Monthly Archives: January 2013

Stockodo Seven: Edition #3

red pool ball

January has been a great month for the market, contrary to my prediction made at the end of December. There has been a few surprises however, notably the decline in Apple (AAPL) stock to levels not seen in the past 12 months. Following are my top seven reading recommendations for this week, as well as special thanks to those who have supported Stockodo recently.

Great Reads

  1. The Market Archive presents some interesting thoughts on the Aluminum industry and where it’s headed. With the global economy (and China in particular) now in growth mode many metals will see growth as well.
  2. Brett @ WStreet Stocks shares a speculative investment in Pacific Drilling. Phenomenal growth possibility, but is it worth it at this valuation?
  3. Matt @ Dividend Monk provides an excellent analysis of Costco, from a dividend investor’s perspective. Low yield, but will it’s dividend growth prospects make up for it?
  4. Marvin @ Brick by Brick Investing schools us in the use of Bear Put Spreads. A useful strategy for when it is believed that a stock will decline within a specific timeframe.
  5. Vanessa @ Vanessa’s Money shares a humorous list of financial lessons she learned at school. Definitely different than my education!
  6. Avik @ One Cent at a Time outlines the 51 mistakes to avoid while selling a home. I’m planning to sell my home sometime in the next few years and these are some useful tips.
  7. JT McGee @ Money Mamba discusses Mark Cuban’s take on the Stock Market. An interesting point of view.

Special Thanks

Photograph entitled “Lucky Number Seven” Copyright © 2013 by YourRisingStorm. Used with permission.

How Stock Fundamentals are Derived from Company Financials Part 3: Cash Flow Statement

File folderThis is the third and final installment of my series which looks at how company fundamentals are derived from the financial statements they’re based on. Previously we looked at the balance sheet and income statement, and in this article we’ll explore the often misunderstood cash flow statement. The cash flow statement ties the other financial statements together, in that it examines how the balance sheet changes, based on income and cash flow into or out of the company, and is a good measure of the company’s liquidity. Continue reading

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How to Calculate WACC

help iconWeighted Average Cost of Capital (WACC) is defined as the minimum return that a company must generate to satisfy its owners, creditors, and other providers of capital or else it would make more sense for them to invest elsewhere. Since there are different components that make up a company’s overall capital, each possibly with a different cost associated with them, this method blends them into an overall cost, proportionally weighting each component based on its size.

Let’s look at a simple analogy first. Suppose we are interested in determining how much a bag of mixed nuts cost. Peanuts make up 60% of the bag and cost $1.99 / lb. Almonds are just 20% of the mix but cost $3.99 / lb. The final 20% of the bag is Macadamia nuts at a cost of $5.99 / lb. How much does 1 pound of mixed nuts cost? We have all the information we need to answer this question. We know the relative percent, or weight, carried by each component and we also have a cost for that component. Continue reading

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DCF: Discounted Cash Flow Analysis

discount diceWhile there are many ways to determine the intrinsic value of a company, I don’t believe any are more popular than the DCF — or Discounted Cash Flow method of analysis. It’s widely regarded to be the most accurate means of determining what a company is really worth, and is commonly used by professional analysts and individual investors alike.

Essentially DCF is nothing more than looking at projections of what the company will earn in the future, and translating that into a dollar amount today. How we get from point A to point B in all of this takes a bit of work and lots of assumptions, but after running through it a few times it is fairly straightforward. Determining the true worth of a company is important, since price is not the same thing as value, and allows us an opportunity to profit from temporary irrationality in the market.

In the next few sections, we’ll look at how to properly conduct a Discounted Cash Flow analysis for a company. Since it’s better to use real numbers, let’s look at a company I recently determined a value for using another method: Chipotle Mexican Grill (CMG). Using the EPS Growth Capitalization method, I determined the true value of CMG to be $292.26. Let’s see what we come up with using DCF.

The Basic Idea of DCF

DCF works on the principle that money in your pocket today is worth more than it is tomorrow — or ten years from now for that matter. For example, what if I were to give you the choice of taking $1 million today, or that same million dollars in exactly one year. Which would you choose? This one is hopefully a no-brainer – you would take it today of course! But let’s think about this a little bit and try to figure out why this is such an obvious choice.

Let’s also assume that you are looking at the million bucks purely as an investment (ie. you aren’t going to go out right away and buy a new house and car). The reason money today is worth more than it is next year is then quite straightforward: You can invest the money today and it will be worth more in the future. If you were to invest that money very conservatively, you might make 3% interest over the course of a year. That means the million dollars you have today will be worth $1,030,000 in a year, or an extra $30,000.

The key to DCF is to look at this process in reverse. In other words we know that we have $1,030,000 in the future, and the question then becomes how much that money is worth today. More generally in the context of stock investment: How do we calculate the present value of a company that has sales & earnings every year for the foreseeable future?

What is Free Cash Flow?

There are several methods of conducting a discounted cash flow analysis, but we’re specifically going to use the most common which starts with annual revenue and makes adjustments line by line to arrive at free cash flow. By taking a line by line approach it is possible to forecast smaller pieces of the puzzle rather than attempting to forecast FCF directly. Specifically, we need to work the numbers into a form by which we can use the following equation:

FCF = NOPAT + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditure

This may look fairly complex at first, but in laymen’s terms FCF is the cash left over after the company has taken what it needs to continue operations and to grow. This is why the Net Working Capital and the Capital Expenditure are deducted in the equation above. FCF is the true representation of the money that a company generates.

Determining Free Cash Flow (FCF)

The first step is to decide how far into the future to forecast cash flows to be used in the analysis. This is quite a subjective number, but there are some rules of thumb to go by:

  • If the company is in its infancy stages and is experiencing high levels of growth, the typical forecast period used is 10 years
  • If the company is growing, but there are competitors in the market and growth is slowing, the forecast period is usually 5 years
  • Large, mature, established companies with low margins and slow growth typically use a forecast period of just one year

Those are some good rules of thumb, but what we’re really doing is estimating what’s called the excess return period, which is defined as the number of years the company is expected to outpace the growth of the economy as a whole. Small, fast growing companies will likely outpace the economy for years to come, while large established companies with lots of competition are more likely to just keep pace.

If we look at CMG, we see that it is experiencing extreme levels of growth on both the top and bottom lines. The company is opening hundreds of new restaurants per year, and is planning to expand internationally. This is definitely a company we will want to forecast out for 10 years at least.

Our next task is to estimate the amount of free cash flow that CMG will generate over the next 10 years. We start by looking at revenue growth.

CMG revenue growth table

The table above shows the phenomenal growth CMG has achieved over the past number of years. This works out to a compound annual growth rate (CAGR) of 23% over the past five years. This is a good starting point for forecasting future growth, however most companies are not able to sustain that level of growth over the long term. It’s even evident in the table above as CMG grew revenues at 31% in 2006/2007 but now is only achieving growth in the 20% range.

Therefore it’s typical to forecast revenue growth to be somewhat lower than past history for DCF analysis. In this example I am going to predict that CMG will be able to sustain 20% growth for the next 3 years, but then decline by 1% every year for the next 7. Using a simple excel spreadsheet, we can now easily forecast revenue for the next 10 years. I’ve summarized below:

CMG Revenue Forecast

With a revenue forecast in hand, we must now work line by line to arrive at an annual projected free cash flow. In other words, we know how much the company is bringing in, but how much is actually free. As discussed above, free cash flow is the amount of money left over after all cash expenses are removed. It’s a true picture of what’s left over to increase shareholder value.

We can determine free cash flow from revenue by taking the following steps:

  1. Deduct Cost of Goods Sold (COGS) to arrive at Gross Profit
  2. Deduct operating expenses (OPEX) to arrive at EBIT (operating income)
  3. Deduct taxes to determine Net Operating Profit After Tax (NOPAT)
  4. Add D&A expenses back in
  5. Deduct capital expenditures (CAPEX)
  6. Deduct the YoY change in working capital
  7. The end result is Free Cash Flow (FCF)!

As with revenue, it’s not the current values we’re interested in, but future values, forecast for each year. Let’s look at each one individually.

Operating Costs

Operating costs are the costs associated with such things as salaries, research and development, the cost of raw materials, marketing, etc. – you get the idea. Starting with revenue, and applying steps 1 & 2 above will give us EBIT. While we can simply look up EBIT directly using any number of websites (or the company financials directly, it’s useful to look at the individual contributions to OPEX directly so that they can be forecast forward. For example, on GuruFocus I can see that CMG’s revenue in 2011 was $2,270 million, and its EBIT (earnings before interest & taxes) was $351 million. However we’re going to break it down into separate components of COGS, D&A, and other expenses.

First let’s subtract COGS from revenue to arrive at Gross Profit every year for the past five years. Let’s also calculate COGS as a percentage of revenue so that we can identify the trend. COGS has been averaging about 73.5% of total revenue. We can use that as the basis going forward. Now we know revenue, COGS, and gross profit for the next 10 years, as shown in the following table (click to enlarge).

cmg-gross-profit-dcf

Step 2 is to determine Depreciation & Amortization costs, as well as other expenses and subtract these from gross profit to determine the operating profit (EBIT). There are usually several types of expenses that make up the other category, but all we’re really interested in is separating out the D&A portion, since we need to add that back in later to determine FCF. We do so, and since we’re looking at this line by line, can see that D&A is in a slight downtrend, which we project going forward as a decline from 3.3% of revenue to 3.0% of revenue over the next 10 years. We also see that total OPEX is holding steady at around 11.1% so we hold that ratio going forward as well. We subtract OPEX from gross profit to determine EBIT as shown in the following table (click to enlarge).

cmg-ebit-dcf

Taxes

Step 3 is to deduct taxes from EBIT, which gives us the net operating profit after tax (NOPAT). Total tax paid for each year can be found as a line item on the income statement. It’s useful to calculate the tax rate as a percentage of EBIT, and in this way we can look at the trend and project taxes going forward. In doing so it appears that CMG is paying roughly 37.4% tax, which I will project forward for the next 10 years. The results are shown in the following table (click to enlarge).

cmg-nopat-dcf

Capital Expenditure (CAPEX)

Capital expenditures refers to the money a company expends to foster growth, and is calculated by taking the company’s Capital Expenditure found on the cash flow statement. Since this money has been consumed, we will subtract it from NOPAT as part of the FCF calculation. We will also add back in the D&A expenses that had been removed previously since although depreciation is booked as an expense, it’s a paper expense and that cash is still available.

CMG spent $151 million on capital expenditures in 2011 and 74.9 million in depreciation. We can now tabulate these for the past five years and look at the trend in CAPEX spending. CMG has been steadily decreasing its expenditures as a percent of revenue to its current level of approximately 6.7%. We will use this as the basis for future CAPEX spending. Chipotle has a very aggressive strategy for growth which primarily consists of the opening of new restaurants, but it appears that revenue will increase at the same pace as CAPEX.

cmg-capex-dcf

Working Capital

Working capital is the short term cash that a company needs to cover its day to day operations such as replenishing inventory. In balance sheet lingo, it’s the cash required to maintain the current assets on the company’s balance sheet and is calculated by subtracting current liabilities from current assets. From CMG’s latest annual report, we see total current assets of $501 million and total current liabilities of $157 million, resulting in $344 million of working capital for 2011. We can do this for the past five years:

cmg-wc-dcf

What we really need for the FCF calculation however is not the working capital itself, but the change in working capital from one year to the next. It’s counted as a deduction/addition against FCF. To determine the change in working capital YoY, we simply subtract the prior year’s working capital. We can also project working capital into the future. Looking at the previous trend, I am going to assume that CMG maintains 12% of its revenue as working capital going forward.

cmg-cwc-dcf

Calculating FCF

We now have all of the inputs required to calculate free cash flow for every year of our 10 year forecast period. It’s usually easiest to summarize everything in an excel worksheet as I’ve done below (click to enlarge):

cmg-fcf-dcf

Starting with NOPAT, we follow steps 4 through 7 to add D&A expenses back in, deduct capex, and deduct change in working capital to arrive at free cash flow. We now have a projection of Chipotle’s cash flow over the next 10 years. Now it’s up to us to discount these cash flows to a present day value.

Determining the Discount Rate

Remember back at the beginning when we were looking at how much that $1 million was worth a year from now? To arrive at the answer we applied an interest rate. Now the question we’re trying to answer is how to convert all of those future cash flows back to a present value, and you guessed it – we’re going to use an interest rate to find it. Since we’re actually reducing a future value back to the present, this interest rate is called the discount rate.

Many investors will calculate the Weighted Average Cost of Capital (WACC) for the company and use that number as the discount rate. I’ve written a detailed article on how to calculate WACC if you want to go that route. WACC represents the rate of return that a company must pay on average to finance its assets. From that point of view it kind of makes sense why we would consider using it for the DCF analysis. But what we’re really after is OUR desired rate of return, which may be wildly different than the 8 or 9% that the company pays for its capital.

Let’s think about this a bit more and fully understand this concept. To do so, let’s go back to our example of that $1 million that we’re going to get paid next year. How much are we willing to pay today to get that million a year from now? The answer depends completely on the rate of return we require. Maybe we’re satisfied with a 5% rate of return. If that’s the case then we would be willing to pay $952,381 today. What if we consider this to be a risky investment however and decide we don’t want to buy it for any less than a 15% rate of return. By increasing our required rate of return to 15% our buying price today actually drops quite significantly to $869,565. That’s the basic concept – a higher discount rate means a lower present value. The future value stays exactly the same, but the present value is defined completely by the rate of return we require.

When setting a fixed rate of return as the discount rate, I usually refer to it as the Minimum Acceptable Rate of Return, or MARR. For investments that I deem to be risky, I typically use a MARR of 15%, and for lower risk investments as low as 9%. Note that on average the market as a whole over history has returned around 8% per year.

I am going to set my minimum acceptable rate of return for this investment to 12% – in other words 12% will be the discount rate used to convert future cash flows to a present day value.

Terminal Value

So far we’ve only looked at forecasting CMG’s cash flow over the next 10 years, but the company won’t cease to exist at that point — in fact it better not or we’re in trouble! To account for the fact that the company is still worth something after the forecast period, we’re simply going to calculate what’s called the Terminal Value. It’s going to be a single number that represents the sum of all future cash flows from year 11 onwards. But why not simply increase our forecast period to a longer timeframe to account for this? Why not forecast 30 years into the future? The reason is that it’s impossible to forecast with any accuracy at this long a period. 10 years is pushing it already. Therefore we simplify things and use the terminal value as an approximation.

Benjamin Graham is a big proponent of the Gordon Growth Model, which is defined as follows:

TV = Final yr cash flow x (1 + LT growth rate) / (Discount rate – LT growth rate)

The only unknown in the above equation right now is what to use for the long term cash flow growth rate. Typically a growth rate in the range of 3 – 4% is used. For this example, I am going to assume a LT growth rate of 3.5%. We use the final year of our projection as the basis for calculating terminal value. Based on this rate, a final cash flow in year 10 of $564 million, and a discount rate of 12%, we determine that the present value of the terminal value for CMG is $2,478 million.

Enterprise Value

We can now calculate the present value of all future cash flows, add it to the present value of the terminal value calculated above, and arrive at what’s called the company’s enterprise value. Following are the results (click to enlarge):

cmg-ev-dcf

The present value for each year is summed to arrive at an enterprise value of $3,733 million today. Enterprise value is a measure of the company’s total value — including debt.

Equity Value

We’re only interested in the value of the equity within the company, not the debt. We therefore need to remove debt from the enterprise value. We also want to account for any cash that the company has on hand, so we’ll add that back in as well:

Equity Value = Enterprise Value – Debt + Cash

Chipotle has zero debt so that term of the equation gets eliminated. CMG does have a total of $456 million in cash, cash equivalents, and short term investments on its balance sheet, so we can add that back in. This results in an equity value of $4,189 million. It’s more useful to look at this on a per share basis. CMG currently has 31.22 million shares outstanding. We divide and arrive at an intrinsic value of $134.17 / share.

cmg-equity-dcf

Comparisons to other methods

The DCF method of valuation is much more complex than the EPS Growth Capitalization Method, and infinitely more complex than simple methods such as Peter Lynch Fair Value. It’s interesting then to see how the final numbers compare. I recently completed a very detailed evaluation of CMG using EPSGC. Let’s see how the numbers look:

  1. Discounted Cash Flow Method: $134.17
  2. EPS Growth Capitalization Method: $292.26
  3. Peter Lynch Fair Value: $172.25 (with growth capped at 25%)

As expected there’s a range of values calculated depending on the method used. This is because there are assumptions and estimates that play a part in any estimate of future value. It’s therefore important to use as realistic and accurate numbers as possible in an attempt to drive accuracy in the final result. This also emphasizes the importance of putting an adequate margin of safety on any entry targets derived from a calculated value which will hopefully act as a suitable buffer for errors that result in an artificially high value.

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Lessons from The Intelligent Investor: Part 1

Pile of BooksI am currently reading The Intelligent Investor by Benjamin Graham for the third or fourth time — I can’t quite remember. Every time I read through I pick up more and more of his teachings. This book is widely considered one of the best books ever written for value investors, and it’s easy to see why.

This post will be the first of a series. I plan to share my learnings, thoughts, and ideas with you here as I read through this book one more time. Specifically I am reading the revised edition with commentary by Jason Zweig. This edition contains the full fourth edition updated by Graham in 1971/72 and since this was quite some time ago now, Jason does an excellent job of translating some of the ideas to the present day. If you have a copy of this book, I encourage you to read along and share your comments below! Continue reading

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Ebix Added to Model Portfolio

red check markYesterday I analyzed Ebix, Inc. (EBIX) in depth and estimated that the company’s current intrinsic value is somewhere in the vicinity of $30.40. The stock has been decimated recently by bad press, some red flags with respect to whether it can successfully integrate other companies it acquires into the overall business, and a slowdown in earnings growth over the past year. Despite all these warning signs, the stock is trading at just $16.66 currently, which is a 45% margin of safety! I am currently long Ebix and will be adding more to my position at this price level. For tracking purposes, I will also add Ebix to the stockodo portfolio. Continue reading

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EBIX Analysis & Valuation

Ebix LogoEbix Inc. (EBIX) is a supplier of software to the insurance industry. Have you ever applied for insurance and the agent asked you about a million questions, some of which seem like they couldn’t possibly have any effect on your premium? Well they’re entering this data into a computer program that compiles all of that data and pops out an insurance rate. That is the type of software that EBIX produces — and does so quite successfully. They actually provide many more services that this simple example, but the point is that they produce a very specialized product for a very specific market.

I discovered EBIX some time ago through a screen using my Predictable Growth Low Debt screener, for which it ranked tier 1 as far as the selection criteria is concerned. Specifically, EBIX has enjoyed phenomenal growth on both the top and bottom lines over the past number of years: a 51% EPS growth rate over the past five years, and a 31% revenue growth rate over the same period. EBIX has extremely low debt (D/E of 0.12) and a steadily increasing book value as well.

Despite this rosy picture, EBIX has been plagued over the past couple of years with some bad press that has severely affected its stock price. In March/11 Copperfield Research wrote an article on Seeking Alpha calling EBIX a House of Cards, and again just recently on Nov. 5/12 Bloomberg published an article claiming that EBIX was to be probed by the SEC for accounting malpractices. In both cases, share prices were decimated. It is widely believed that the 2011 article was nothing more than a short attack on the company however, and despite the supposed imminent SEC probe back in November, there’s been nothing formally announced. A recent post at the Long Term Value Blog shares some interesting thoughts on this matter. In any case every investor needs to form their own opinion, and my personal belief is that EBIX is an excellent company and this bad press is potentially providing an excellent buying opportunity at a greatly reduced price. The remainder of this article will focus on the company’s fundamentals and attempt to determine an intrinsic value for EBIX under this assumption. Continue reading

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The Stockodo Seven: Edition #2

Four of a KindWelcome to the 2nd edition of the Stockodo 7, where I’ll review the top seven reads I’ve come across over the past couple of weeks and pay thanks to some of my supporters. It’s been an interesting week, as the whole fiscal cliff situation didn’t really play out as I predicted and it will be interesting to see what happens next. I had really been hoping for some great values to surface due to the uncertainty in the economy, but there’s a chance that it’s now behind us.

  1. One Cent at a Time published a great article on the 10 Habits of Wealthy and Successful People that we all Know. I actually read this article a few times – it seems like common sense at first, but there are a few ideas here that had some additional meaning.
  2. Dividend Growth Investor presents a list of Seven Companies expected to Grow Dividends in 2013. Dividend strategies come secondary to my value investment ideas, but I still follow them closely and will write about them from time to time. This is a great post that presents some good opportunities for 2013.
  3. Money Mamba shares an interesting Post on Investing in Japan. I tend to avoid overseas markets. This article reminds me why.
  4. Robert @ The College Investor shares his tips on Dollar Cost Averaging vs. Lump Sum Investing. I occasionally write about entry strategies as well, and found this article interesting since it mirrors some of my own ideas.
  5. Matt Alden @ Dividend Monk has shared an excellent analysis of Kinder Morgan. I am really enjoying following his investment style that combines value and dividend growth.
  6. John @ Frugal Rules shares some of his favorite investment tools. I have covered a few of them in recent posts myself and agree with his assessment.
  7. Rob Berger @ Dough Roller has written an excellent guide to Revitalizing your Finances in 12 months. He presents it in a step-by-step format with links to various resources for each step.

Special Thanks

I’d like to pay special thanks to the following people who have featured or mentioned Stockodo recently. Although the site has only been around a short while, it’s growing faster than I imagined. I really appreciate everyone’s help & support!

The image “Four Times Seven” is copyright © 2012 ~inDeathsEmbrace. Used with permission.

Peter Lynch Fair Value

money treeI am always on the lookout for new stock valuation techniques. Rather than rely on any single method, it’s usually better to evaluate a potential purchase in multiple ways. With any value calculation there are always assumptions that need to be made, which prevents determination of the true value with absolute certainty, but I am more confident in my numbers if more than one method gives me close to the same result. Today I’m going to cover a very simple rule of thumb check developed by Peter Lynch, aptly named Peter Lynch Fair Value. Continue reading

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How Stock Fundamentals are Derived from Company Financials Part 2: Income Statement

File folderIn the first installment of this series, we looked at a company’s balance sheet to learn how to derive a number of useful fundamental ratios and metrics about the company. Since balance sheets are based on a reconciliation of the company’s assets and liabilities, the fundamentals that arise from this information give us a good idea of the company’s financial health. In part 2 of this series, we will examine the income statement, and determine how additional metrics such as the PE, PEG, market capitalization, and ROE are determined, among others.

This time around we’ll use the most recent annual report from Apple (AAPL) to go by, and we’ll use GuruFocus to compare our calculations with an online source. I use GuruFocus because it provides access to the past 10 years of financial data and supports nearly all of the ratios and metrics we’re interested in.

See also: Part I of this series: Balance Sheets

Apple’s fiscal year 2012 annual report was issued on October 31, 2012 and was based on the 12 months ended September 29. I would suggest that you download a copy of it so that you can follow along. The income statement can be found on page 43, and is called the Statement of Operations in this case. There will be a few situations where we need to pull some information from the other statements, but all of these are readily available in the same report. The following screenshot shows Apple’s 3rd quarter 2012 income statement (click to enlarge).

Apple 2012 Income Statement

As mentioned above, we’ll be using GuruFocus’ numbers as a comparison to the ones we derive ourselves. A link to Apple’s fundamental data on GuruFocus can be found here.

Market Capitalization

The size of a company is often measured by what’s called its Market Capitalization, which is a number which represents what it would cost to buy all of the company’s common stock right now at its current trading price. It is calculated by multiplying the total number of common shares outstanding by the current price per share as follows: Continue reading

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