Tag Archives: Value-Line

Three Valuation Case Studies; Classical Gold Standard

Deadline

“No they cannot touch me for coining, I am the king himself.” –William Shakespeare,King Lear

Valuation Case Studies

Sit down with the Value-Line tear sheet and write down your thoughts. Does the company grow? Is it profitable and by how much? Good or bad balance sheet? And what would you pay and why?  Then listen to the lectures and see where you agree or disagree. On Friday or the next post, I will go over each company quickly–the goal is to acquaint you with an easy search tool-Value-Line and what to look for when analyzing a company.

Coach (COH): COH then Video Lectures: http://www.oldschoolvalue.com/blog/stock-analysis/video-coach-coh-valuation/

General Mills: GIS then Video Lectures: http://www.oldschoolvalue.com/blog/stock-analysis/video-general-mills/

Oracle: ORCL then Video Lectures: http://www.oldschoolvalue.com/blog/stock-analysis/video-oracle-orcl-valuation/

Learn how the founder of Old School Value got started: http://classicvalueinvestors.com/i/2010/03/interview-with-jae-jun-from-old-school-value-blog/

Controlling for Quality to improve investment results (Quant Investing)  http://greenbackd.com/2013/03/19/performance-of-the-decile-approach-to-magic-formula-alternative-quality-and-price/

More on currency wars…….

You need to understand the strengths and weaknesses of the Classical Gold Standard:

Warren Buffett’s Dad: Howard Buffett on the Gold Standard

The St. Louis Fed’s View: St Louis Fed 1981 on Classical Gold Standard

And the Austrians: The Gold Standard Perspectives in the Austrian School

PS: I haven’t forgotten readers’ questions like suggestions on accounting, how to start, etc.

 

Pepsico, Inc. (PEP) Value-Line Case Study

Robert L. Rodriquez, CFA and CEO of First Pacific Advisors in a speech to Institute for Private Investors on Feb. 15, 2012: “I met Charlie Munger in my USC graduate school investment class and had the opportunity to ask him this important question, “If I could do one thing to make myself a better investment professional, what would it be? He answered, “Read history! Read History!” This was among the best pieces of advice I ever received.”

The full speech  at Gurufocus is here (scroll down for the direct link): http://www.gurufocus.com/news/162873/caution-danger-ahead–r-rodriguezfpa

Value-Line Analysis of Pepsi

Our last analysis of a Value-Line Tear Sheet was Balchem (BCPC): http://wp.me/p1PgpH-CY

Now lets look at Pepsi Co., Inc. (PEP): Pepsi_VL

Without glancing at price (easy to do when flipping through the Value-Line at the library or open the digital PDF while looking away from your computer, scroll down and then focus on the numbers) I see Return on total Capital (ROTC) of 30% to 16%, now in the high teens. Return on Equity has ranged 42% to 29%. The 80% higher ROE than ROTC means debt is helping boost returns significantly. Debt is useful as long as its doesn’t impair the company under stressful conditions. The ten-year history of 16 to 25% ROTC shows that this is probably a franchise. Good. Value will be in the growth.

As a review for beginners from Value-Line:

Return on Shareholder Equity, meanwhile, reveals how much has been earned on just the stockholder equity. Value Line calculates this by dividing net profits by shareholder equity, which includes both common and preferred equity. Again, higher percentages are generally better.

Neither of these measures can be used in exclusion, however. They are best used as a starting point or as a comparison tool. Note that comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries. Indeed, because of the differences between industry fundamentals, some industries will have a preponderance of low scores while others will have large numbers of companies with high scores. That said, using these two measures as a first screen can help to quickly limit the number of companies under review and will, generally, direct investors toward higher quality entities.

It is also interesting to compare these two measures for the same companies, which can provide insights into how well companies are making use of their debt. For example, if Return on Total Capital is going up but Return on Shareholders Equity isn’t following along, or, worse is static or falling, additional debt financing isn’t benefiting shareholders.

Another statistic to consider along with these two is Retained to Common Equity, which is colloquially referred to as the “plowback ratio”. Value Line calculates this measure by dividing net income less all dividends (common and preferred) by shareholder’s equity. It measures the extent to which a company has internally generated resources to invest in the company’s future growth. A high percentage here, coupled with an increasing Book Value, is a clear signs that management is increasing the value of its business. This can help validate both the above measures and provide a degree of reassurance that a business is self-sustaining. Like the other two measures, this data point is available in the Statistical Array of each Value Line report.

Back to the PEP Value-Line

Operating margins 20% and net profit margins at 10% with a slight trend down. This may be good or bad depending if margins will stabilize or go up. Even if the margins go down even more–if the company is earning more than its cost of capital and the market price is more pessimistic–then the company could still be a good investment, depending upon price. Just note the slight decline in margins, the business is under temporary stress? Higher capex, higher costs that are not passed through, etc.  We don’t know the details of the story, just a question we need to answer with further research.

Sales per share have been rising 8% to 10% for the past decade, and sales did not drop in 2009, so this company has a stable product with low cyclicality.

Book value shows a steady 6% to 7% increase. 40% to 45% of their earnings are being paid out to shareholders in the form of dividends, share count is declining very slightly. Good, the company is a slow grower and is returning excess capital to shareholders.  The danger might be if management leveraged the company too much.

A glance at the balance sheet shows $26.8 billion in long-term debt; $5.5 billion in net pension obligations and 1.6 billion in cap. leases then subtract 3 billion in cash so we have 30.9 billion or $31 billion in net debt (round up) to add to the market cap to reach our Enterprise Value (Remember we are buying the whole company including its debt). With 1.55 billion shares that is $31 debt/1.55 shares or $20 of net debt per share.

I see about $6 of “Cash Flow” and about $2 of capex for $4 of FCF per share. Note the jump in Capex from 2009 to 2010-what happened? With no growth I certainly would pay $40 to $45 for about a 10% return if I was confident of the company’s franchise. All metrics have grown 7% to 10% over the past ten years. Can that growth continue? This company seems like and inflation pass-through–Sales and profits will rise at least as fast as nominal inflation on average. Good. So if this company could grow at 5% to 6% and I was confident of that growth I would pay $65 to $80 per share for that cash flow, but my confidence level for that future growth had better be high.

Anyway, I have about $40 no growth value for the company but more like $65 to $80 for the business if I assume 5% to 6% growth–like buying a bond. My alternatives are 3% for 20 year US Bonds.

Now to the market price, I see we have a $66 share price as of April 4, 2012 so the market cap is 1.55 billion shares x $66 or about 102 billion but for simplicity–$100 billion then add the 31 billion in net debt for a total of $130 billion for the business (133 billion if we wish to be more precise) for an Enterprise value of $84 to $85 per share.

My range is $65 to $80 (aggressive assumptions?), so the company is out of my range by $5 to $20 or a 5% to 25% swing in price), but a swing of 10% to 15% in price (thank you index selling!) could make this an attractive investment.

Now I do a quick double-check. I have about $85 per share in enterprise value divided into $4 of FCF for an earnings yield of 4.7%. Growth has averaged 9% for the past ten years and I will knock that down to 4% to 6% to be conservative, then add that to 4.7% earnings yield–over 45% of that earnings yield is being paid out to me in the form of a 3.5% dividend yield based on the current market price. Now I have a range of return 8.7% to 10.7%. Not bad assuming I can have confidence in the franchise which 80 years of history leads me to believe I can. However, I do need to note the issues I brought up like the increase in capex from 2009 to 2010, insider activity and the terms of the company’s debt (ALWAYS check terms of debt and READ THE PROXY).

The company trades at a market multiple but is an above average company. If I HAD to own stocks, I would own PEP because you are getting an above average company for the market price. However, I (not you perhaps) seek a 12% to 15% return. A $8 to $15 dollar drop (certainly possible) could make this very attractive to me. Conversely I could sell a 2013 or 2014 put at a 55 strike for the amount of shares I would wish to own (I want a 20 to 25 company portfolio of “cash gushers” to supplement my spin-off asset investments).

I place this in the #2 work-on pile. Remember not to fool yourself. If I drove up to Pepsi’s headquarters in Purchase, NY (20 minutes from where I live) and spent two years studying the company, I don’t think I would understand the business better than reading the last 5 annual reports and proxies.  PEP is a world-wide conglomerate operating in 100 countries with 100s of different products in major food categories. I am looking at this more as a financial machine. Since the company is selling consumer products (branded food) I know the operational risks are lower than a cyclical steel company.  I will look for bombs on the balance sheet or any tricky accounting. If I can’t understand the financials, then pass. Time spent 2 minutes.

Miller Industries, Inc. (MLR)

Anyone want to take a crack at MLR: MLR_VL? I will post your analysis.

Part 4: Value-Line Analysis of Balchem

“Communism proposes to enslave men by force, socialism — by vote. It is merely the difference between murder and suicide.” – Ayn Rand

Reading the News

I ignore the headlines because the news generates too much distracting noise. For example, (yesterday, April 3, 2012) markets sell off because the FED will not continue with Quantitative easing “It’s just surprising that so many investors had expectations all over again that we would get an announcement that could indicate QE3,” said Zane Brown, fixed income strategist with Lord Abbett. http://www.cnbc.com/id/46942271.

Watch what they do not what they say: http://scottgrannis.blogspot.com/2012/04/with-no-shortage-of-liquidity-more-qe.html or go to the Federal Reserve Data Site: http://research.stlouisfed.org/fred2/series/STLFSI. If you couple the current data with Austrian Business Cycle Theory (“ABCT”), you know “quantitative easing” is at full throttle. Go Obama!

Part 4: Using Value-Line

In the first 45 seconds, the video describes Buffett’s search for “cigar butts” through looking through Moody’s Manuals: http://www.youtube.com/watch?v=35u8hoVIguM&feature=relmfu

Here are several Buffett investments found through Moody’s manuals (Interesting blog): http://compoundingmachines.wordpress.com/category/warren-buffett/

Balchem

Go to Part 3 of our series on Value-Line http://wp.me/p1PgpH-CJ to download the Case Study on Balchem if you have not done so.

Balchem is found in the Value-Line Small Cap Edition with only 8 or 9 years history. I penciled in Balchem’s 2011 numbers from their most recent (FY 2011) press release. Go here for the Value-Line: BCPC_VL

I IMMEDIATELY glance at the return on total capital (return on total capital is annual net profit plus ½ of annual long-term interest divided by the total of shareholders’ equity and long-term debt) and Return on Equity, ROE. Both are mid-to-high double digits for the past 9 years. Returns over 15% on total capital are strong and since returns track ROE there has been no-to-low levels of debt to fund growth (almost no pension obligations). Book value has been growing on average 20% per year. The company is growing through internally generated funds and excess cash of over $4 per share (144 million) in 2011.

A glance at the balance sheet shows only $3.4 million of LT debt versus $100 million (and more recently $145 million in cash in FY 2011).  Here is a strong balance sheet which reduces bankruptcy/default risk. Good.

The business has steady and high returns so I classify tentatively as a potential niche franchise. The company is generating cash so what are they doing with the cash? They are raising their dividends and letting cash build up. Shares are rising minimally but not shrinking. Good.

I jump up to sales and see a 10% to 14% rise in sales per share over the past 9 years with a blip down in 2009, but cash flow per share rose in 2009. All companies’ financial performance is somewhat cyclical but Balchem has shown amazingly steady results. Customers’ demand seems inelastic. The $290 million in revenues means the market is relatively small for their products? There is a need to understand the market size for this company’s products.

Sales are about $270 to $300 million so the business seems relatively small. Market cap is sub-$1 billion. Three analysts follow the company.  There probably isn’t much following on Wall Street since the company doesn’t raise money through Wall Street. But with performance being so steady for the past 10 years, this is not an orphan stock.

I estimate Free Cash flow is $about $1.30 or $1.60 – 0.28). To put a back of the envelope value I take $1.30 and divide by a cost of capital of 10% to 11% minus a perpetual growth rate of 5% to 6% (real growth of 2% and 3 to 4% of nominal growth) which–based on its past 22% growth in sales, earnings, cash flow and book value over 10 years–seems conservative. This past year, though, profitable growth “slowed to 10% to 14% in sales to cash flow per share. Perhaps there will be an immediate slowing of growth. If cash is building up then perhaps growth opportunities are harder to find? A $1.30 per share in FCF divided by (r-g) or (11% – 5% or 10%-6%) or $22 to $32 then add back the $4 per share in cash to get an estimate of $26 to $36 per share.  This is a down-and-dirty back of the envelope use to ball park my urgency.

STOP!  I use a DCF because this company is being valued on its future growth, but with three divisions, I will need to break out the valuation of each business–perhaps do a sum of the parts. This exercise is simply to ball park a tentative range of values to assess my urgency of doing more work on the company. It is NOT a comprehensive valuation!

Balchem seems reasonably priced. If the market were to believe the growth could stay at 10% for several years then probably in the $40s.

Right now, I am looking at a company with a good balance sheet that has grown at a high (15% to 22% rate) for the past 5 to 10 years through internally generated funds. This seems like a good business but I do not know what are the sources of competitive advantage.  Is the company experiencing a hiccup or a more fundamental competitive issue in its markets? Problem #1.

Can I understand this business? There are three segments: Choline Chloride to feed cows, sterilization products, encapsulation products for the food industry.  I don’t know, but I will read the last two years of annual reports of the business description and Management MD&A to see if I can get at the source of their returns and the market size of their products. Problem #2.

This may be time-consuming so find an hour to review. This business seems like it is a niche company compounding its capital at double-digit rates—it warrants the time. If the price dropped into the low $20s or high teens, there might be a good opportunity to buy. Do the work now, if you can grasp the business and what drives the company’s returns and whether it operates within protective barriers to entry.

If growth slows and cash keeps building up what will management do with the excess cash? Check management ownership and share ownership. Problem #3.

Verdict put this in the Read Annual Report File.

Notes:

Retained to common equity also known as the “plowback” ratio,” is net income less all dividends (common and preferred), divided by common shareholders’ equity and is expressed as a percentage. It measures the extent to which a company has internally generated resources to invest for future growth. A high plowback ratio and rapidly growing book value are usually considered positive investment characteristics.

All dividends to Net Profit, or “payout ratio, “ measures the proportion of a company’s profits that is distributed as dividends to all shareholders—both common and preferred. Young, fast-growing firms reinvest most of their profits internally. Mature firms are better able to pay out a large share of earnings.

How do companies’s operating margins compare with the industry’s operating margins? Better

How do a company’s net profit margins compare with the industry’s margins? Better

Are a company’s returns on total capital and on shareholders’ equity greater or smaller than those of the industry? Better

The problem I see in deepening my analysis of Balchem is just my ability to understand the business, but I would need to check this by at least reading the annual report.

Comments and complaints welcomed. I will proceed with the Pepsi and Miller Industries in the next few posts.

Part 3: Using Value Line

No gold digging for me, I take diamonds. We may be off the gold standard some day.–Mae West

Part 3: Using Value-Line:

Part 2 was posted http://wp.me/p1PgpH-Bx. Also, Carl, a reader, kindly provided this link on analyzing Value-Line from a blog:http://www.rationalwalk.com/?p=7544

With experience you will come to recognize opportunities that make you tremble with greed or feel like being hit in the face with a flounder http://www.youtube.com/watch?v=IhJQp-q1Y1s. If you don’t know what opportunity is, then expect to do this: http://www.youtube.com/watch?feature=endscreen&NR=1&v=sLB-uMPj27s

Purpose

Our goal is to find an inkling (first step) of a  compelling investment as we go through Value-Line—typically by industry groups. My methods are three-fold:

Number 1: I seek to categorize and eliminate companies quickly to narrow my search. Your investment process drives your search strategy. I categorize companies as either franchise companies that have profitable growth within barriers to entry (sub-3% of all public companies I estimate) and non-franchise companies or asset-based companies (95% to 98%). Of course, there are gradations within and between the categories.

Buffett would advise that you purchase the investment with the biggest discount to intrinsic value. An asset/non-franchise company–that can be valued with earnings power value cross-checked with replacement value and then you may have a conservative private market transaction as another marker—may be a better investment than a franchise type company depending upon the discount.  Time, however, is against your investment reaching your estimate of intrinsic value because growth is not profitable and without a catalyst like a corporate restructuring, you are dependent upon the market recognizing the value. If you buy a non-franchise type company make an effort to buy at a large discount and know why such a discount might be available—obscure, forgotten, hated, no analyst coverage or some combinations of those aspects. Are you fooling yourself?

With a franchise company I hope to receive the growth for free or for a low price as long as I am confident within reason of what the company will be earning.

Number 2: Note which companies you want to research in more detail; prioritize your efforts by urgency. What questions do you need answers for? Avoid reading the Value-Line comments and timeliness ratings because you wish to reach your own conclusions. Your goal is where to fish deeper not jump to a conclusion to buy or sell. Remember that steady sales, return on capital, strong balance sheets over a long period of time (eight to ten years plus) is EVIDENCE of not PROOF of a franchise/competitive advantage. The Value-Line is a first sweep.  The importance of using a Value-Line as a research tool is its simplicity and long history (Pepsi had 15 years of data) on one page.

Number 3: Gain a sense of the industry economics and overall prices being paid for various businesses. Which industries have poor, normal, great economics—steady sales growth, high and consistent ROIC, ROA, ROE, cash rich balance sheets? Is there anything unusual like very high or low profit margins, etc. Look for the unusual like high cash or debt levels. What seems to be the prices paid for various businesses? Look at prices after you have estimated the value of the business. What may strike you is how much investors are willing to over pay for weak companies. Graham considers this the major error investors make—overpaying at the top of a market for poorly performing (operationally/financially) companies. A money manager once joked that the secret to always outperforming an index was simple. Buy every company in the index except for the airlines.

Value-Line will report on each company about four times a year, so if you form the habit of going through the Value-Line tear sheets each week or every few weeks depending upon your interests, you will easily sort through companies quickly because you will remember your previous thoughts on each company. It takes practice but have good habits (Buffett’s talk to students on habits) http://www.youtube.com/watch?v=14SK4CX_KYY

Let’s take an easy Tear Sheet, Capstone Turbine (CPST) here:http://www.yousendit.com/download/M3BueEVha0RWRC9FdzhUQw. (If link is gone then material is in Value Vault; ask for key) First, look at return on total capital (like a Doctor taking your pulse—focus on one key variable first). There is NMF or not meaningful. This company is profitless for almost a decade (PASS!). Sales are minimal, slow and erratic. No cash flow. How is the company surviving? Negative retained earnings. The management is eating into past capital (note book value per share declining steadily) raised and constantly shares are being issued as share count rises from 85 to 260 million shares. The company has no net debt, but the business seems dormant or in the land of the living dead. This is an immediate no interest (unless for short selling). File in the circular file. Time spent—15 seconds.

For fun, look how the company has been valued in the past as prices have ranged 3-xs to 5-xs from high to low price while this asset-based (microturbines) company clearly has no competitive advantage yet trades every two years at 5 times book value and 8 times sales while bleeding cash. Sales growth is meaningless. And the market is efficient? Investors love a lottery ticket.

IF there was any hidden value there might be large NOLs (Net Operating Losses to shield or reduce future taxes if profits are made in the future), but without future profits even that is a pipe dream.  Next time, I would glance for 1/10th of a second at the company, then flip the page or scroll down the computer screen.

In Part 4, next post: I will go immediately into Balchem, Pepsi, and Miller Industries. I penciled in the Balchem’s 2011 numbers from their most recent (FY 2011) press release. Tear Sheets are available from Part 2 here:http://wp.me/p1PgpH-Bx

Thanks for your patience.

Part 2: Using Value-Line Case Study-Balchem (BCPC)

Reach of Federal Power is Questioned (Obama Care)

It’s “the old Jack Benny thing,” Justice Scalia said, invoking the joke where a robber holds up the famously stingy comedian and says, “‘Your money or your life,’ and, you know, he says, ‘I’m thinking, I’m thinking,’” Justice Scalia said. “It’s funny, because there is no choice.”

BalChem (BCPC)

Initial post on using Value-Line:http://wp.me/p1PgpH-Bc

Then I posed a case study of a Value-Line with the market prices and name removed here:
https://rcpt.yousendit.com/1436735756/193a1b94378638992ed275c546460c22

The company in the case study is Balchem: https://rcpt.yousendit.com/1439168384/30543fcee251a06356192fe6d4de2c7f

Take a few minutes to review the Value-Line to determine if your perceptions of your initial analysis changed. Ask if the company is worth studying further. There is no correct answer; it depends upon your investment philosophy.

Part 3 will be my discussion of Balchem using the Value-Line posted tonight or early tomorrow. In the spirit of full disclosure, I have owned Balchem (BCPC) back in 1996 - 1999 (before the 10x rise in price!) so take my words with an antidote. I bought on the basis of book value, made money, but I had no clue back then of what was a good or bad business. I was buying on the basis of cheap metrics. You can make money but still make a mistake. Ignorance was my blinder.

Below are a few more Value-Lines which I will discuss in the next post (part 3)

CPST:http://www.yousendit.com/download/M3BueEVha0RWRC9FdzhUQw

MLR:https://rcpt.yousendit.com/1439169064/e81960cdf6b1c4d5b009edf49dc727c2

PEP:http://www.yousendit.com/download/M3BueEVha0RwM241SE1UQw

Imagine sorting through a huge pile of mail. You need to discard companies that are of no interest. Value-Line publishes updates on each company about 4 times a year, so you will become more adept sorting companies the more times you review Value-Line. At first, the process will be time-consuming, but you will learn more about companies, valuations and market perceptions.

What would you pay?

Buffett said that he likes to thumb though Moody’s Manuals and Value-Lines without looking at the price of the company.

You are sitting today in the library worried about central banks running their printing presses while flipping through your Value-Line when you see this

A company with $5.50 in after-tax free cash-flow.  Sales and cash flows have grown about 9% over the past 10 years and are estimated to continue growing 6% over the next few years. Debt is 15% of total capital.  Ret. On total capital has averaged 14.5% over the past ten years; return on equity has been 15% on average. R&D is 16.5% of sales (above average for its industry). Dividend yield is 4.4% and 42% of net profits. This company is considered one of the strongest in its industry and one of the top companies in the world–well-diversified internationally by geography and product type.

What would you pay per share ball park for this business?   Take no more than 33 seconds.