Right Price Checklist: Value

· Business, and an Explanation of the Checklist
· Moat
· Management
· Financials

Valuing a business is how a successful investor can decide when to buy and when to sell great companies.

Before I start, I'd like to add that when doing my analysis I like to keep any valuation out of my head until the end, to keep myself from becoming biased, I don't even look at the stock price.

In this article the methods of valuations I will use are:

• Target Price
• Pabrai Multiple
• Pabrai DCF
• Matt Richey's DCF
• Absolute P/E
• Croesus Test
• Reverse DCF
• Liquidation Value

Valuation

Target Price

The first test is relatively simple, but not one that should be used without taking a spoonful or so of salt.

To find a target price, one projects revenue five years into the future, then converts that into income with a projected net margin, then after projecting the amount of shares five years out convert the income into EPS and finally apply a multiple where the business would likely trade.

This method shouldn't be used for valuation, but it helps to show how much the share price can rise with the expected growth and margin expansion.

Pabrai Multiple

In an interview Mohnish Pabrai said a business with no growth, but consistent cash flows, should be valued at 10x cash flow plus excess capital, conversely a growing business should be valued at 12-15x cash flow plus excess capital.

This is the formula for excess capital: Excess Capital = Book Value – Fixed Assets – Goodwill – Working Capital Needed for Operations (2% of Sales)

Pabrai DCF

In his first book Pabrai spends a chapter detailing how to use a DCF.

His use is a little off the usual, but it works. He recommends predicting ten years of cash flow, discounting it back to the future and then assuming the business would be sold for the excess capital at the end of the tenth year.

Matt Richey's DCF

Matt Richey is one of the mutual fund managers for whom I have the most respect. When he wrote for The Motley Fool he wrote an article on DCFs and was kind enough to send me his spreadsheet. The sheet allows for three different expected growth rates to find the best worse and most likely cases.

Absolute PE

This method is the newest one to me. It is found in Active Value Investing by Vitaliy Katsenelson.

The model uses a chart to determine a basic P/E using expected growth and dividend yield, and then applies the basic P/E to this formula:

• Basic P/E x[1+(1 - Business Risk)]x[1+(1 - Financial Risk)]x[1+(1 - Earnings Visibility)]

The book shows the chart to use for basic P/E and how to determine the different risks, I encourage anyone who hasn't already to buy the book.

Croesus Test

The Croesus test is one of my favorite methods. It's comparable to the target price, but instead of entering earnings growth one enters in the dividend yield and the return they want over a certain number of years, and the P/E at the end, and the method tells them what earnings CAGR is needed to produce this return.

For more information on the math involved, I first read about this method in It's Earnings That Count.

Reverse DCF

In a DCF an analyst applies his expected growth rate to cash flow and then adds up the cash flows after discounting them back to the present. This tells the analyst what the value of the company is.

In a reverse DCF the current market value is inputted and the method shows what earnings growth is needed to support the current market value, this does not give a specific market value, but does give a general view on whether or not the stock is undervalued.

Liquidation Value

I first read about this in Seth Klarman's book (I won't link to it because it's like $3,000 or something), he uses it to find what the bottom for a stock is potentially.

Though a company may have a certain liquidation value that does not mean the stock will never trade below that value (Sears Holding currently trades below liquidation value), just that an investor should not have long-term losses below it.

In liquidation value an investor should assume the full value for liabilities and for assets the following percent should be realized:

Asset               Percent%

Cash                    100%
Marketable Securities   100%
Accounts Receivables     85%
Inventories              50%
PP&E                     45%
Goodwill                  0%
Deferred taxes            0%

I'd like to add to this that if a company owns its own real estate this should be taken 100% and if the market has gone up a conservative appreciation should be added.

Best Buy

In the Best Buy valuation I will use a 5% margin on Revenue, the FCFF of $1.7 billion, growth over the next five years of 12%, growth in years 6-10 of 8% and growth from years 11-20 of 5%, terminal growth of 2.5% and a discount rate of 10%.

Target Price

At 12% growth in five years revenue will be about $69.6 billion, 5% of that is about $3.5 billion, then assuming no share dilution (and to be conservative no shares repurchased).

At a 17x multiple this gives a share price of $122.27, which is 186% growth in five years from the current price.

Pabrai Multiple

Applying a 15x multiple to Best Buy's current EPS of $3.19 give a value of $47.85 per share, it has negative excess capital because of its high accounts payable so I will just add the cash per share which is $2.73 this gives a value of $50.58

Pabrai DCF

Using the expected growth and not adding excess capital Best Buy has a value of $69.76 per share.

Matt Richey's DCF

Using 3% more for the growth in the best case and 3% less for the low case, I get values of $130.26, $90.69 and $64.75.

This gives very high values, if the discount rate is changed to 12% the median case drops almost $18 per share, and as shown 3% less per year growth makes it drop $26 per share.

Absolute P/E

16.4 x [1+(1 - .95)] x [1 + (1 - .95)] x [1+ ( 1- 1.05)] = 17.18

$3.19 * 17.18 = $54.86

Croesus Test

These three inputs all assume and ending P/E of 15x, and using the net income of 1.4 billion.

To get a 25% CAGR over two years Best Buy would need earnings CAGR of 22.7% over the same period.

For 17% over five years, 16%.

For 15% over the next ten years, 14.5%.

Reverse DCF

Using Quicken if Best Buy grows 6% terminally and using a 15% discount rate (the 6% can't be changed and 15% discount rate is used to offset it) Best Buy needs to grow 4.7% annually over the next ten years.

Liquidation Value

Asset                    Value         Adjusted Value (in millions)
Cash                    $1,319         $1,319
Marketable Securities   $  295         $  295
Accounts Receivables    $  739         $  628
Inventory               $7,451         $3,276
PP&E                    $3,260         $1,467
Goodwill                $1,182         $    0
SUM                                    $6,985