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Analyst Program AP Business Valuation and Stock Selection Meeting

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Title: Analyst Program AP Business Valuation and Stock Selection Meeting


1
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
2
Business Valuation
  • Learning to Invest
  • with a Margin of Safety

3
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

4
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

5
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!
6
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

7
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)

8
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

9
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!

10
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

11
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!

12
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

13
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

14
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?

15
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

16
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.?

17
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

18
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

19
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

20
Stock Selection Process
  • So you think youve found a cheap stock? Heres
    what to do next

21
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

22
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

23
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

24
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

25
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

26
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

27
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.

28
Questions?
29
Appendix
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