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Jul
2
A visitor just sent this email to me and I figured (as per his last line) that it would be better suited in a post rather than in a private email response. The question: Should I use the owner's margin on lowered sales as I project the intrinsic value of a company rather than sticking with historical growth and projections?
I will not take too much of your time. I'm valuing a company which sells durable goods (appliances) and it would seem like BDK is undervalued from 2007's FCF. Nevertheless, the idea that consumers might stop spending as much on these items gives me another reason to question my FV estimates.
For this reason, I have to thank you for your post on the FCF margin (as a % of sales). With this in mind, if BDK's sales drops within the next year and months; in which case, we would be overpaying for its future cash. To keep a long story short, I was wondering if it would be sensible to reduce FCF in my estimate by applying that 10% FCF margin that the company seems to have?
In this case, I'd take into account a worse case scenario, say a drop in 30% in sales which leads me to a FCF (discounted at 15%, MOS 50% growth 12%) I would not pay more than $31.
This is a HUGE contrast from a price of 55-58$ if it grew at only 6%, disc 15%, Mos 25% WHERE FCF was the best scenario possible(2007).
What is your view on these two contrasting methods of valuing. One of them is conservative on its last year's FCF while the other is conservative on Growth estimates. Which one would be congruent with Graham/Buffett philosophy of investing? Your insights would be MUCH appreciated! In fact, this can be great post on your fantastic website!
Take care Mr. Ponzio!
My Response
You bet! The value of a company lies entirely in the future. The past can give us some insight into the business, but it is not a substitute for a thorough analysis and estimate of what the future will bring for a business. That's why you will see so many seemingly crazy purchases from Buffett and other great investors.
Think of it this way: XYZ Company generates $500 million in revenue and generates $20 million — $0.50 per share — in earnings. Its owner's margin is 20%, or $100 million. With a PE of 15, it's a $7.50 stock ($0.50 x 15). This year, it's expecting to take a 20% hit to revenues, and that will translate right to the bottom line until the company can adjust by selling assets, cutting jobs, and making other adjustments.
Sales come in at $400 million, and earnings drop to an $80 million loss — a loss of $2 per share. Owner earnings are about zero. The stock? Hammered down to $1.20 a share.
You feel that the business is good, that management is top notch, and that, in time, they will return the business to "normal" operations — an owner's margin of 20%, or $80 million on the lowered sales. Whereas your previous assessment said it was a $7 per share company, you now see a $5 per share company when things return to normal.
Focused solely on earnings, Wall Street hammers the stock down as though the company is in terminal trouble (and remember that it may be terminal) — in turn, creating an opportunity for an investor looking at what will happen, regardless of the when.
Of course, businesses don't fix themselves overnight. You buy at $1.20, and it subsequently sinks to $0.80 a share over the next year as the loss — originally at $2.00 per share — comes in at just $1.10 per share. Things are improving, but not immediately.
Three years later, the company is generating $460 million in revenues, operations and expenses have been shored up, and things are back to "normal" at the business and on Wall Street (as they pertain to this company). Earnings are $18.4 million, or $0.46 a share. Back at a 15 PE, the stock is trading at almost $7.
That's the long answer. The short answer: Forget the past; predict the future, and then give yourself a margin of safety. Just don't be so gullible as to believe that all companies will return to "normal" after suffering a major blow. Look at management and ask yourself, "Are these the guys/gals that can turn this thing around?"
Hope that helps!
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by Amit D. on July 6, 2008 at 8:41 PM