend payouts, it could be a sensible strategy for long-term investors focused on value appreciation. However, it remains to be seen whether Wise will change its dividend policy in the future.

Share Buybacks & Shares Outstanding 

Wise Plc Class A has an outstanding number of 1,024,777,200 shares. In contrast to dividend payments and stock buyback programs, the company, for a specific reason, entirely channels its resources into the growth of its business operations. Any available funds are strategically invested in expanding and advancing the company. This strategic approach underscores Wise Plc's emphasis on long-term value creation and innovation, rather than short-term payouts to shareholders.

Return On Invested Capital

The Return on Invested Capital (ROIC) is of paramount importance to me, as it provides insights into how efficiently a company manages its deployed capital. This metric allows for the assessment of a company's ability to generate higher cash flows from the invested capital.

Wise plc presents varying performance compared to its direct competitor. Western Union and OFX exhibit a notably higher Return on Invested Capital (ROIC) than Wise. Conversely, Wise performs more favourably in comparison to Remitly and PayPal. The ROIC of Wise is just below the benchmark of 10%, providing room for improvement. Hopefully, the company will be able to enhance its profitability in the near future.

Valuation

After a thorough analysis of the financial statements, I aim to gain a comprehensive insight into the true value of Wise plc. To get a rough overview, I've chosen to initially examine the traditional stock metrics of the last 3 1/2 years, as we have limited historical data. These metrics should provide me with an initial indication of how the company has fared in terms of traditional valuation benchmarks.

In the next step, I plan to employ two different valuation methods: the Discounted Cashflow model and the Owner Earnings method. These approaches are intended to give me a precise insight into the real value of Wise plc and serve as a basis for informed decision-making.

It is evident that the financial indicators suggest that the stock was excessively overvalued during this period. This is particularly conspicuous for a growth-oriented company like Wise plc, as the market holds high expectations for the company and its products and services. A price-to-earnings ratio (P/E ratio) of nearly 50 and a price-to-book value ratio (P/BV) higher than some skyscrapers indicate a significant overvaluation. These metrics imply that the current market price of the stock, in relation to the earnings and book value per share of the company, is considered excessively high.

Discounted Cash Flow Model

Using the Discounted Cash Flow model, I aim to calculate the present value of Wise plc by discounting its future cash flows. The following figure illustrates the Discounted Cash Flow model for Wise plc.

After a thorough analysis and application of the Discounted Cash Flow (DCF) model, an impressive calculation emerges for the intrinsic value per share of Wise plc at the time of this report: a commendable £7.21. Interestingly, the examination reveals that even with a current market price of approximately £8.61, Wise plc's shares are trading at a premium of 16.2% according to the DCF model.

To gain a more comprehensive understanding, let's now explore an alternative valuation method.

Owner Earnings Method

Instead of using Free Cash Flow, I am now employing Owner Earnings as the basis for my DCF calculation to determine the intrinsic value of the stock. This allows for a more precise analysis, as Owner Earnings account for specific adjustments such as capital expenditures and changes in working capital, providing a more accurate assessment of the company's actual profitability. The following DCF model is calculated on the basis of owner earnings.

By incorporating owner's profits instead of free cash flows into the Discounted Cash Flow model, there are differences compared to the previous calculation using free cash flows. The analysis reveals that the determined value is higher than the current market-traded price. The Equity Value per Share stands at £8.99, while the traded price is £8.61, resulting in a discount of just under 4.4%. Which is a very minimal discount and does not indicate a cheap bargain.

Expected Return

For Wise, an annual growth in profit and revenue of 7.5% and 14.3%, respectively, is predicted. The earnings per share are expected to increase by 6.8% per year. The return on equity is projected to reach 18.2% in three years. Personally, I anticipate that if the results continue to evolve as described in the coming years, and with an average expected return of around 12% per annum, a normal case scenario is estimated.

Final Thoughts

Wise plc, a fascinating company, has established itself as an outstanding alternative to traditional financial service providers. Personally, I have used the platform as a customer, particularly for international transfers to the USA. In comparison to my high street bank, Wise not only offered lower exchange rate fees but also provided a straightforward and fast process.

Whether Wise is a better alternative to PayPal requires a nuanced perspective. Both companies target similar demographics; however, PayPal's primary focus is on facilitating payments in e-commerce, whereas Wise concentrates on cost-effective and transparent cross-border money transfers for individuals and businesses. In this regard, I would say that Wise surpasses PayPal in terms of innovation and cost structures, while PayPal still plays a key role in online payment processing.

Why have I increased my position in Wise since the IPO and continue to hold it? Apart from my positive customer experience, as an entrepreneur and investor, I value digital business models. The decision to invest in Wise is based not only on trust in the company, but also on the insight that it could be a company of similar calibre to the next PayPal. Although I typically do not invest immediately after an IPO, I seized this opportunity as I see the long-term potential of Wise. Despite the usual volatility with young companies, I am holding my position for now and patiently observing what the future holds for Wise.

Reference

CNBC
Fintechs.fi
Investing.com
Netguru
OFX
PayPal
Remitly
Statista
The Guardian
The Motley Fool
Western Union
Wise plc Owner | Investor Relations
Wise Platform
Wise.com
Yahoo Finance

Holdings Disclosure
I hold a position in Wise.
This article is not intended to be a solicitation for you, the reader, to buy or sell the stock. I wrote this article myself, and it reflects my personal views and opinions. I do not receive any remuneration nor do I have any business relationship with any company whose shares are mentioned in this article.

Legal Disclaimer
I am not a registered investment advisors, brokers/dealers, securities brokers, or financial planners. This article is being provided for informational and educational purposes only and on the condition that it will not form a primary basis for any investment decision. The views about companies and their securities expressed in this article reflect my personal opinions. I do not represent the opinions on whether to buy, sell or hold shares of any particular stock.
None of the information in our articles is intended as investment advice, as an offer or solicitation of an offer to buy or sell, or as a recommendation, endorsement, or sponsorship of any security, company, or fund. The information is general in nature and is not specific to you. Wall St. Nerd is not responsible and cannot be held liable for any investment decision made by you. Before using any article’s information to make an investment decision, you should seek the advice of a qualified and registered securities professional and undertake your own due diligence. I did not receive compensation from any companies whose stock is mentioned here. No part of the writer’s compensation was, is, or will be directly or indirectly, related to the specific recommendations or views expressed in this article.

Quick Overview - Canadian National Railway Stock Analysis

Investment Thesis

An industry that is crucial for trade and the economy of the North American continent: In North America, railways play an important role in transport, both for freight and passenger traffic. Freight trains transport a variety of goods, including raw materials, agricultural products, finished goods, containers and more. Rail is often a cost-effective and efficient way to transport large quantities of goods over long distances.

Canadian National Railway, the No. 1 railway in Canada: The Canadian National Railway undoubtedly stands as a leading railway company in Canada and is among the most significant players in North America. With its extensive rail network spanning Canada and the United States, CN holds a key position in rail transportation. Particularly in freight transport, the Canadian National Railway is renowned for its comprehensive infrastructure and high transport capacity. CN plays a crucial role in promoting economic activities in Canada and the United States by facilitating efficient and reliable freight transportation.

Is Canadian National Railway stock undervalued? Canadian National Railway is the better railway company in terms of stability. It has the best revenue growth, good margins, an excellent return on equity, an impressive dividend and a solid balance sheet. Is there still more strength in the Canadian stock, or should investors wait to buy in despite the fair valuation?

Where is the fair value, and how much potential is actually still in the stock? That's what I want to work out step by step in the following company analysis. Let's get started!

Company - Canadian National Railway

History

The first fully rail-bound vehicles were constructed at the beginning of the 17th century. At that time, wooden wagons were used in mines to transport heavy raw materials to the surface and ultimately to barges. Over the years, this system was constantly improved and expanded. However, the real boom did not occur until the 19th century, when the industrial revolution was in full swing. The demand for raw materials increased rapidly, and horse-drawn carts quickly reached their capacity limits. A new, more efficient transportation vehicle was therefore needed.

This is where George Stephenson comes in. He grew up in the north of England in a poor family and had to work in a coal mine from the age of 14. When his father went blind in an accident with a steam engine, George became more intensively involved with these devices. In 1814, he developed his first steam locomotive. Although it was not the very first locomotive, it was definitely the first to be used industrially. Under his leadership, the world's first railway line was opened in 1825. The 39-kilometre line ran from Stockton in England to Darlington and could be travelled at a speed of 16 to 17 kilometres per hour. Of the 36 carriages on the train, twelve were loaded with coal and flour, while the others carried passengers. Shortly afterwards, railway fever spread to the rest of the world, including Canada in 1836.

The Railway Comes To Canada

The Canadian government was forced to found the Canadian Pacific Railway and build the line itself. At the beginning of the 20th century, however, GTR also wanted to operate a transcontinental railway network and ultimately had to come to an agreement with the government. When the president of the railway company, Charles M. Hays, died on the maiden voyage of the Titanic, the management of GTR deteriorated. And the construction costs for the new railway line eventually led to the company's insolvency.

The Canadian government founded Canadian National Railways on 20 December 1918 to prevent the collapse of transport networks in Canada due to the insolvency of several railway companies. By 1923, several railway companies, including the Grand Trunk Railway, had been taken over and united under a new state umbrella. Until the 1980s, business was rather poor. This was largely due to the fact that political decisions were made in the company instead of economic ones. With the recapitalisation in 1978, the Canadian National Railway Company began its reorientation. This was followed by a full IPO in 1995. Since then, the company has mainly been active in the following business areas: Rail (transport business with 32,000 km of track - from the Pacific across the Atlantic to the Gulf of Mexico), Intermodal (container business on rail, road and water), Trucking (truck forwarding company), Supply Chain Services (logistics services) and Business Development (working with customers to plan and implement new locations).

Industry

The North American rail network is an integral part of the continent's economy and logistics. It comprises various railway companies serving different areas and transporting a variety of goods. With a total length of 202,137.7 km, the rail network spans all three countries of the continent, Canada (43,473.69 km), the USA (142,371 km) and Mexico (16,329.01 km).

The North American railway industry is highly fragmented and dominated by several large Class I railway companies, each covering specific geographic areas. Shown here on the chart are some of the major Class I railway companies in North America:

The areas served by these railway companies overlap at certain points, and there are also regional and local railway companies that operate within specific regions and often work in collaboration with the Class I companies. These railway companies transport a wide range of goods, including coal, oil, agricultural products, cars, chemicals and more.

The infrastructure and operations of railway companies in North America are critical to the continent's trade and economy, as they provide an efficient and cost-effective way to transport goods over long distances.

BNSF Railway (Berkshire Hathaway)

The BNSF Railway, also known as the Burlington Northern Santa Fe Railway, is one of the largest Class I railway companies in the United States. It was formed in 1996 through the merger of the Burlington Northern Railroad and the Santa Fe Railway.

BNSF Railway has been part of Berkshire Hathaway Inc. since 2009. Berkshire Hathaway is the 100% owner of BNSF and acquired the company to take advantage of the long-term opportunities and potential of the rail freight business. Warren Buffett has repeatedly emphasised that he is invested in the rail industry and the economic strength of the United States for the long term, and sees BNSF as a major freight carrier.

Union Pacific

The Union Pacific Railroad is one of the oldest and largest Class I railway companies in the United States. Founded in 1862 as part of the transcontinental railway project that opened up the west of the USA, the Union Pacific plays a key role in freight transport and rail traffic in the country.

Union Pacific transports a wide range of goods, including agricultural products such as grain and livestock, chemical products, coal, crude oil and refined petroleum products, building materials, automobiles and intermodal transport such as containers and trailers.

CSX

CSX Transportation is a major Class I railway company in the United States, with a route network that primarily serves the eastern part of the country.

Norfolk Southern Railway

Norfolk Southern Railway is a Class I railway company in the United States, operating mainly in the eastern part of the country. It was formed in 1982 from the merger of the Southern Railway and the Norfolk and Western Railway.

Norfolk Southern transports a variety of commodities, including coal, agricultural products such as grain, chemicals, crude oil and refined products, building materials, automobiles and intermodal traffic such as containers and trailers. Like the other major Class I railways, Norfolk Southern plays a significant role in the United States' freight transportation system and provides an important transportation route for various industries and sectors.

Canadian Pacific Kansas City

The Canadian Pacific Kansas City (CPKC) Railway is a joint venture between the Canadian Pacific Railway (CP) and the Kansas City Southern Railway (KCS). The two companies have joined forces to form a new transcontinental railway company linking the USA, Canada and Mexico. CPKC was created through the acquisition of Kansas City Southern by Canadian Pacific Railway, a deal that was finalised in 2021.

In terms of freight, the Canadian Pacific Kansas City Railway transports a wide range of freight, similar to the participating companies Canadian Pacific and Kansas City Southern. These include agricultural products, energy products such as coal and oil, chemical products, automobiles, intermodal traffic such as containers and trailers, and other types of freight.

Business Model

Let's have a closer look at the business model of the Canadian National Railway. It is the only railway company that covers 3 coasts of the North American continent: the Atlantic, the Pacific and the Gulf of Mexico.

As briefly mentioned earlier, the business model consists of 5 supporting segments:

Which goods are being transported?

The Canadian National Railway plays a crucial role in the transport of various goods, except for passenger transport. The three main commodities transported over its rail network include intermodal shipments (such as containers), petroleum and chemicals, and grain and fertilisers.

Intermodal transport, which includes containers and their contents, is crucial for moving goods from ports to consumers. Crude oil and chemicals are mainly transported from oil-rich provinces to industrialised cities, where they are further processed into fuels or chemicals in refineries or by chemical companies.

Most grain comes from the Midwest of the USA and the prairie provinces of Canada. After harvesting, it has to be transported from the vast fields for further processing.

The company therefore plays a crucial role in the transport of these goods, supporting the economy and supply chain both in Canada and the US, as well as internationally.

Who are the customers?

Canadian National Railway's customers include a variety of companies from different industries that use its services to transport freight and materials. Some of the customers could be:

These are just a few examples of Canadian National Railway's potential customers, as its services can be used by a wide range of companies in various industries.

How is the income realised?

Canadian National Railway currently generates its income exclusively through the operation of its rail network and the associated transport services.

Summary of the business model

Canadian National Railway has a business model that is simple to understand. There is a rail network and trains run on it. That is the core business that we understand. It mainly transports goods, which means that companies pay money to transport goods. As the map showing the Canadian National Railway's route network already shows well, the company primarily connects two oceans (Atlantic and Pacific) with each other and the Gulf of Mexico.

I have always liked the railroad business because it has multiple moats. Each railroad company has its own operating territory, which creates an almost impenetrable barrier to entry by others. Once you build a rail line, you own it, and you can operate it without fear of a new entrant replicating it. The upfront cost of infrastructure would be very high, and creating excess transportation capacity when demand growth is limited would destroy value for existing operators and new rail companies. Existing railroads have an economy of scale because most customers and busy corridors are already served by one or two railroads, so there is no need for additional railroads. In addition, rail is the best and most cost-effective option for moving bulk commodities when origin and destination are not connected by waterways. Fuel efficiency combined with the greater capacity of rail cars and length of trains provide cost advantages over trucking. This also applies to intermodal container traffic, which mainly involves consumer goods.

Furthermore, CNI owns almost 50% of the Canadian rail network and its direct Canadian competitor Canadian Pacific Railway only just under 25%, with the rest falling to smaller railway companies. Thus, one more argument is that the Canadian National Railway has a moat.

Company Strategy

Canadian National Railway has long been a nation builder and trade enabler and is essential to the North American economy. The company's strengths are multi-faceted: it has a network along three coasts, offers geographical diversity and a wide range of customers and products. Its proven innovation is also reflected in the operation of a reliable railway system. Canadian National Railway’s business strategy is based on a vision of sustainable growth for customers, employees, and the communities in which it operates. Canadian National Railway’s strategic plan focuses on achieving operational excellence on a daily basis, building strong customer relationships, expanding geographic and product reach, and continuous innovation efforts. Canadian National Railway strives for sustainable and profitable growth by providing outstanding customer service, growing faster than the economy, pricing above rail and continuously improving operational efficiency. This strategy is based on Canadian National Railway’s strong commitment to responsible delivery, ensuring the safe and efficient transport of its customers' goods to minimise environmental impact. Canadian National Railway attracts and retains top talent, promotes the development of safer and more resilient communities, and adheres to the highest standards of governance.

Shareholders

The top 10 shareholders of Canadian National Railway collectively own nearly 38% of the company's shares. Among them, the Bill & Melinda Gates Foundation Trust stands out as the largest shareholder with 8.49%, followed by financial entities like Vanguard and banks such as Royal Bank of Canada. The Bill & Melinda Gates Foundation Trust follows a similar investment approach to Warren Buffett's Berkshire Hathaway, focusing on companies with sustainable competitive advantages. It's worth noting the close friendship between Bill Gates and Warren Buffett.

Management / Salary

After more than 25 years of dedicated service to the Canadian National Railway, Jean-Jacques Ruest deservedly retired in January 2022. As CEO, he provided the company and all our stakeholders with strong and inspiring leadership. He had been CEO of CNI since 2018. He deferred discussions about his retirement plans to navigate the company through the potential merger with KCS and the completion of the transaction, as well as the implementation of the strategic plan announced on September 17, 2021, which is starting to yield results.

Robinson is already familiar with the rail industry but brings an additional perspective to CNI: experience as a shipper. That should prove invaluable if CN aims to continue growing.

In my opinion, it is particularly important for the CEO to be very familiar with the business they are in. As evident with Tracy Robinson, she understands the business and has even worked as a shipper. Furthermore, her in-depth knowledge of customers will aid CNI in increasing shareholder value.

Turning to the CEO's compensation, the annual total remuneration is CA$13.73 million, comprising 7.1% salary and 92.9% bonuses, including company shares and options. She directly owns 0.001% of the company's shares, valued at CA$547.37 thousand. The average tenure of the management team and the board is 1.6 years and 2.7 years, respectively, which is not very long. However, this is likely due to recent leadership changes.

After nearly 2 years in service, I consider her a suitable successor to Jean-Jacques Ruest. But only time will reveal where her journey leads.

Historical Financial Performance

Share Price

Canadian National Railway's share price performance over the past ten years has reflected a remarkable increase, as it has more than doubled. With an average annual growth rate of around 10 %, this development paralleled the performance of the S&P 500.

During this period, there were attractive entry points for investors, including during the outbreak of the COVID-19 pandemic between March and April 2020. During this time, the importance of stable infrastructure for regions became evident, potentially strengthening interest in companies like Canadian National Railway. Similarly, investors might have seen opportunities to enter the company at more favourable prices during the onset of the Ukraine war.

In my first blog post, I emphasized the impact of continuous focus on stock prices, which often creates unrest and leads to emotional reactions such as fear and greed. It is therefore crucial not only to analyse a company's business model, as we have already done, but also to have a closer look at its financial indicators. This allows us to better estimate and understand the potential value of the company.

Financial Statements

Income Statement

Canadian National Railway's income statement in 2022 and the last 12 months (Q4 2022—Q3 2023) shows remarkable trends. Over the last 10 years, Canadian National Railway has seen an average annual revenue increase of 5.78%, while total operating costs have only increased by 5.23% per year over the same period. These figures indicate the efficient cost control and successful revenue growth that the company has been able to achieve.

Another important aspect is the ratio of interest expenses to operating income. The ratio of interest payments to operating income over the last ten years is 9.27%. This indicates that Canadian National Railway manages debt effectively and has a low dependence on long-term debt financing. This low interest expense ratio of 9.27 % compared to the benchmark of 15 % indicates that the company has a solid financial health and a conservative financing strategy.

Over the past 10 years, Canadian National Railway has maintained a consistently high average net margin of 29.9%, which is extremely impressive. This consistency suggests that the company must have had a sustainable competitive advantage over a long period of time to generate such high average net margins of over 20%.

In the quarters from Q4 2022 to Q3 2023, the positive trend continued and manifested itself in a sustained positive development. This period reflected constant growth and underlined the company's continued strength. The ongoing positive performance continued throughout the past year until the third quarter of 2023.

Balance Sheet

Canadian National Railway's balance sheet as at 30. September 2023 shows many assets, including various plant and property and equipment such as rails, trains, real estate and other long-term investments. At the same time, the company has liabilities to banks, suppliers and other creditors.

The current ratio, which measures the ratio of current assets to current liabilities, is largely below the industry average of 1. From a traditional perspective, this could indicate financial risks. However, the company's earning power is exceptionally strong. It enables the company to easily cover its current liabilities. In addition, the company is able to raise additional short-term funding through the market for favourable commercial paper if required without getting into difficulties.

The ability of the company to service its current liabilities while leveraging its profitability to generate additional financial resources represents solid financial stability. Although the current ratio falls below the usual benchmark, the company is well positioned due to its strong earnings to meet its short-term liabilities and raise additional funds if necessary.

Over the past decade, Canadian National Railway has maintained a consistent equity ratio of approximately 43%, indicating a solid balance sheet and capital structure. While investors typically prefer an equity ratio exceeding 50%, the company has used the favourable debt capital to make profitable investments, which has proven to be a wise decision. 

The company's return on equity is particularly impressive, averaging at 23.67%, well above the benchmark value of at least 10%. This high return on equity demonstrates that the company efficiently utilizes retained earnings. 

For shareholders of Canadian National Railway, it's crucial that management effectively allocates invested capital to maximize profit. Evidently, the company is capable of doing so, thereby strengthening shareholder confidence.

Cash Flow Statement

Let's have a look at how money moves within the Canadian National Railway. The cash flow statement is an extremely useful source of information to determine if the company has a sustainable competitive advantage (Moat). Particularly revealing is the analysis of capital allocation that can be derived from the cash flow statement.

Capital Allocation

In the long-term return on an equity investment, the efficient use of the operating cash flow generated plays a decisive role. This is determined by capital allocation, which refers to the strategic distribution of cash flow to different areas. There are three main areas that I pay particular attention to: CapEx, dividends and share buybacks.

Investing activities & Capital expenditures (CapEx)

Canadian National Railway has launched major investments since 2022 to promote sustainable growth and build a state-of-the-art railway infrastructure for the 21st century. These investments are part of a capital programme that accounts for approximately 17% of annual revenue. Key projects include major track expansion projects that will increase capacity and enable Canadian National Railway to serve its ever-growing customer base more efficiently.

The Canadian National Railway has dedicated a significant portion of its profits in recent years towards improving and expanding its infrastructure, as well as investments within its capital expenditure (CapEx) to ensure smooth freight transportation across its rail network. The shares of these investments in net income were 59% in 2021, 54% in 2022, and 64% in the first three quarters of 2023. These percentages are below the average of 71% over the last 10 years.

This strategy reflects Canadian National Railway ambition to continuously improve and expand its infrastructure in order to increase the efficiency of freight transport while meeting the company's future needs. The recent investment rates may be below the historical average, but demonstrate the company's continued focus on strengthening its operational performance and providing world-class rail freight services.

Canadian National Railway plans to acquire Iowa Northern Railway (IANR), a short line railway company with a network of approximately 275 miles (approximately 443 km) in Iowa. This acquisition will help Canadian National Railway to strengthen its presence in the region.

Dividends

Canadian National Railway pays a dividend 4 times a year. Distribution months are March, June, September, and December. With 26 straight years of dividend increases, Canadian National Railway is a so-called dividend aristocrat. The dividend yield is 1.89%. This means that CNI pays out a good dividend of CA$3.16 to its shareholders.

Share Buybacks & Shares Outstanding 

The railway industry is known for aggressive share buyback programmes. The Canadian National Railway is doing the same. CNI has launched a CA$4 billion share buyback program during 2023 until January 2024. This allows CNI to purchase up to 32 million common shares over a 12-month period, representing 4.8% of its 671,253,977 common shares.

Return On Invested Capital

I personally attach great importance to a company's return on invested capital (or ROIC). It tells you how well a company is able to generate higher cash flows from the capital reinvested in the company.

The consistently remarkable aspect is that, except for CPKS (Canadian Pacific Railway), all railway companies have a return on invested capital (ROIC) that is consistently above the 10% benchmark. This means that they generate a consistently higher cash flow with the reinvested capital. This is an extremely positive feature and emphasises the efficiency and profitability of these companies in managing their capital resources.

Valuation

After a thorough analysis of the financial statements, we would like to gain a comprehensive insight into the true value of Canadian National Railway. Given the variety of valuation methods and models available, it is my decision to use three different valuation methods: the discounted cash flow model, the owner earnings method and the equity bond method.

However, to get a rough idea of the valuation first, let's have a look at the traditional stock metrics of Canadian National Railway over the last 10 years. This data will give us an initial indication of how the company has performed in terms of traditional valuation metrics.

It is clearly evident that the financial metrics suggest the stock was more or less fairly valued to slightly overvalued during this period. Particularly noteworthy is the trailing twelve months (TTM) period, where all indicators unmistakably point towards a potential overvaluation. A Price-to-Earnings Ratio (P/E) above 25 and a Price-to-Book Ratio (P/B) close to 5 signal a comparatively high valuation. These metrics indicate that the current market price of the stock is considered high in relation to the company's earnings and book value per share.

Discounted Cash Flow Model

With the Discounted Cash Flow model, I intend to determine the present value of the Canadian National Railway by discounting its future cash flows. The following diagram illustrates the Discounted Cash Flow model for the Canadian National Railway.

Following the analysis, an impressive calculation emerges: The estimated intrinsic value per share for the Canadian National Railway stands at a proud CA$270.56, based on the Discounted Cash Flow model at the time of this report. Interestingly, it is evident that even with a current stock price of approximately CA$166.55, Canadian National Railway shares seem to be significantly undervalued according to the DCF model.

Let's check what the two other methods will tell us.

Owner Earnings Method

The traditional use of net income for valuing companies is often hampered by different accounting practices. Free cash flow provides a better basis, but short-term investments in individual years cannot adequately represent the future development (as already calculated in the DCF model above).

Owner earnings provide a logical solution by adjusting the free cash flow. Long-term averages for capital expenditure and working capital are used to eliminate elements not attributable to shareholders. The logic behind this concept is compelling, as it provides a more realistic assessment of a company's financial performance.

The accurate determination of owner earnings and the translation into an intrinsic value using perpetuity are hence a central task in a thorough stock analysis. This approach provides a well-founded assessment of the true value of a company, independent of short-term fluctuations and accounting influences.

Integrating owner earnings instead of free cash flow into the discounted cash flow model shows an estimated intrinsic value per share for Canadian National Railway of an impressive CA$254.24. Interestingly, even at a current share price of approximately CA$166.55, Canadian National Railway shares also appear to be significantly undervalued.

A final, last method to be sure.

Equity Bond Method

The Equity Bond Method is a less well-known but utilized by investors like Warren Buffett to estimate the intrinsic value of a stock. This method requires just five key values: Equity per Share, Earnings per Share, Dividend Payout Ratio, the current stock price, and the average P/E ratio of the last 10 years (as indicated in the box with the blue numbers).

With this information, the actual value of the stocks can be determined, along with the calculation of the average annual return.

By applying the Equity Bond method, I was able to determine the estimated intrinsic value per share for Canadian National Railway to be an impressive CA$296.49. This analysis suggests that the company's stocks may be significantly undervalued, especially when considering the current market price of approximately CA$166.55.

Expected Return

The Canadian National Railway demonstrates an impressive return outlook based on various valuation methods. The Return on Invested Capital (ROIC) stands at a robust 15.9%, while the Equity Bond Method forecasts an annual return of 14.5%. Considering these promising figures, I personally aim for an annual return between 12% and 15%, which seems quite achievable, if not surpassed.

The proven ability of Canadian National Railway to deliver such returns enhances my confidence in its strong positioning and long-term stability. This positive outlook, compared to an ETF that can offer an average return of 10%, underscores the attractiveness of the Canadian National Railway as an investment option. The well-founded financial data and solid market positioning of Canadian National Railway make it a promising choice for investors seeking sustainable and growing returns.

Final Thoughts

The railway business has several moats that allow railway companies to operate at high profit margins and return a lot of capital to shareholders. Based on several metrics, I believe that Canadian National Railway is the most stable railway stock on the market.

Furthermore, I believe that all railway stocks will continue to perform well in the future and could be a good buy at the right price. However, I believe that Canadian National is the better railway company in terms of stability. It has the best revenue growth, good margins, an excellent return on capital, an impressive dividend and a solid balance sheet.

I am concerned about the stagnant operating margin. However, the improvement in the operating ratio in the last second quarter under new CEO Tracy Robinson seems promising for future margin expansion. In addition, Canadian National is dependent on the health of the Canadian and US economies, including retail and industrial end markets. The downside risk to freight demand is currently elevated due to inflation and lower consumer spending. I think these risks will abate in the medium term.

In summary, Canadian National Railway is a company with a wide moat and is now available at an attractive price, considering historical valuations. In my opinion, investors should be cautious when looking at historical valuations as the macroeconomic outlook changes. Therefore, Canadian National Railway is a company worth keeping an eye on. Especially since it pays to buy quality companies in difficult times, as they tend to perform quite well in the long run.

Reference

Holdings Disclosure
I hold a position in CNI.
This article is not intended to be a solicitation for you, the reader, to buy or sell the stock. I wrote this article myself, and it reflects my personal views and opinions. I do not receive any remuneration nor do I have any business relationship with any company whose shares are mentioned in this article.

Legal Disclaimer
I am not a registered investment advisors, brokers/dealers, securities brokers, or financial planners. This article is being provided for informational and educational purposes only and on the condition that it will not form a primary basis for any investment decision. The views about companies and their securities expressed in this article reflect my personal opinions. I do not represent the opinions on whether to buy, sell or hold shares of any particular stock.
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