Analyst Program AP Business Valuation and Stock Selection Meeting

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Analyst Program (AP) Business Valuation and
Stock Selection Meeting
Wednesday, September 17th
Justin Van Vleck Co-President of Operations
Felix Popescu VP of Analyst Program
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Business Valuation

• Learning to Invest
• with a Margin of Safety

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From last week

• We want to invest in companies that are trading
  below their intrinsic value
• Not only that, we want to find companies trading
  at a significant discount to their fundamental
  value
• This is called a investing with a margin of
  safety, because you are protecting yourself
  against further losses by buying a business on
  sale
• A business could be good or bad, but the price
  you pay for it is the most important thing

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How Assets are Priced

• Assets are priced based on the present value of
  the cash flows they will produce in the future
• These cash flows are discounted back using a
  discount rate
• The discount rate represents the opportunity cost
  of investing in this asset given its individual
  level of risk

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How Assets are Priced

• Time Value of Money A dollar today is worth more
  than a dollar tomorrow.
• A dollar today can be invested to earn a rate of
  return or interest.
• What is todays dollar worth tomorrow (future
  value)?
• What is tomorrows dollar worth today (present
  value)?

This is how we calculate stock prices!
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Example

• MSU Candy Co. is expected to have cash flows of
  5, 10, and 15 in the next 3 years
  respectively. The business is small, but not too
  risky, so a discount rate of 10 will do. There
  are 3 shares of stock in the marketplace.
• How to calculate the theoretical stock price
• PV Year 1 CF 5/((110)1) 4.54
• PV Year 2 CF 10/((110)2) 8.26
• PV Year 3 CF 15/((110)3) 11.26
• Adding these together gives us 24.06
• 3 shares in the market place means stock should
  be trading at 24.06/3 8.02 per share

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Discount Rate

• The expected rate of return available on
  alternative investment opportunities of similar
  risk levels, or in other words, the Opportunity
  Cost of this investment
• Historically, the stock market has generated an
  average annual return of about 10.
• Good method to start outCAPM model
• Cost of Equity Rf B (Mkt Rf)
• Beta can be found on Yahoo! Finance, Rf can be 5
  year Treasury interest rate, and (Mkt-Rf) 5.6
• Doesnt hurt to add a few extra percentage points
  to your calculated discount ratethis will
  increase your margin of safety
• Be conservative! The higher the discount rate the
  better! (to a degree)

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How to Value a Company

• Discounted Free Cash Flows (NPV)
• Multiples
• Valuation Multiples
• Comparable Transactions
• Liquidation Value
• Tangible Book Value
• Break-up Value
• Net Working Capital per Share
• Net-Net Working Capital per Share

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Free Cash Flows to Stockholders

• Finds the cash flows to a business available to
  stockholders in the future discounted into
  todays dollars
• Net Income
• Plus Depreciation
• Less Increases in Net Working Capital
• Less Capital Expenditures
• This is what we use for our DCF model
• Note Earnings are NOT the same as cash flows,
  and often times they will be different!

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FCF Example

• MSU Candy Co. has earnings of 5 for 2007. It
  also has depreciation on its building of 2, with
  an additional amount of candy needed that will
  cost them 2, as well as a store repair that will
  cost them 1. What is MSU Candy Co.s Free Cash
  Flow?
• Net Income 5
• Plus Depreciation of 2 7
• Less Increases in NWC of 2 5
• Less Capital Expenditures of 1 4 FCF

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Perpetuity on the DCF Model

• Use 3 revenue growth
• Profit margins should be reduced
• Net Working Capital as a percentage of sales may
  not change that much
• Capital Expenditures and Depreciation will be
  close to the same
• When in doubt, be conservative!

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Multiples

• Ex. Stock with a 20x P/E multiple means investors
  would be willing to buy this business for 20
  times its current level of earnings, discounted
  back to todays dollars
• What multiple should be used to value the
  company?
• What has the 5 year average looked like for that
  multiple?
• Why is the multiple at a discount?
• Why wont it contract further?
• Morningstar has a helpful website for this
• http//quicktake.morningstar.com/StockNet/StockVal
  uation.aspx?CountryUSASymbolUSU

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Liquidation Value

• Value of a company if it were to be sold today
• Will differ depending on speed of liquidation
• Good conservative metrics include
• Book value per share
• Net working capital per share
• Net-net working capital per share
• Break up value of company divisions

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Liquidation Value Examples

• MSU Candy Co. has assets of 20 inventory, 20
  delivery truck, and 10 of accounts receivable
  due to it. The company also owes the bank 10,
  and owes its supplier 10. What is the companys
  liquidation value if there are 3 shares on the
  market?

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Liquidation Value Examples

• Quick and dirty method of Liquidation value is
  Net Working Capital per Share
• Current Assets
• Inventory of 10
• Delivery Truck of 20
• Accounts Receivable of 20
• Total Current Assets 50
• Current Liabilities
• Bank note of 10
• Accounts Payable of 10
• Total Net Working Capital of 30
• With 3 shares on the marketplace the company
  would be sold at 10/share if it were sold today

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Liquidation Value Examples

• MSU Candy Co. also has a chocolate division. For
  the year 2007, it had earnings of 3. The
  chocolate division has all its own equipment and
  buildings. If similar chocolate companies are
  trading on the stock market at 10x earnings (P/E
  of 10), what would be the break-up value of MSU
  Candy Co.?

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Liquidation Value Examples

• First, lets keep everything with the candy
  division the same. We concluded it was worth
  10/share if it were sold today.
• With the chocolate division making 3 in
  earnings, thats 1/per share in earnings
• With a 10x PE multiple, this adds 10 of value to
  each share of MSU Candy Co. stock.
• Its now worth 20/share in break-up value

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Which method is appropriate to use?

• Valuation method selection should be based on
  what the catalysts will be
• Ex. If you think the company is very likely to be
  sold or split up for some reason, then a version
  of liquidation value is likely the most
  appropriate
• Ex. If you think the catalyst will be a change in
  the companys earnings power somehow, then
  perhaps the earnings multiple or DCF is more
  appropriate
• Liquidation value, however, often serves as the
  floor value, so even if the catalyst wont be a
  sale/breakup, this measure of valuation is a
  great place to start

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Screening for Stocks

• Yahoo! Finance Stock Screener is easy to use, so
  we recommend using that
• http//screener.finance.yahoo.com/newscreener.html
  
• Screening Criteria Include
• Price to Book less than 1.5
• Price to Earnings less than 20

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Stock Selection Process

• So you think youve found a cheap stock? Heres
  what to do next

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Understand the Business Model!

• If you cannot understand how the company makes
  money, stop wasting your time and look at other
  stocks
• Look at a few of the companies Warren Buffett
  owns
• Dairy Queen
• Coca-Cola
• Washington Post Co.
• Where to find it
• 10-k filing

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What is/are the business competitive advantages?

• How will this company continue to exist in the
  future?
• What does it do that will prevent competition
  from eating away at its business?
• Note the greater the margin of safety a business
  has based on valuation considerations, the weaker
  the competitive advantage can be
• Where to find it
• 10-k filing

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And then

• Go through the presentation criteria!
• Figure out why the stock has been sold by so many
  people!
• This is the key debate part of the presentation
• Good examples include a huge missed earnings
  quarter, announcement of a competitor product,
  loss of government contract, lawsuit
• Where to find it
• Look at the stock chart for the past year or so
  and see where it really tanked, then find the
  most recent conference call transcript to find
  out what people are saying about it
• Good website to use http//seekingalpha.com/tag/tr
  anscripts?sourceheadtabs

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Once you figure that out

• Does it make sense that the stock should be that
  cheap?
• Does it seem like this is a one time thing and
  that business as usual should be strong?
• If it seems like people overreacted, then you
  must explain why people overreacted, and why you
  think they are wrong

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Further questions to ask

• How does the company fund itself?
• Is it self sustaining through its cash flow from
  operations or does it have to borrow to continue
  to grow?
• Can this cash flow cover capital expenditures
  too?
• Easy way to determine this is to see if CFO is
  not only positive, but bigger than the CFI part
  of the cash flow statement
• What does its Return on Equity look like in the
  past? If a companys ROE is continuously less
  than its discount rate, it is destroying value
• If you pick a company like this, you should have
  a good reason why things are going to turn around

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In short

• READ THE 10-K!
• It is the best place to learn about all aspects
  of a business
• Focus on the Managements Discussion and Analysis
  section
• Read conference call transcripts and see what
  people are asking questions about

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Just to Recap

• We are looking to buy good solid companies that
  are undervalued, a dollar for fifty cents
• The greater the discount to fair value you have,
  the greater the margin of safety, and the more
  attractive the investment opp.
• You may not be able to find a company in your
  space thats below book value
• Make sure your valuation argument is compelling,
  however.

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Questions?
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Appendix