Blind Stock Valuation

One of the bloggers I follow on a regular basis over at Gurufocus has put up a blind stock valuation challenge here.   In any case, I took a stab at valuing the company which I have copied out below.  You’ll probably want to check out the actual article first though just to see what information was provided.

What do you think?  Am I in the ballpark or wildly out of line on my estimate of intrinsic value?  In any case, here it is:

Blind Stock Valuation:

Based on the conditions in the article, here as the major assumptions I’ve used:

  1. 35% tax rate.
  2. No other significant assets or liabilities on the balance sheet other than what is reported in the table.
    1. Given the fast growth of the company, it is unlikely that they maintain a significant cash & equivalents position.
    2. No debt is assumed as stated in the article.
  3. The share count has been assumed to be relatively constant over time.
    1. This is generally confirmed by the change in book value (using the asset & liability assumption above) in comparison to retained earnings over the 10 years after assuming a 35% tax rate.

Using those assumptions, we can come up with CAGR’s for the following metrics.

 

1-year

3-year

5-year

10-year

Sales

32%

35%

36%

42%

Gross Profit

32%

35%

36%

43%

EBITDA

34%

33%

35%

40%

EBIT

33%

32%

33%

39%

Net Income

33%

32%

33%

39%

Book Value

28%

30%

32%

36%

Working Capital

37%

26%

25%

34%

Total Assets

20%

30%

36%

38%

The first thing that stands out is the growth rate over the last 10 years.  It is extremely high and was maintained above 30% for the entire period which is very impressive.  Now, let’s take a look at some financial metrics.

Year

1

3

5

7

9

11

Ave.

Profit Margin

4.9%

4.9%

3.9%

4.6%

4.3%

4.2%

4.5%

Asset Turnover

3.18

2.85

3.32

3.97

3.74

4.01

3.46

RoA

15.7%

14.1%

12.8%

18.2%

16.2%

16.7%

15.6%

Leverage Ratio

1.50

1.31

1.35

1.43

1.54

1.54

1.46

RoE

23.5%

18.5%

17.2%

26.0%

24.9%

25.7%

22.7%

The first thing that stands out here is that we have a very high asset turnover rate compared to most other businesses.  Profit margins are average which results in a very good RoA.  Given the relatively minimal operating leverage, also a very respect RoE.

So essentially we have a company earning around 23% on the book value of equity in a relatively unleveraged scenario that is retaining all of its earnings to grow.  As the business matures, it is likely that the leverage ratio could be increased by between 0.5 and 1.0 giving a levered return on equity of between 34% and around 45%.  Now, let’s assume that a normal rate of return for the market is approximately 7% over the long term.  Based on the unlevered (current) situation, this would suggest a fair market value of around 3x book value or $30.19 per share.  In a leveraged case, this may double to approximately $60 per share.

Since this is such a high growth stock, we can also examine pricing the company using a PEG approach or Graham’s approach.  Based on the last year’s growth rate of 32% (as it is the lowest in the series), a PEG of 1 would yield a fair price of $67.52 whereas applying Graham’s formula yields $153.2.

Now that we’ve come up with a few estimates of fair value that cover a wide range, let’s look at what the expected return on the stock would be if you bought and held for 10 years at various PE’s assuming that it would end at a market average PE of 15ish assuming different CAGR’s for EPS over the time span.

10-Year EPS Growth / PE

10

15

20

25

30

35

0%

5%

0%

-3%

-6%

-7%

-9%

5%

10%

6%

2%

0%

-2%

-4%

10%

16%

11%

8%

5%

3%

1%

15%

22%

17%

13%

10%

8%

6%

20%

28%

22%

19%

16%

13%

11%

25%

34%

28%

24%

21%

19%

17%

30%

40%

34%

30%

26%

24%

22%

Now, what this illustrates is that if you expect the hyper growth (30%+) of this company to continue, really almost any PE is going to make out well.  In fact, with that growth rate a PE of 110 would still net you compounded returns of 7% per year even with PE compression to 15 at the end of the 10 year time span.  Looking at this, really Graham’s estimate is not out of line if you expect hyper growth to continue.

Now, most companies can’t sustain this type of growth for long, so let’s assume a relatively conservative (in this case) compounded growth rate of 15% per year.  So long as the stock could continue to grow at 15% per year, if you bought at a PE of 30 and experienced a PE compression of 15 over 10 years, you would still make an 8% return on your investment.  A PE of 30 is about 63.39, so let’s put that at our ‘conservative’ estimate of intrinsic value on the high side.

So, what do we have?  Well, I would peg the intrinsic value of the company at around $65 per share based on the PEG and assuming that the company’s growth will slow in the future, but average 15% over the next 10 years.  Depending on future growth, the range of intrinsic value I think may fall anywhere from $30 per share to well over $100 per share.  A better idea of the sustainability of their business, their customers, competitive position, etc. would be needed in order to make this determination.

At $60 per share, this gives the company a market cap of somewhere around $2.1 billion, with the intrinsic value range falling between around $1 billion and say $4 billion+.  That’s big enough to be out of the micro-cap space, but not large enough to prevent them from growing quickly for many years into the future (depending on their industry, scalability, etc.).  Even at 30% a year for the next 10 years, that ends with a maximum market cap of around $32 billion.

In terms of what I would pay, I am looking to buy at around a 50% discount to what I would consider intrinsic value, so in this case I would be a buyer at around $32 per share.  Given at this price that there is basically no consideration given to high continuing growth, or the potential for increasing leverage on the shareholder base, I think that at this price the company would turn out to be a relatively safe investment to hold for the long term with at least a market return and the potential for a much, much higher return if the company can keep performing.  In any case, I think this is an interesting example as a lot of deep value investors would likely skip it as it never will seem cheap enough on a straight earnings yield basis to consider.

Until next time,
Nathan @ EngineeringIncome.com

 

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