I’m a business owner so I know what it means to be cheap. Okay, that sounded bad; still, I like the philosophy of “why pay for what you can get for free.” In business, just as in your personal finances, cash is king-so you don’t want to blow it unnecessarily.
There are three rational ways to value a business: break-up value, ongoing enterprise (F Wall Street) value, and buy-and-resell (Pabrai or Williams) value. If you can buy at a discount to any of those three valuations, you’ll be on your way. Let’s find some opportunities.
Break-Up Value: Price To Book Ratio
The break-up value of a company is its liquidation value-the cash left over if operations ceased and the company’s assets were sold, liabilities paid, and cash dispersed to shareholders. MSN Money has a nice (free) deluxe screener that allows you to pinpoint opportunities.
I set up a screen for Price/Book Value : <= : 0.75 and Market Capitalization : >= : 250,000,000 and was presented with a list of 165 companies that are trading at or below 75% of their break-up value. But don’t run off and buy them just yet-they require further research.
For example, I was looking into Citadel Broadcasting-trading at what seems to be 60% of its break-up value. When I started reading the last annual report, I saw that the company was in the process of being sued by its bondholders. The long and short of it is that the bondholders feel that the company defaulted on its obligations when Citadel merged width ABC Radio-and the bondholders want their $330 million.
High uncertainty? Yes-Pabrai would love it. But if the suit is successful-and it appears that it may be (they have a good case)-Citadel may have to start selling stations or issuing stock to cover the hit. In that case, the book value would drop-and we wouldn’t be buying it at a discount today.
The moral of the above story is that the stock screener is a starting point for further research.
Ongoing Enterprise Value And Buy-And-Resell Value
When screening for solid businesses to own for the long-term-be it forever or for a few years-the goal is to find businesses with positive owner earnings or free cash flow. We can forgive one or two tough years in ten (even last year), but not much more than that.
We also have to find those businesses when the markets have beat them up or held their stock prices back. To do that, we have to play Wall Street’s game by using their screening criteria.
Yahoo! has a nice screener that allows you to search for companies with positive free cash flow. If you’ve read the past posts, you’ll know that I pay for Morningstar’s premium service because it allows a more comprehensive screen to find companies with ten years of positive free cash flow.
Combining The Tools
On Morningstar, I find 19 companies with 10 years of positive free cash flow and a price to book of less than 1. Now that’s interesting-and worth researching. One such company is Lee Enterprises, down more than 60% this year alone, is offering a 4.15% dividend, and looks to be selling for 80% of book value. Or La-Z-Boy, down 50% on the year. La-Z-Boy is paying a 6.14% dividend and appears to be trading at 90% of book value.
Wait! I’m not saying buy them-but I’m going to be looking. They’re worth a few minutes of my day.
Today’s Debacles
Remember that Mr. Market punishes uncertainty by beating down stock prices. I like to quickly check out the day’s debacles by heading over to Yahoo!’s collection of the biggest price losers (on a percentage basis). Every once in a while, you might find something interesting.
F Wall Street User Contributions
In addition to the above tools, a few visitors have been playing around with screeners and the spreadsheets here. Robert set up an Excel spreadsheet that pulls data from Morningstar to help automate the process, and a few visitors have expressed an interest in using it. If he sends it to me (and allows it), I’ll post it here.
In addition, Sanjay Shetty who blogs at India Investor posted a list of free stock screeners. Check it out.
Always Remember…
You are not looking for the next hot stock-you are looking for the companies that Wall Street is punishing for whatever reason. Let the gamblers and traders overreact. That’s how we make big money.
And Congrats…
…to Allen who reported a handsome one-month gain. Though we do not look for short-term gains, we aren’t upset when we get them. Allen purchased a company at a substantial discount and that company was (one month) later acquired for right around fair value.
That’s the joy of buying $0.50 dollars!
Filed under: How to Search for Opportunities
If you check out Pabrai’s book he gives a whole list a places to look for ideas. Also run a search via google and there is also an interview where he reiterates those potential idea generators.
Value Investors Insight, Value Line, Gurufocus, Outstanding Investor Digest are some of the places.
Good luck,
Casey
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Joe,
It is interesting you should mention Citadel Broadcasting. At the time of the ABC Radio acquisition I was a Disney shareholder and therefore received a calculated number of Citadel shares for each share of Disney that I owned. Upon receipt of the Citadel shares I needed to determine a course of action (hold or sell). I did not like the new debt load Citadel was under after the ABC Radio acquistion and therefore decided to head for the hills and sold the Citadel shares.
I agree with your conclusion that stock screening activity produces “ideas” as opposed to “decisions”. While on the subject, here are a few “ideas” that have come to the surface as a result of recent screening and valuation activity.
ITT appears to be trading at 21% below value
PFE appears to be trading at 73% below value (27% below Wiki value)
X appears to be trading at 55% below value (26% below Wiki value)
DIS appears to be trading at 50% below value
KG appears to be trading at 77% below value (88% below Wiki value)
I have not looked in detail at Lazy-Boy but noticed that it did show up in the results for one of my screening jobs.
Glenn
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Hi Joe,
I’ve created an Excel sheet and written a macro to automatically scan the S&P 500 list of companies. I’ve leaned on others for help and your methodology and the Excel sheet provided by you is the basic foundation.
I did email the Excel to you, feel free to put it up on your site, and I’ve posted it on my blog http://indiainvestor.wordpress.com/ as well as I’m sure there would be updates which I’ll keep doing to it.
I trust others out here will find it as useful as I do 
The blog post for your reference is: http://indiainvestor.wordpress.com/2007/10/15/automatically-scanning-the-sp-500-using-fwallstreetcom-method/
Regards,
Sanjay Shetty
I blog at: http://indiainvestor.wordpress.com/
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Hi Joe and everyone else who reads the blog
Iâ??ve seen considerable interest in the Excel sheet I provided earlier to automatically scan the S&P 500, quite a few downloads , Iâ??m happy people are finding it useful. I received, some useful feedback: providing better status updates, possibly speeding up the program etc. and hence, over the weekend, Iâ??ve updated the program further.
Iâ??ve added some new features:
1. Adding companies to a separate WatchList sheet, in case their current price doesnâ??t match the value you feel you should pay for the company, however they have excellent CROIC and FCF Growth. Basically Mr. Market is overpricing them currently. Such a company should be kept on a watchlist and thats the additional functionality Iâ??ve included.
2. Speed: Iâ??ve updated the program, such that my code doesnâ??t add any significant additional time to the data retrieval process (by tapping in to Excel Events). So the program now works much faster.
3. Status indicators: Iâ??ve added several status messages, to make sure the user is aware of what company is currently been scanned, the total time taken for a scan etc. This helps in knowing what the Excel sheet is doing currently, and prevents it from looking hung.
With the additional speed improvement, comes a bigger caveat: Donâ??t scan all 500 at one go. The sites providing data observe large repetitive requests, often they block data provided to the particular requester(based on the source IP address etc.). As always scan in batches of 10-20.
You can download it out here:
Regards,
Sanjay Shetty
I blog at: http://indiainvestor.wordpress.com/
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Hi Sohrab,
You can start by reading the article at http://www.fwallstreet.com/blog/25.htm Calculating The Value Of A Business – Part I
It’s a four part series and is simply beautiful
Also you might want to see an article I recently wrote on Understanding the Numbers at http://www.valueinvestingnews.com/blog/sanjayshetty/understanding-numbers
Regards,
Sanjay Shetty
I blog at: http://indiainvestor.wordpress.com/
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Sohrab,
We seek to figure out the value of a business as though it were a private company and as though we wanted to acquire the entire company. Once we are comfortable with out valuation, we then figure out if we can buy that company at a deep discount.
At the end of the day, it is important to remember that the stock market is nothing more than a place to buy and sell businesses. If you have a good idea of what those businesses are worth, you’ll know how much to pay for them and what to expect from them.
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Joe, excellent as usual.
I’ve got a request. Could you explain what you mean by “Ongoing Enterprise Value”? Is this a term you came up with? I know about Enterprise Value and I’m fascinated with this measurement. I’m finding a lot of companies (especially in China right now) that have unbelievable Enterprise Value relative to their market cap.
Just as an example, say I found a company with a market cap of $500M, but it’s enterprise value is like $30M. Cash on hand is $470M, and no debt. Normalized FCF is, say, $20M per year. Theoretically, if I could buy the entire company, I would pay $500M, pocket the $470M of cash, leaving a net investment of only $30M. Let’s say the rest of the year the company makes $10M in FCF, and the next year it makes $20M – as usual in cash flow. So, I have made my investment back in 1.5 years. This is all if I purchased the entire company. Is there anything I need to be wary of when buying individual stock of this company? Obviously I wouldn’t have controlling interest. I guess the management could make an egg-headed move and buy a worthless asset with all that cash, and then my investment would decline, right?
Like I said, I’ve seen a few companies like this. Am I missing anything that would deflate my excitement a little bit?
Naturally, these get me pretty excited, but am I overlooking something?
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Eliot Murray,
In this article, I mention the “Ongoing Enterprise Value” as the value of the future cash flow, discounted at an appropriate rate. I use that term as the opposite of “Break-Up Value” — the value of the company if it were shut down and sold off in pieces.
This image shows the intrinsic value of a business — somewhere between the floor (the rock bottom, break-up value) and the ceiling (the future cash generated from operations):
If you know your business will shut down tomorrow, you buy at a discount to the floor. If you know it will go on forever as an “ongoing enterprise,” you buy at a discount to the ceiling. I never pretend that the business will go on forever; so, I value ongoing enterprises between the floor and the ceiling.
Make sense?
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Hello,when screening for stocks using multiples is low p/fcf the most important? More so than p/e,p/s etc.
Also when looking at your screen results is there a quickway you can check to see that a stock is probably undervalued on a DCF basis,eg if the p/fcf ratio has been declining over the last 5 years,or can you just do a rough DCF by averaging the free cash flows over the last five years & discounting them in your head? (a quick check to see if a stock warrants further investigation)
Thanks for any help.
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If you have found a stock that trades at 2 or 3 times FCF or Owner Earnings (whatever your preference is) AND you think that those levels are at least sustainable (at best, they will grow!), you have no reason to do a DCF; you have found a cheap stock. I would even say that at 5 or 6 times FCF the stock could still be quite cheap.
That being said, just like low PE ratios, low P/FCF ratios can be a mirage so make sure you check for any one-time additions to FCF that might be skewing your ratio. Hope that helps!
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No problem. I want to make sure my caveat in my post was clear though: if a stock has a low P/FCF it is definitely cheap, but there may be a reason for that. Maybe a new regulation was passed that will cause next year’s FCF to be halved. Maybe the company is going out of business. Just wanted to make it clear that just because this ratio is low doesn’t make something an automatic buy.
As for other ratios, the other ones are all something to look at but if you’re looking for something that’s really cheap I often like to look at P/S. If it is very low you may have a bargain. Hope this helps.
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Joe,
First of all I wanted to thank you very much for all the work that you have been doing to teach valuating a company’s intrinsic values to the people like us.
I came across American Eagle outfitters (AEO) in one of my screens & I calculated its intrinsic value. I think it is trading on substantial discount.
Detail:
Actually it’s free cash flow growing at about 35.4%. Even if it grows about 10% from now for 10 years & 5% for another 10 years, it is discounted to 52% of its intrinsic value. As a note insiders are accumulating this stock very recently.
Median CROIC is 18.5% over 10 years (5 & 7 years period calculation)
I think it is a very good buy at this point of time. Or am I missing something??
I would be delighted if you can throw some of your inputs on this.
Regards,
Gopinath
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