Category Archives: Valuation

Duck Hunt with Aflac Insurance

In light of the recent market run-up since the beginning of the year, I’ve been focusing my attention on large-cap, dividend-paying (and yes somewhat boring) companies to invest in. My reasoning for this is that in the event of a significant market correction, the dividend will provide an income stream during the recovery and share prices of these large established companies don’t tend to get battered quite as badly as the small-cap growth stocks I usually pay attention to. Currently, my only exposure to the insurance industry is through my investment in EBIX, however this position will be closed out soon because the company is being bought out by a Goldman Sachs affiliate. Today I will be looking at another insurance company in terms of its suitability as an investment at present time, namely Aflac Inc. (AFL).

Aflac Inc.

While known for its cute advertising campaign featuring the “Duck” equally, if not more so than the actual services the company provides, Aflac is a provider of health and life insurance policies, headquartered in Columbus, Georgia. This company has grown at a 17% compounded rate since 1983, and has increased its dividends every year for the past 30. Despite being based in the US, Aflac does a significant portion of its business in Japan – seen as a risk to some and a benefit to others. Let’s take a look at some of the highlights in Aflac’s Q1 2013 report:

  • Owing to unfavorable yen/USD exchange rates, revenue was unchanged from the year-ago quarter at $6.2B, however EPS increased to $1.90 compared to $1.68 – a 13% increase.
  • Ignoring the currency exchange, revenue in Japan was up 9.7% and earnings up 10.7% in the first quarter. This includes an investment income increase of 7.3%.
  • The company is actively engaged in a share repurchase program, having purchased 3 million shares in the first quarter at a value of $150M. The company intends to repurchase a total of $400M – $600M worth of shares by year-end 2013.
  • Reiterated guidance of 4% – 7% earnings growth for 2013.

DDM analysis: As of Friday’s close, Aflac was trading at $55.69 and paid a dividend of $1.40, yielding 2.50%. Historically, the company has increased its dividend by over 19% annually over the past 10 years, but has only been averaging about 6-10% growth over the past 5 years. Using a dividend growth rate of 6.16% and a discount rate of 9% in the dividend discount model, I arrive at a valuation of $50/share.

EPS Growth analysis: My EPS growth method returned an intrinsic value of $69. Inputs to the analysis were a future EPS growth rate of 9%, a future PE equivalent to the 5-yr average 12.5, and a discount rate of 12% over a 5 year timeframe.

Valuation ratios: A look at current valuation ratios compared to historical numbers produced numbers ranging from $59 – $79 / share. These were arrived at based on an average 5-yr yield of 2.4%, avg. PE of 12.5, and an avg. PS of 1.14.

Graham Number: Plugging EPS of $6.33 and BVPS of $34.05 into the Graham equation, produces a fair valuation of $69.64.


It appears based on this analysis that AFL is undervalued, although cannot rely on the dividend alone to maintain current trading levels. My target price for Aflac is $65. I will be entering a position on Monday’s open.

Readers: What are your thoughts on Aflac? How much of a concern is the company’s exposure to Japan, and by extension its currency?

Using the Dividend Discount Model to Value Stocks

I’ve been devoting my stock research towards dividend stocks recently, or more specifically dividend growth stocks. I am focusing on companies that have a long history of increasing their dividends year after year. Over the long term companies that follow this policy often provide much greater income than other companies that for example may have a high yield currently but never increase their payout.

The vast majority of dividend growth stocks are large cap, well-established companies that are well past their high-growth phase. In fact, this is what allows them to pay dividends and increase them on a regular basis. The management of smaller high-growth companies are often able to achieve better returns by reinvesting earnings in the company, whether it be for plant expansions, new R&D, or marketing. Larger companies are obligated to pay back earnings to their owners (stockholders) in the form of dividends if ROI is too low for any internal investment options.

One of my favorite ways to determine the intrinsic value of a company is through EPS growth capitalization. It’s fast, easy to understand, and it works well under most circumstances. It works best however on companies that are priced for growth – the main inputs into this valuation method are an estimate of future PE and earnings growth. Dividend growth stocks by comparison certainly have earnings growth built into their share price, but more important is the dividend yield and dividend growth. Dividends don’t factor into the EPS growth capitalization method at all (directly), so today I am going to explain the use of another stock valuation method called the Dividend Discount Model (DDM), which is used specifically for dividend growth stocks.

It’s a very simple equation as follows:

IV = D / (r – g)


  • IV = Intrinsic Value of the stock
  • D = Current annual dividend
  • r = Discount rate (%)
  • g = Dividend growth rate (%)

The intrinsic value is what we’re trying to determine. Once calculated, we can compare it to the current trading price of the stock and determine whether the company is trading at fair value or whether it is over/underpriced. The current annual dividend is simply found from any stock data website such as Guru Focus. The remaining two parameters in the denominator of the equation require a bit more explanation.

Discount rate: The discount rate is technically the cost of equity for the company, but in simpler terms it can be thought of as the minimum acceptable rate of return (MARR) that we are willing to accept for this investment. Typically this number ranges between 9 – 15%. I use 9% for large, solid “safe” companies, and numbers closer to the 15% range for riskier investments. It should be noted that this number has a huge impact on the results of the evaluation, particularly when it is close to the dividend growth rate.

Dividend growth rate: This is the annual growth rate of the company’s dividend as a percentage. For example, a company that paid a $1.00 annual dividend last year and increased it to $1.10 this year would have a 10% dividend growth rate for this year. Rather than simply use last year’s rate though, I prefer to look at how the dividend has increased over time. I look at the 10-yr, 5-yr, 3-yr, and 1-yr compound annual growth rates (CAGR) and either choose the lowest or use an average as my input into the “g” term in the equation. I’ve recently written an article on how to calculate CAGR if you’re unfamiliar with how to do so.

DDM Example

To make sure this is all perfectly clear, let’s look at an example using an excellent dividend growth stock: Chevron (CVX). This company has a history of increasing its dividend every year for the past 25 years.

  • Chevron is currently paying an annual dividend of $3.60 and is currently trading at around $118/share for a yield of 3%.
  • Chevron is a large, well-established company, but is still growing earnings at 8 – 9% / year. I am going to use a middle of the road discount rate of 12% in this case.
  • Dividend CAGRs for the past 5, 3, and 1 years are 9.2%, 9.7%, and 13.6% respectively. To be conservative we will choose the lowest: 9.2%

Feeding these into our equation we determine Chevron’s intrinsic value:

IV = $3.60 / (0.12 – 0.092) = $128.57

Today CVX closed at $117.52, which is about 8.5% lower than the intrinsic value we calculated above. Based on this, it would appear that CVX is slightly undervalued at the moment, however it’s important to use a healthy margin of safety (MOS) to cover any uncertainty in the assumptions made.

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Evaluation of Canadian Banking Stocks

Being a Canadian, I try to allocate at least a portion of my portfolio towards Canadian companies. A very small part of me does this for reasons of patriotism, but more importantly I do it to at least partially avoid currency risk. Canadian investors who were fully invested in the US stock market during the past decade probably regret it being that the Canadian dollar increased in value from a low of $0.62 to par against the US dollar over that same time period. Specifically today I will be conducting an analysis of the major Canadian banks in an effort to select one as an investment candidate. The Canadian banking system is much more stable than that of the US due to tighter regulation among other things, generally pay healthy dividends, and the entire industry is in a period of growth as the Canadian economy strengthens and continues to recover from the financial crisis in 2009. Bob Johnson, a fellow Seeking Alpha author, offered an excellent summary outlining the strength and soundness of the Canadian banking industry which I encourage you to read.

Canada has six major players in its banking industry as follows:

  1. Bank of Montreal (BMO)
  2. Scotiabank (BNS)
  3. CIBC (CM)
  4. National Bank (NA)
  5. Royal Bank of Canada (RY)
  6. Toronto Dominion (TD)

All of these banks are listed on both the TSX and the NYSE, however all of the analysis that follows will be based on the TSX data/prices in Canadian dollars unless stated otherwise. First, let’s look at a quick snapshot of these companies. The following table highlights some of the fundamentals:


For each of the comparative criteria, green highlighting indicates the best, and yellow the second best. There is a large disparity in size between the largest bank (RBC) and the smallest (National), with market capitalizations of $86B and $12B respectively. All six banks pay a healthy dividend currently yielding greater than 4%, however BMO and CIBC are edging closer to 5%. Earnings growth over the past 5 years was dominated by TD at about 10.5% annually. Projected earnings growth over the next five years shows an edge for Scotiabank, however these are based on analyst consensus and all are relatively close together in the 6.5% – 8.5% range. From a valuation perspective, National Bank has both the lowest PE and PEG – significantly lower than the other companies. Finally, from a profitability standpoint, Scotiabank is head and shoulders above the rest from a profit & operating margin standpoint, while National Bank offers the best return on equity.

Looking at the above high level analysis Scotiabank seems to have an overall advantage from a growth and profitability standpoint, however National looks to be the best value while at the same time providing the best ROE.

Next let’s look at past stock performance over the past year:


As one would expect these stocks are highly correlated, however there are some observations that can be made. Notable, National and TD have lagged the other four over the past 12 months. Secondly, all banks are off of their recent highs achieved in late February by a significant margin, including a steep decline over the past week due to disappointing Canadian employment data.

Now let’s look at performance over the past five years:


Over the past five years, National was the clear winner, which could explain it’s lackluster performance recently as it may have been overbought. National is a smaller bank and as such is a bit more volatile. I am always interested in buying good value, so let’s use an additional valuation technique to determine whether any of these banks are over or underpriced at the moment. Specifically I am going to use the EPS growth capitalization method. The results are summarized in the following table:


For the above calculations I assumed a future PE of 12 for all companies and I used a discount rate of 9%. Current price, EPS (ttm), and analyst consensus estimated EPS growth rates from Yahoo Finance were used. It’s clear from the above table that National Bank appears to be quite undervalued at the moment. This is inline with the low PE ratio we noticed above. Scotiabank also looks to be slightly undervalued, while the other intrinsic values calculated are so close to today’s price that for all intensive purposes they can be treated as fairly valued. What’s interesting to note, is that these are the same two companies I identified above as being possible investment candidates.

Based on the above analysis, I will be looking to enter into a position in National Bank at or below current price levels within the next week. I will also be adding Scotiabank to my watch list with a target entry price representing a MOS of 15% below the intrinsic value I calculated above of $62.91. The represents an entry price of $47.18, which may be possible over the next few months based on the recent weakness due to unemployment.

Disclosure: I plan to take a long position in NA and BNS in the coming weeks.


Is CAT a bargain right now?

I’ve been following Caterpillar (CAT) closely the past few months looking for a good opportunity to initiate a position. I’ve been searching for high quality dividend stocks to add to my portfolio to provide an income stream and reduce volatility. CAT has been beaten down from its recent high just shy of $100 in February to around $83 as of this morning’s trading. That’s a 17% drop, and I believe it opens the door to position entry. In fact, I initiated a position this morning at $83.37 on the dip at the open due to the lackluster US jobs report. Following are my reasons why.

Caterpillar is in the business of heavy mining & construction equipment, engines, and turbines. Visit virtually any industrial site and you’re virtually guaranteed to see some of their equipment in use. CAT is a $55B worldwide company, headquartered in the US but with a large focus on growth regions such as China more recently. General consensus is that the stock has underperformed as of late due primarily to uncertainties in some of the company’s key markets. With the price of gold plummeting, mining companies are becoming more cautious with their capital investments. Demand in China is showing signs of uncertainty as well. I prefer to look at the long term picture though rather than short term fluctuations. Long term there will be an ongoing demand for heavy machinery, and CAT is well positioned to supply that demand. For that reason I am treating this dip in share price as an opportunity rather than a cause for concern.

CAT is currently trading just North of $83/share at a PE ratio of just under 10. The company pays an annual dividend of $2.08 which works out to a yield of around 2.4%. Better yet, CAT has increased dividends every year for the past 19 years and with a payout ratio of just 25%, looks capable of continuing this policy in the future. Stock performance itself has lagged the rest of the market due in part to the reasons I’ve outlined above, with share prices down nearly 20% from a year ago and 5% YTD. CAT has a debt/equity ratio currently of 1.58, and appears capable of meeting it’s near term obligations per it’s current ratio of 1.43.

I have used several valuation techniques in an attempt to ascertain what a reasonable price to pay for Caterpillar stock would be as follows:

  • EPS Growth Capitalization: Using a future PE of 13 and a projected EPS growth of 9.4% over the next five years, I arrived at an intrinsic value of $98.14 which is 17% above today’s trading price using a 12% discount rate.
  • Discounted Cash Flow (DCF): Using an initial revenue growth rate of 15%, declining to 3% over the forecast period, a terminal growth rate of 3%, and a 12% discount rate, my discounted cash flow analysis resulted in an intrinsic value of $105.34 which is 19.5% higher than today’s price.
  • Dividend Discount Model: Based on a current dividend of $2.08/yr, a long term dividend growth rate of 5.2% (3-yr avg.) and a 12% discount rate, fair value for CAT works out to be just $30.91 using the dividend discount model. Clearly what this is saying is that we must rely on capital appreciation in addition to dividend distributions if we are willing to pay today’s prices for this stock. Also dragging this number down was my choice to use the 3-yr average in an attempt to be conservative. The 1-yr and 5-yr dividend growth rates for example are circa 9% and would result in a fair value of $66 if used.
  • Graham Number: Based on earnings of $8.49 over the past 12 months, and a current BVPS of $26.86, the Graham Number equates to $71.63, or about 18% lower than today’s price.
  • Other multiples: Using historical PE analysis, PB analysis, and dividend yield analysis, fair value appears to be $155.18, $98.51, or $83.74 respectively.

Throwing away the two extremes (high and low), the fair value range for CAT looks to be between $71.63 and $105.34. The average valuation is $91.47 and the median is $89.80. Based on this, it would appear that Caterpillar is trading within it’s fair value range, but erring to the low side approximately 9% below the mean. As stated above, I am taking this opportunity to initiate a position despite the low margin of safety.

Disclosure: I am long CAT.

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Buying Chevron at current Price Levels

As I mentioned earlier this week, I am in the process of adding some long term dividend stocks to my portfolio in an effort to reduce the volatility arising from the growth stocks I own. After further analysis of the stocks in this list, I have decided to buy Chevron (CVX) despite the fact that it is near all-time highs. This may sound counterintuitive from a value standpoint, but based on my analysis, CVX is still reasonably priced, even at $118 / share.

Chevron is a multinational energy corporation operating in over 180 countries. The company’s primary focus is in the oil & gas industry (both upstream and downstream), but is also involved in geothermal, chemical manufacturing, and power generation. It is the 2nd largest oil company in the US, and employs over 62,000 people worldwide.

As of today, Chevron is trading at $118 / share and currently pays $3.60 in annual dividends which results in a 3.05% yield. The company has a solid history of increasing dividends every year for the past 25 years, and based on a current payout ratio of just 27% it would appear that this policy will continue for the foreseeable future.

Chevron has achieved earnings growth of 8.73% compounded over the past 5 years and revenue growth of 3.58% over the same period. Analysts forecast earnings growth 7.6% (source: Morningstar) over the next five years, which is inline with historical numbers.

CVX carried both short and long-term debt, with a debt/equity ratio of 0.09 as of last quarter. The company is in good shape to handle it’s current obligations as evidenced by a current ratio of 1.63. Chevron is currently involved in some ongoing legal issues in several countries, most notably in Ecuador. Un unfavorable outcome could negatively impact the company significantly in the future.

I believe that the rewards outweigh the risks for CVX and will be initiating a position so long as the price is reasonable. In an attempt to determine a fair price to pay for Chevron I conducted several different valuation techniques as follows:

  1. EPS Growth Capitalization: Using a future PE of 9.3 and a projected EPS growth inline with analyst estimates of 7.6% over the next five years, I arrived at an intrinsic value of $101.38 which is 16% lower that today’s trading price using a 12% discount rate.
  2. Discounted Cash Flow (DCF): Using an initial revenue growth rate of 5%, declining to 3% over the forecast period, a terminal growth rate of 3%, and a 12% discount rate, my discounted cash flow analysis resulted in an intrinsic value of $149.22 which is 21% higher than today’s price.
  3. Dividend Discount Model: Based on a current dividend of $3.60/yr, a long term dividend growth rate of 9.2% (5-yr avg.) and a 12% discount rate, fair value for CVX works out to be $128.57 using the dividend discount model — about 8.7% higher than today’s price.
  4. Graham Number: Based on earnings of $13.32 over the past 12 months, and a current BVPS of $70.01, the Graham Number equates to $144.85, or a 19% premium to today’s price.
  5. Other multiples: Using historical PE analysis, PB analysis, and dividend yield analysis, fair value appears to be $123.69, $100.06, or $108.75 respectively.

In all, seven different valuation techniques were used, admittedly some more complex than others. Fair value for CVX appears to be in the range of $100.06 to $149.22. The average valuation is $122.36, and median is $123.69. Based on today’s trading price of $118, it would appear that CVX for all intensive purposes is within the fair value range, perhaps leaning towards being slightly undervalued.

Disclosure: I am long CVX.

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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).


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).



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).


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.


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:


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.


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):


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):


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.


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.


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


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


Chipotle Mexican Grill (CMG) Analysis & Valuation

Chipotle Mexican Grill (CMG) LogoI have been following Chipotle Mexican Grill (CMG) for quite some time now, and it didn’t come as a surprise to me that it scored very well in a recent stock screen I made for companies which exhibit high, predictable growth and little debt. Chipotle Mexican Grill’s EPS has grown at a compounded annual rate of 39% over the past five years. Sales have grown at 23% per year. As of Dec. 31, 2012, CMG was trading for $297.46 which translates to a market cap of $9.15 billion.

I will now review the latest annual and quarterly reports in detail to determine if there are any red flags which would preclude an investment in Chipotle. Following that, we will attempt to determine a reasonable estimate for CMG’s current intrinsic value and use that information to set an entry price target.

Detailed Analysis

CMG is an owner and operator of Mexican fast food restaurants which have a core menu consisting of burritos, tacos, and salads. The company does not franchise, and their claim to fame is their focus on high quality ingredients and training of their people. This has brought them a great deal of success thus far. Chipotle Mexican Grill’s most recent annual report was for fiscal year 2011 which ended on December 31, 2011. As that was now over a year ago, we will also pay close attention to the 3rd quarter report, which ended September 30. Following are the key takeaways from both reports.

2011 Annual Report Highlights

  • CMG places an emphasis on naturally raised meat and dairy and locally grown produce. The company believes that this increases the quality, taste, and integrity of its food. There is inadequate supply of naturally raised meat to commit to this goal fully however, and some regions occasionally revert to conventionally raised meat in these cases. This is a potential red flag due to the company’s very ambitious growth aspirations. Will CMG’s suppliers be able to keep up with demand?
  • The company is extremely focused on customer education and engagement. Programs include a web-based program called the Farm Team to educate customers about what makes CMG’s food unique, a Cultivate Festival which drew 17,000 people in Chicago, the production of a short film to expose customers to the benefits of sustainable farming, and finally the establishment of a non-profit organization to assist those who are making efforts in areas such as animal welfare and sustainable farming. Continue reading
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Buffalo Wild Wings (BWLD) Analysis & Valuation

Buffalo wild wings logoBuffalo Wild Wings (BWLD) was one of the top performers in a recent stock screen for companies that exhibited steady, predictable, growth with little debt. As part of the value investing workflow we developed in an earlier article, a detailed analysis must now be conducted, followed by a determination of BWLD’s intrinsic value.

BWLD is a restaurant owner, operator, and franchisor operating primarily in the United States, with a few locations in Canada as well. Restaurants are themed as sports bars, but attempt to be equally friendly to both sports fans and families alike. They have managed to succeed in obtaining a dominant position with their brand, and the company’s restaurants are the destination of choice for Sunday football as well as other major events. The company was founded in 1982 and has been publicly traded since 2003.

Buffalo Wild Wings has enjoyed phenomenal and consistent growth over the past decade. EPS has grown at a compounded annual rate of 24% over the past five years with sales growing only slightly lower at 23% / year. As of today, BWLD was trading for $71.94 which translates to a market cap of $1.34 billion. The company meets all of the other PGLD criteria as well, and boasts zero long term debt. Let’s look a bit deeper at the latest quarterly and annual reports to get a better picture. Continue reading

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