Short Inventory Stocks of Small Store

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					           Analyst Program (AP)
            Business Valuation and
           Stock Selection Meeting
               Wednesday, September 17th

Justin Van Vleck                  Felix Popescu
Co-President of Operations        VP of Analyst Program
Business Valuation

     Learning to Invest
  with a Margin of Safety
             From last week
• We want to invest in companies that are trading
  below their intrinsic value
• Not only that, we want to find companies trading
  at a significant discount to their fundamental
• This is called a investing with a ―margin of
  safety,‖ because you are protecting yourself
  against further losses by buying a business on
• A business could be good or bad, but the price
  you pay for it is the most important thing
        How Assets are Priced
• Assets are priced based on the present value of
  the cash flows they will produce in the future
• These cash flows are discounted back using a
  discount rate
• The discount rate represents the opportunity
  cost of investing in this asset given its individual
  level of risk
         How Assets are Priced
• Time Value of Money: A dollar today is worth
  more than a dollar tomorrow.
   – A dollar today can be invested to earn a rate of
     return or interest.
• What is today’s dollar worth tomorrow (future
                 ( )
               FVPV i N
• What is tomorrow’s dollar worth today (present
              PV /( i
                  1 )          N     This is how we
                                     calculate stock prices!
• MSU Candy Co. is expected to have cash flows
  of $5, $10, and $15 in the next 3 years
  respectively. The business is small, but not too
  risky, so a discount rate of 10% will do. There
  are 3 shares of stock in the marketplace.
• How to calculate the theoretical stock price
  – PV Year 1 CF = 5/((1+10%)^1) = $4.54
  – PV Year 2 CF = 10/((1+10%)^2) = $8.26
  – PV Year 3 CF = 15/((1+10%)^3) = $11.26
      • Adding these together gives us $24.06

• 3 shares in the market place means stock
  should be trading at $24.06/3 = $8.02 per share
                  Discount Rate
• The expected rate of return available on
  alternative investment opportunities of similar
  risk levels, or in other words, the Opportunity
  Cost of this investment
  – Historically, the stock market has generated an average annual
    return of about 10%.
• Good method to start out—CAPM model
  – Cost of Equity = Rf + B * (Mkt – Rf)
  – Beta can be found on Yahoo! Finance, Rf can be 5 year
    Treasury interest rate, and (Mkt-Rf) = 5.6%
• Doesn’t hurt to add a few extra percentage points to
  your calculated discount rate—this will increase
  your margin of safety
• Be conservative! The higher the discount rate the
  better! (to a degree)
     How to Value a Company
• Discounted Free Cash Flows (NPV)
• Multiples
   – Valuation Multiples
   – Comparable Transactions
• Liquidation Value
   – Tangible Book Value
   – Break-up Value
   – Net Working Capital per Share
   – Net-Net Working Capital per Share
 Free Cash Flows to Stockholders
• Finds the cash flows to a business available to
  stockholders in the future discounted into today’s
• Net Income
   – Plus Depreciation
   – Less Increases in Net Working Capital
   – Less Capital Expenditures
• This is what we use for our DCF model
• Note: Earnings are NOT the same as cash
  flows, and often times they will be different!
               FCF Example
• MSU Candy Co. has earnings of $5 for 2007. It
  also has depreciation on its building of $2, with
  an additional amount of candy needed that will
  cost them $2, as well as a store repair that will
  cost them $1. What is MSU Candy Co.’s Free
  Cash Flow?
• Net Income = $5
  – Plus Depreciation of $2 = $7
  – Less Increases in NWC of $2 = $5
  – Less Capital Expenditures of $1= $4 FCF
  Perpetuity on the DCF Model
• Use 3% revenue growth
• Profit margins should be reduced
• Net Working Capital as a percentage of sales
  may not change that much
• Capital Expenditures and Depreciation will be
  close to the same
• When in doubt, be conservative!
• Ex. Stock with a 20x P/E multiple means investors would
  be willing to buy this business for 20 times its current
  level of earnings, discounted back to today’s dollars
• What multiple should be used to value the company?
• What has the 5 year average looked like for that
• Why is the multiple at a discount?
• Why won’t it contract further?
• Morningstar has a helpful website for this
           Liquidation Value
• Value of a company if it were to be sold today
• Will differ depending on speed of liquidation
• Good conservative metrics include:
  – Book value per share
  – Net working capital per share
  – Net-net working capital per share
  – Break up value of company divisions
   Liquidation Value Examples
• MSU Candy Co. has assets of $20 inventory,
  $20 delivery truck, and $10 of accounts
  receivable due to it. The company also owes
  the bank $10, and owes its supplier $10. What
  is the company’s liquidation value if there are 3
  shares on the market?
    Liquidation Value Examples
• Quick and dirty method of Liquidation value is Net
  Working Capital per Share
   – Current Assets =
       •   Inventory of $10
       •   Delivery Truck of $20
       •   Accounts Receivable of $20
       •   Total Current Assets = $50
   – Current Liabilities =
       • Bank note of $10
       • Accounts Payable of $10
   – Total Net Working Capital of $30
   – With 3 shares on the marketplace the company would
     be sold at $10/share if it were sold today
   Liquidation Value Examples
• MSU Candy Co. also has a chocolate division.
  For the year 2007, it had earnings of $3. The
  chocolate division has all its own equipment and
  buildings. If similar chocolate companies are
  trading on the stock market at 10x earnings (P/E
  of 10), what would be the break-up value of
  MSU Candy Co.?
   Liquidation Value Examples
• First, let’s keep everything with the candy
  division the same. We concluded it was worth
  $10/share if it were sold today.
• With the chocolate division making $3 in
  earnings, that’s $1/per share in earnings
• With a 10x PE multiple, this adds $10 of value to
  each share of MSU Candy Co. stock.
• Its now worth $20/share in break-up value
Which method is appropriate to use?
• Valuation method selection should be based on
  what the catalysts will be…
  – Ex. If you think the company is very likely to be sold
    or split up for some reason, then a version of
    liquidation value is likely the most appropriate
  – Ex. If you think the catalyst will be a change in the
    company’s earnings power somehow, then perhaps
    the earnings multiple or DCF is more appropriate
• Liquidation value, however, often serves as the
  floor value, so even if the catalyst won’t be a
  sale/breakup, this measure of valuation is a
  great place to start
        Screening for Stocks
• Yahoo! Finance Stock Screener is easy to use,
  so we recommend using that
• Screening Criteria Include
  – Price to Book less than 1.5
  – Price to Earnings less than 20
   Stock Selection Process

So you think you’ve found a cheap stock?
          Here’s what to do next…
  Understand the Business Model!
• If you cannot understand how the company
  makes money, stop wasting your time and look
  at other stocks
• Look at a few of the companies Warren Buffett
  – Dairy Queen
  – Coca-Cola
  – Washington Post Co.
• Where to find it:
  – 10-k filing
       What is/are the business’
       competitive advantages?
• How will this company continue to exist in the
• What does it do that will prevent competition
  from eating away at its business?
• Note: the greater the margin of safety a business
  has based on valuation considerations, the
  weaker the competitive advantage can be
• Where to find it:
  – 10-k filing
                      And then…
• Go through the presentation criteria!
• Figure out why the stock has been sold by so
  many people!
   – This is the ―key debate‖ part of the presentation
   – Good examples include a huge missed earnings quarter,
     announcement of a competitor product, loss of government
     contract, lawsuit
• Where to find it:
   – Look at the stock chart for the past year or so and see where it
     really tanked, then find the most recent conference call transcript
     to find out what people are saying about it
• Good website to use
    Once you figure that out…
• Does it make sense that the stock should be that
• Does it seem like this is a one time thing and
  that business as usual should be strong?
• If it seems like people overreacted, then you
  must explain why people overreacted, and why
  you think they are wrong
       Further questions to ask
• How does the company fund itself?
  – Is it self sustaining through its cash flow from operations or does it have
    to borrow to continue to grow?
  – Can this cash flow cover capital expenditures too?
  – Easy way to determine this is to see if CFO is not only positive, but
    bigger than the CFI part of the cash flow statement

• What does its Return on Equity look like in the
  past? If a company’s ROE is continuously less
  than its discount rate, it is destroying value
• If you pick a company like this, you should have
  a good reason why things are going to turn
                   In short…
• READ THE 10-K!
• It is the best place to learn about all aspects of a
• Focus on the Management’s Discussion and
  Analysis section
• Read conference call transcripts and see what
  people are asking questions about
               Just to Recap
• We are looking to buy good solid companies that
  are undervalued, a dollar for fifty cents
• The greater the discount to fair value you have,
  the greater the margin of safety, and the more
  attractive the investment opp.
• You may not be able to find a company in your
  space that’s below book value
  – Make sure your valuation argument is compelling,

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