12/19/2010

Intrinsic Value greater than Market Price

Relative valuation is one method of valuation that compares the stock/company valuation to similar competitors or as I did in the previous days post to the company’s historical valuation.


http://www.shadowstock.com/121910ReviewPost.html

But with the market more normalized or even stretched valuations the intrinsic value becomes more critical and useful in buying a business/stock at an opportunistic price. When I say intrinsic value as most of you know the valuation method is just a discount of the future cash flows. So a company is worth the present value of future cash flows the company can produce.

So for this post I’m focused on future free cash flow coupled with other important metrics to create a margin of safety.

Discount rates, estimated timing and amount of future cash flows are next to impossible to determine with 100% certainty. Modifying any of the inputs will dramatically change the valuation. This is why many value investors correctly in my opinion focus on the balance sheets as opposed to projecting future earnings.

So this is how I began my pool of stocks to mine for companies selling below intrinsic value.

Strong balance sheet and shareholder friendly capital structure; Enterprise value (Price + Total Debt) – Cash/Price <1.20 or specifically from 1.15(HWG) down to .42 (RIMG); Stable or reduced share count over the past few years, Reduction of total debt from 2007 compared to the TTM

Only companies with top line growth as measured by quarterly YOY revenue growth

Free Cash flow measures that justifies stock trading below the intrinsic value or PV of future FCF

At this point FCF was my focus. The future free cash flow measure helps justify the stocks trading below the intrinsic value or PV of future FCF.

These were some of the ideas that met all the above criteria along with additional metrics.

EVI: EnviroStar, Inc (1.06 to 1.20 days range on 12/17/10)

Current EBITDA+Average 4 year Capital Expenditures/EV= 24.262%

Average FCF over the past 3 years divided by the current enterprise value = 23.3193%

Average FCF over the past 5 years divided by the current enterprise value = 23.32%

HWG: Hallwood Group Inc. (26.47 to 26.50 days range on 12/17/10)

Current EBITDA+Average 4 year Capital Expenditures/EV= 41.35%

Average FCF over the past 3 years divided by the current enterprise value = 29.95%

Average FCF over the past 5 years divided by the current enterprise value = 17.12%

GPIC: Gaming Partners International Corporation (5.81 to 5.98 days range on 12/17/10)

Current EBITDA+Average 4 year Capital Expenditures/EV= 23.42%

Average FCF over the past 3 years divided by the current enterprise value = 16.50%

Average FCF over the past 5 years divided by the current enterprise value = 5.50%



TRCI: Technology Research Corp (3.57 to 3.60 days range on 12/17/10)



Current EBITDA+Average 4 year Capital Expenditures/EV= 20.38%

Average FCF over the past 3 years divided by the current enterprise value = 20.51%

Average FCF over the past 5 years divided by the current enterprise value = 15.39%



RIMG: Rimage Corporation (15.80to 16.11 days range on 12/17/10)

Current EBITDA+Average 4 year Capital Expenditures/EV= 14.13%

Average FCF over the past 3 years divided by the current enterprise value = 16.97%

Average FCF over the past 5 years divided by the current enterprise value = 20.06%

AHCI: Allied Healthcare International (2.54to 2.60 days range on 12/17/10)

Current EBITDA+Average 4 year Capital Expenditures/EV= 14.30%

Average FCF over the past 3 years divided by the current enterprise value = 9.05%

Average FCF over the past 5 years divided by the current enterprise value = 10.86%

Additional data on the above ideas

Click to view the stock quotes on the above ideas

3 comments:

Michael said...

Thank you for sharing your thoughts. I am new to your blog, but appreciate your thoughts. However, I was hoping you might comment on one aspect of your methodology --- the first metric you employ for each stock is EBITDA+Average 4 years CapEx/EV. This is similar to the concept of "owner earnings" as a proportion of EV. However, "owner earnings" has consistently subtracted out normalized CapEx and not added it back in. Your approach seems to be the opposite - you are subtracting out all non-cash charges to earnings (depreciation and amortization) but also subtracting out real cash charges for CapEx.

The problem I see is that a company that makes no reinvestment in assets can't possibly continue to generate level earnings.

Anyhow, I am interested in your perspective.

ShadowStock said...
This comment has been removed by the author.
ShadowStock said...

Hi Michael

Thanks for the input. The 4 year average capital expenditures was actually subtracted from EBITDA to give us a more realistic “owner earnings”.

When I say added the number is actually subtracted from EBITDA. Capital expenditures are negative on the cash flow statement. Sorry for the confusion, “Capital Expenditures” on the cash flow is negative or a subtraction of cash. So the average capital spent over the past 4 years was deducted from the EBITDA.

This was not clear and I apologize for any confusion.

Best
John