# Tag Archives: Valuation Exercise

## Quiz Comments and Prize Awarded

The key to the quiz (here: http://wp.me/p2OaYY-1q4) is to make the least bad choice. In investing as in life there are no “perfect” choices but you must choose—even if that means not choosing.  You may think Company B (Yahoo) is priced too richly at \$21.7 billion to \$100 million in net income and \$250 million in free cash flow, but returns will flow to shareholders since the company is debt-free and throwing off free cash flow despite rapid growth. However, due to the high price being paid for the future, a purchase may lead to a permanent though not total capital loss.

Shareholders in Company A stand far behind debt holders and legacy employee obligations.  Keep things simple in your analysis. A company can be financed through debt and equity. Equity shares in the success of the business while debt holders have priority payment in return for a fixed return.

You see \$6.8 billion of equity compared to \$202 billion of debt with \$61 billion in pension liabilities.  This business looks like a pension obligation attached to a car company.  Debt holders and employees stand in front of shareholders. There is 3.3% of equity of the total capital structure (\$6.8 billion of equity divided by (\$202 in debt + \$6.7 billion in equity). There is no margin for error. You don’t know when the debt falls due or its terms, but it is an easy guess to figure out that the 2.5% return on fixed assets and 0.7% return on average capital can’t generate the returns to pay interest on the debt.

Free cash flow is negative (-\$18.9), so the high amount of fixed assets can’t be  replaced or maintained.  Adding more debt to pay maintenance capital expenditures will only hasten the demise of the shareholders.

Just because the company is capital intensive doesn’t mean it can’t have competitive advantages. Look at Boeing  BA_VL.  Note the high returns (though cyclical) on capital. But Company A (GM) has below normal returns on capital (2.5% on fixed assets and 0.7% on average capital). The company may be facing a cyclical low in sales, earnings and cash flow but we have a non-franchise business with poor returns and a huge debt load. This is not a good long-term choice to own the equity of. Now if you wanted to own an asset cheaply, then perhaps you could look at where the company’s debt is trading to perhaps own cheap equity in a restructuring, but you were not given that choice here.  Ben Graham says the worst mistake is to pay an optimistic price for a bad business.  See below:

“The risk of paying too high a price for good-quality stocks-while a real one—is not the chief hazard confronting the average buyer of securities….the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.”

September 2003, the time of this exercise may not have been considered favorable business conditions, but a poor quality business laden with a high debt load certainly makes the equity a low-quality security. Go Short.

This quiz hopes to focus you on the balance sheet. Company A offers practically no hope of return to shareholders.

Company B, on the other hand, has low capital intensity, high returns on fixed assets (42.5%) and decent returns on capital (5%) considering how fast the company has been growing (70%).  Obviously, a 70% growth rate will not be sustained for long and the investments to grow are probably not yielding a normal return yet. But with a debt-free balance sheet  and free cash flow despite rapid growth (the business is self-funding), I, as a shareholder, at least stand a chance to earn a return, though not much of one due to the high current price (expectations) that I am paying.

By a process of elimination, I go long Company B. Yahoo_VL_2012

As the links above show, GM eventually goes to \$0 while Yahoo grows rapidly for another two to three years before growth slows and the stock price sells off.

At the time of your assignment Company A was shorted at \$23.8 billion market value while you went long Company B at \$21.7 billion.  At the end of five years, during the dark days of Sept. 2009, Yahoo was trading at a 50% quotational loss while GM was down 75% on its way to \$0. You netted \$25% on \$10 million or your payday after five years was about \$2.5 million.

For those who chose to invest in Company A, please review how to read a balance sheet (In Book Vault) and view: http://youtu.be/6eXFxttxeaA

Readers posting the correct answer and others who think they deserve a prize can go here: