Short Inventory Stocks of Small Store

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

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

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
value
• This is called a investing with a ―margin of
safety,‖ because you are protecting yourself
sale
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
value)?
 ( )
FVPV i N
1
• What is tomorrow’s dollar worth today (present
value)?
FV
PV /( i
1 )          N     This is how we
calculate stock prices!
Example
• 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
• 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
• 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
dollars
• 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!
Multiples
• Ex. Stock with a 20x P/E multiple means investors would
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
multiple?
• Why is the multiple at a discount?
• Why won’t it contract further?
• Morningstar has a helpful website for this
– http://quicktake.morningstar.com/StockNet/StockValuation.aspx?Countr
y=USA&Symbol=USU
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
• http://screener.finance.yahoo.com/newscr
eener.html
• 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…
• 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
owns:
– Dairy Queen
– Coca-Cola
– Washington Post Co.
• Where to find it:
– 10-k filing
• How will this company continue to exist in the
future?
• 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
cheap?
• 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
• 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
around
In short…
• 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
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,
however.
Questions?
Appendix

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