Case Study: Valuing a Real Publicly Traded Business

Valuing a business is not an easy task.  There are a lot of different methods, some of which work better than others.  Also, no one method is appropriate for every business.  A larger, mature company may be best valued using a discounted cash flow valuation, while a small company just starting out may best be valued using the price to sales ratio. Small start up companies are extremely difficult to value, if they can even be valued at all.  Many times you will hear people say that company xyz is worth $56 per share or company abc is worth exactly $11.5 billion dollars.  Valuing a company is not an exact science.  No one knows for sure exactly what a company is worth, only a range of values based on a range of future outcomes.  If it is impossible to come up with a reasonable range of future outcomes for a business,(i.e. a start up company), then the company cannot be valued and would be considered a speculation, not an investment.  I like to come up with a range of values for a company based on conservative assumptions (I stress the word conservative here) and buy based on the lower end of the range or ideally below the range, although that is usually only possible during bad economic times, or if the company is going through some short term issues that are fixable.  The business I am about to value is a small publicly traded company that I won’t name, although someone that wants to dig enough should be able to figure it out.

This business is a small west coast outfit that sells food products of the Italian variety.  They use several food brokers (although highly concentrated with two brokers comprising about 77% of sales, so that is a risk) and sell their products both to restaurants as well as grocery stores.  They are also available on Amazon as well as other e-commerce sites.  They have had a really solid operating history for the last ten years, so there is some consistency in their operations.  More on that later in the post.

So to come up with a value for the business, we first have to figure out the company’s current earning power.  Normally, I would use free cash flow (operating cash flow minus any capital expenditures needed to maintain, not grow the business) as a proxy for earnings power, but this business has spent a lot of money recently in order to upgrade their facilities due to the increased demand for their products.  Because of this, the cash flow statement is a little muddied so I will use net income as a proxy for earning power instead of free cash flow.  Historically, net income has slightly lagged free cash flow, but it shouldn’t lead to a large discrepancy in valuation.

The way I am going to value this company is what is called a discounted cash flow methodology, or DCF for short.  By definition, the theoretically correct way to value an asset is to add up all the future cash flows, and discount them back to the present at a discount rate an investor deems appropriate, (also known as an investor’s hurdle rate) to come up with a present valuation.  Although a great way to value an asset, it has a few flaws.  The biggest flaw being that it is impossible to precisely determine future growth rates of a business, because well….the future is uncertain.  So it relies heavily on some educated guesswork.  I like to come up with three different valuations.  One is a base case, or what rate I expect the business to grow, one optimistic, and one pessimistic.  I like to calculate these conservatively based on the company’s history, usually the previous five or ten years’ results.  Although I look at the previous five or ten year’s results, I use them as a guide and do not try to extrapolate that growth into the future.

Last year this company had an after tax net income of $5,086,774.  They have 32,065,645 shares outstanding, so that gives them earnings per share of ~$.16, rounded up from $.1586 for simplicity.  Normally I would go through the cash flow statement to figure out the amount of money that can be extracted from the business every year without harming its’ competitve position.  This is also referred to as owner earnings, or free cash flow.  This is where it gets a little tricky, but manageable.  The company’s cash flow statement is a little unclear due to them expanding their facility, so for better simplicity, I will use net income for this example.  Normally I would use free cash flow instead.  Also, due to the corporate tax rate being cut from 35% to 21% based on the Tax Cuts and Jobs Act, that will provide a significant boost to earnings in 2018, even if pre-tax income stayed the same.  So far for this year we have two quarters of results, and they were outstanding.  For the first two quarters, the company had a net income of $3,242,166 or $.101 per share.  Given that they had a net income of $1,931,281 or $.06 per share for the second quarter, I am going to operate under the assumption that they will hit at least ~$6,415,000 in net income for the year, or $.20 per share.  Using this number will make projecting earnings for the next ten years a little easier, because we will not have to factor in gains from the tax change in year one.  Now that we have a revised base number to use as a proxy for the company’s earning power, let’s get on to projecting earnings.

In order to project earnings, we need to look at the last ten years of the company’s financial results and financial position to get a view of how earnings have grown in the past, and a feel for how they will grow in the future.  If we go back to the year 2008, we see the company had a net income of $988,000 and ~35,000 shares outstanding, so roughly $.028 per share of net income.  This tells us that the company has grown earnings at a compound annual growth rate of ~21.75%…. which is outstanding!  Very, very few companies can grow at that rate for a decade.  If we compare net income to the total capital of the business which is found on the balance sheet (total capital = shareholders equity + short & long term debt) we find that the company has had returns on invested capital >25% per year for the last ten years, most of the time hovering between 35-40%.  That is truly an outstanding business!  ROIC of over 25% for ten years or longer also provides quantitative evidence that the company has some sort of competitive advantage, in this case it is most likely the brand.  Also, the company has used very little debt in their operating history and have always had healthy cash levels on the balance sheet as well.  They do not need leverage to achieve high returns, which is great.

Now for projecting the earnings for the next ten years.  Just to reiterate, these are educated guesses designed to come up with a range of values for the business.  For the first scenario, I will value the company on what I expect over the next ten years, also known as a base case.  I do not think the company will grow earnings as fast as they did in the past, and I want to err on the side of being conservative.  I am going to assume the company can grow earnings at 10% per year on average for ten years, before settling into a terminal growth rate of 3% earnings growth per year. It is fairly subjective as to what rate the company will be able to grow in perpetuity.  Some companies such as Hershey or McCormick have been able to grow at above average rates for a very long time.  I normally will use a terminal growth rate after ten years, but other people may decide to use after five years or fifteen years or some other year amount.  The point of this valuation method is to come up with a range of values, so use what you believe is appropriate.  As far as a 3% terminal growth rate goes, that is an educated guess as to how fast the company could grow once it has saturated it’s market and is well into the maturity phase.  Truthfully, it would probably be higher (maybe 5-6%), but once again it’s good to be conservative.  Other investors may use a higher or lower rate.  Higher terminal growth rates and assuming a company can grow earnings at a high rate for longer such as 15 years or more, will lead to a much higher valuation, just like using a lower terminal growth rate and shortening the years of higher growth will lead to lower valuations.  Once again, it is up to the investor’s judgement as to which numbers they should use.

For my analysis I will also use a 11% discount rate, which is close to but slightly more than the stock market as a whole has returned historically.  Also known as an investor’s hurdle rate, it’s the minimum standard that I expect an investment to meet.  That doesn’t mean an investment will meet that standard, some will do better and some will do worse.  Some people us higher or lower discount rates, but 11% is the number I feel comfortable with as a base line.  Using the base 2018 earnings level of $.20 per share or $6,413,100 with an 11% discount rate and assuming 10% growth per year on average over the next ten years, before settling into a 3% growth rate in perpetuity, we arrive at a valuation of $4.26 per share or $136,600,000 for the entire business.  Next we will use a more pessimistic assumption for growth rates.  Suppose the business flounders or competition heats up and the business is only able to grow earnings at 5% per year for 10 years.  This is far from a worst case scenario, but certainly not a very good one.  Growing earnings at 5% per year for ten years, and 3% in perpetuity using an 11% discount rate gives us a valuation of ~$3.00 per share or $96,200,000.  Lastly, we will use an optimistic growth rate, although one that is still attainable.  Using an educated guess and based on the company’s stellar economics, suppose they grow at 14% per year for 10 years before settling into a 3% terminal growth rate.  That is not as fast as the previous decade’s growth rate, but I don’t like to assume the company can continue a torrid growth rate for twenty years or longer.  Operating margins for the company increased from ~8% in 2008 all the way to ~20% today.  The company may be able to expand margins a little more, but I doubt margins will expand by another 1200 basis points in ten years.  Earnings growth will likely mirror to sales growth which I believe will be in the 8-12% range.  If they do actually manage to grow earnings at 21-22% for another decade, the investment will be a home run if someone bought today, but I would not assume that kind of growth.  Remember it’s better to be on the conservative side.  For the optimistic valuation, if they do manage to grow earnings at an average of 14% per year for the next decade, that gives the company a valuation of ~$5.70 per share or ~$182,800,000.  That gives us a range of $3.00-$5.70, or $96 million, to almost $137 million.  As we can see, that is a wide range of values based on different growth rates.

So what price should an investor pay for this business?  That depends on many variables already discussed, such as growth rates an discount rates.  Also, should the investor just buy if the company falls in the range of values, the low end of the range, or even lower than the range of values?  Again, that depends on the investor.  Personally I like to buy on the low end of the range, or preferably below the range, but many times a company will not get below a conservatively estimated range of values unless the economy tanks and/or the stock market hits bear territory.  There is no right answer as to what specific value to pay, an investor just needs to be confident that the company can hit a certain growth target.  I like to be a little more conservative, so I would buy this company around the lower end of the range which is right around $3 per share, or if I had ~$96,000,000 that needed to be invested, (wouldn’t that be nice) would I buy this entire company for that price?  That’s another great way to think of valuation that many people overlook, just focusing on the price per share instead.  Sometimes it helps to think about whether or not you would buy the entire business based upon its current price if you could.  Of course in the real world hardly anyone has the capital to do something like that, but if an investor decides they would not buy the entire business, they should think twice about investing in the stock at the current price.

Other investors may decide to pay a slightly higher price for this company given its outstanding economics and fundamentals.  Currently it trades for around $2.80 per share or ~$90,000,000 for the entire business.  That is about 15x trailing 12 month earnings, which in my view is substantially undervalued.  Other more strict value investors would probably disagree, saying that there is not enough of a margin of safety.  Although a much simpler way to value a business, price to earnings ratios can be misleading at times.  There are many other ways to value businesses which I will explain in a follow up post.  Like I mentioned earlier, very few companies can sustain a 25%+ return on capital for a decade or longer.  If it were a larger company that traded on the New York Stock Exchange instead of on the Over The Counter Market, it would command a much higher multiple of earnings, likely a premium multiple around 20-25x earnings.  That said, 15x trailing earnings or 14x fiscal year 2018 earnings is a nice price for a business with really outstanding fundamentals.

To sum up this post, a DCF analysis works well for a company with a solid operating history that an investor can be reasonably confident that the company will be earning more money in the future.  Of course, forecasting earnings is not an exact science and there are times when companies will disappoint and time when companies will grow faster than expected.  When valuing a business, use conservative estimates and buy on the low end of the range of values calculated, or below the range if possible.  Also, make sure to look for companies that have outstanding fundamentals and durable, sustainable advantages over other companies in their industry.  Valuing a business is not easy, and this is a simplified example, but it’s a worthwhile skill to have if someone wants to become a serious investor.

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