Saturday, September 30, 2006
For the purposes of this analysis, we will take 2005 annual report as the basis. Taking the 2005 report gives us a conservative basis as the company was impacted by massive gulf hurricanes - Karina, Rita and Wilma.
Total berkshire hathaway share holder equity at the end of 2005 was 91,484 million dollars. The share holder equity is up significanly this year and is likely increase by 10% or more this year.
The next thing to look at is the cash flows. The cash flows in Berkshire balance sheet is divided into three segments. Cash flows from operating acitivities, cash flows from investing activities and cash flows from financing activities.
Cash flows from operating activities in 2005 was 9446 million dollars. The cash flows from operating activities were 7311 million dollars and 8341 million in the previous two years respectively. The average cash flow for the past three years is 8344 million dollars. We will take this value for our analysis purposes.
We are going to leave the cash flows from investing activities alone as this should be in the negative territoty for a while as Warren Buffett and Charlie Munger find home for the boatloads of cash on Berkshire balance sheet.
Earnings from financing activities is expected to be the positive category in the future for Berkshire Hathaway. We will take the low end of this figure and estimate gains of about a billion dollars per year till perpetuity.
Adding these two figures gives a net cash flow per year of 9344 billion dollars a year. Using the infinite geometric series with a discount rate of 11%, the intrinsic value of Berkshire Hathaway through cash flows is 94180 million dollars.
Adding the book value and the value of future cash flows gives an intrinsic value of 185664 million dollars to Berkshire Hathaway. This puts Berkshire Hathaways current stock price at a 25% discount to its intrinsic value.
This valuation puts Berkshires intrinsic value at 119750 as per the financial statements from the 2005 annual report. The cash flows used for this valuation are extremely conservative. Giventhe growth and improvement this year, the intrinsic value is significantly higher - more likely in the 130-140K range by end of 2006.
Saturday, September 23, 2006
Momentum investing is typically done over a short period of time typically over a few months or a few years. The number of years for momentum investing is typically less than three and definitely not more than five. One example of this showed itself during the .com boom which lasted for about four years from 1996-2000. Recently we have had the commodities boom which also is not likely to last over longer than five years. In other words, performance in each sector is bound to revert to its mean over long periods of time.
First, there is the problem of finding the right security. The right security can be obtained by screening message boards, reading business magazines and or using the "magic formula". Joel Greenblatt in his book the little book that beats the market introduced the so called magic formula. The formula involves
- Buying stocks that rank highest in a combination of
- Earnings yield (the inverse of the price-to-earnings [P/E] ratio) and
- Return on capital.have doubled the market's returns
This system can be used as an effective screen but the mechanical screen itself will not identify great businesses at attractive prices.
It is always good to apply the basics that Charlie Munger talks about in Poor Charlies Almanac to the stocks selected. The basic principles that Charlie talks about are.
- Answer the no brainer questions first.
- Apply mathematical models to assert scientific reality.
- Think problems forward and backward - or "invert, always invert".
- Apply fundamentals from different disciplines to analyze the company further.
- Really big effects, lallapalooza effects will often come only from large combination of factors.
In this article we look at possible mathematical models that can be applied to value a company. One should always value a company conservatively so that a margin of safety is built into the company that prevents the downside during market downturns.
The book "Value Investing from Graham to Buffett and Beyond", Bruce Greenwald et.al describe a few methods to value a company. Some of the methods they describe are:
- Valuing the asset value that is required to produce the necessary goods or service. This model assumes no competitive advantage - i.e., another market entrant can produce the same goods and service by investing similar capital.
- Earning power value - this minus the asset value of the company gives the franchise value because of competitive advantages.
- The value of growth is the value of the company on top of EPV.
Needless to say, the Munger factors kick in before one can value the company properly using these approaches. Typically, calculating the EPV involves taking the net income and adding a part of R&D and sales budget and dividing by the cost of capital. Adjusting the net income is a complicated process and involves significant guess work. Any calculation that involves significant guess work is likely prone to errors.
Another way to calculate the intrinsic value of a company is to take the book value of a company and add to it the discounted cash flow for the next ten years. This model is simple and works fairly well. For a company with no growth with 11% discount rate, this value can be calculated as book value + 7 x cash flow + 0.3 terminal cash flow. Appropriate adjustments can be made to value the company appropriately. If one can be reasonably sure the company is going to be around for the next next one hundred years, the value of the company can be calculated as book value + 10 x cash flow.
In future segments, we will use of the afore mentioned methods to value a company and we will specify the model used.
Sunday, September 17, 2006
Microsoft is a very profitable company. In FY2006, Microsoft had 28.5 cents of net income on every dollar of revenue. The total net income at Microsoft has remained stagnant at 12.5 billion dollar range for the past couple of years. The investments in less profitable ventures such as XBox and MSN have compensated the lack of revenue growth.
It is natural that a business that is very profitable attracts competition. Microsoft has attracted competition in a variety of forms from free software (Linux) and that includes government intervention from places like the European Union and Korea. The one time charges that Microsoft has been taking is endless and is not likely to subside anytime soon.
Let us take Microsoft's net earnings from FY2006 and assume no growth. This assumption makes sense for a conservative evaluation because of the many legal and competitive challenges Microsoft faces. FY2006 income came in at 12.5 billion. We will add 25% of R&D to net income as this expenditure will accrue to earnings. We will also add 10% of marketing revenue to the earnings. Marketing is less important at Microsoft because of its dominant position in the desktop and server markets. Putting these together puts Microsoft net earnings at 15.1 billion. Now we need to subtract capex and expense for stock based compensation and add back amortization/depreciation. Microsoft spent 1.6 billion in additions to property and equipment. So the total income after adding these in is 14.4 billion. At a cost of capital of 0.08, the earning power value of Microsoft comes in at 180 billion. However, we still have to substract the effects of stock based compensation of 1.8 billion. If we take into account the effects of stock based compensation, the earning power value declines to 157.5 billion. The effects of stock based compensation has been declining but will probably settle around 1.4 billion. In this case, the EPV of Microsoft comes in at 162.5 billion.
To this we need to add the cash in the balance sheets which was at 34 billion at the end of FY06. Adding these in, Microsoft's intrinsic value comes in around 194.5 billion dollars. Even if one completely negates the effects of stock based compensation, MSFT intrinsic value comes in at 214 billion dollars.
At the current market cap of 268 billion dollars, Microsoft is still over valued by about 20%. Given the world wide recognition of its brand name, executives and its software, Microsoft is trading at a premium and cant be considered a value stock at the moment.
Wednesday, September 13, 2006
The average selling price for a barrel of crude was $50=00 and $6=00/mcf for natural gas in the first six months of the year respectively*. Net income in this period was 8.4 billion dollars. Subtracting capex and adding back depreciation and amortization to the net income produces a figure of 3.4 billion for the first six months of operation. Using a cost of capital of 0.08, this puts the earning power value of COP at 85 billion for an entire year. If one adds the book value to the EPV, the intrinsic value of COP with no growth is 68% undervalued compared to its market price today.
Let us assume lower selling prices for crude and natural gas as exploration and production constitutes 62% of COP's net income. Let us assume a 20% decline in prices for crude oil and natural gas. This puts the price of crude at $40=00 and $4.8/mcf for natural gas respectively. This reduction in crude and natural gas prices will put COP income at 7.4 billion for the first six months. Subtracting capex and adding back amortization and depreciation, we get an EPV of 60 billion. Adding in the book value gives a value of 137 billion. This is a 43% appreciation potential to intrinsic value.
This represents an intrinsic value for COP in the range of $83-$98. The current price of $58=00 represents a significant discount to the current trading value.
*The crude oil and natural gas prices are at the high end of the spectrum from COP 10-Q for the first six months and our estimate is very conservative.
Sunday, September 10, 2006
If we estimate that Home Depot's net earnings this year will be 15% higher than last, Home Depot earnings will come in at 6700 million dollars. To this we will add amortization/depreciation and subtract capex. Amortization/depreciation is to the tune of 3.6 billion dollars a year and the capex is about 6 billion. Taking out two billion for new stores, the total amount is about 6300 million dollars. Putting the cost of capital at 8%, this gives an EPV of 78.5 billion with no growth. Adding in the cash and inventory gives HD a value of 92.7 billion. Assuming no growth, this shows that HD is 25% under valued compared to its market value at the moment.
Saturday, September 09, 2006
The NYTimes reported that the construction spending is up 5.1% this year compared to the prior year. This growth has slowed down somewhat but has been increasing since 2001. The personal savings rate is negative and continues to be in that trend. The manufacturing index is also showing an expansion at 54.5 in August. This is down from July value of 54.7. The housing supply meanwhile has increased significantly in the meantime. This should mean continued good fortune at the construction related manufacturing such as USG.
The SP500 finished at 1300 at trailing P/E of 18. The US companies overall are doing well and index should have some upside in the next year. The emerging market index had a slow week with its value falling. It is currently trading at a slight discount to its NAV.
Among the BRICs, Indian market did well moving up on the back of optimistic prognosis for economic growth. The Brazilian index went down significantly similar to EEM. The Chinese index went up slightly. The Korean, Taiwan and Singapore exchanges all declined slightly last week.
From trailing P/E stand point, the different markets were priced as follows. This shows an upside for emerging market funds such as EEM and VWO.
India - BSE Sensex - 20
China - 21
Brazil - 10
Korea - 11
Taiwan - 11
Russia - 13
Singapore - 10
South Africa - 8
Israel - 14
Hongkong - 12
The canadian index also went down from a high of 12200 to a low of 11900 by Friday. The US index also had a down week.
Looking at everything in total, the downside correction last week looks like a temporary blip. The reduction in oil and commodity prices bodes well for growth in the emerging markets as it does in the developed countries. It doesnt look like the growth train is going to stop anytime soon.
From the 10-K, Lowes describes its market as follows:
We estimate the size of the U.S. home improvement market to be approximately $700 billion, $550 billion of which comprises product demand, and $150 billion for the installed labor opportunity. Data from a variety of primary and secondary sources, including trade associations, government publications, industry participants and other sources was analyzed as the basis for our estimate. This estimate includes import and export data and key end-use markets, such as residential repair and remodeling, and nonresidential construction and maintenance. This data also includes a wide range of categories relevant to our business, including major appliances and garden supplies.
As we continue to monitor economic data and the home improvement marketplace, there are many indicators demonstrating continued strength in consumer demand for the products and services we offer. The key indicators that we monitor include personal income, employment growth, housing turnover and home ownership levels. Demographic and societal trends also remain supportive of home improvement industry growth.
Personal income continues to grow, which is supported by data from the February 2006 Blue Chip Economic Indicators™, which forecasts real disposable income growth of 3.4% for calendar 2006, compared with 1.4% in calendar 2005.
Employment growth is a strong indicator of home improvement sales. The relatively low unemployment rate suggests Americans will likely be more confident in calendar 2006 about employment prospects than in the past several years.
Housing turnover is expected to continue at a historically high pace according to The National Association of Realtors®, which forecasts calendar 2006 housing turnover to be the third strongest year on record.
Near-record U.S. homeownership levels provide an established customer base for home maintenance and repair projects. The vast majority of our customers are homeowners and they are not willing to let what is often their most valuable financial asset deteriorate.
Out of the factors mentioned above, the disposable income has increased at 6.8% rate this year while inflation has been creeping up at 4.1%. Employment growth is also strong with unemployment at record lows. Interestingly enough, housing turn over may be unaffected by the housing slow down and defaults. The only factor that may affect lowes is that less people will have the money to spend in their stores. This was evidenced recently as Lowes earnings missed the estimates by one cent.
There are several factors in favor of Lowes as noted in the Home Depot analysis. Some of the factors in play for Home Depot are true for Lowes as well. Just to recap, the factors in favor of Lowes are:
Confluence of factors
In each of the above categories, Lowes is equal or better than Home Depot at the moment. It doesnt hurt that Lowes is growing at a faster pace.
Let us take a look at the balance sheets to compare Home Depot and Lowes. HD has a return on asset ratio of 13.5% and a forward earning yield of about 9%. Lowes on the other hand has an earnings yield of 8% and return on assets of 13.3%. HD has a larger per share in book value at 37.6% to Lowes 35%. However, Lowes is growing at a faster pace than Home Depot with the recent expansion to Candada being a good example. Lowes also carries a lower debt compared to Home Depot when normalized by market capitalization. In addition, Lowes has a higher per ticket average and increase in same store sales (3.3%) compared to lesser per ticket average and decline in same store sales in Home Depot.
Lowes balance sheet is sound and it spent a bundle of money buying back shares. This has helped stem the dilution through stock option offerings.
As noted in Lowes 10-K, the capital expenditure budget is as follows:
Our 2006 capital budget is $4.2 billion, inclusive of approximately $387 million of leases. Approximately 79% of this planned commitment is for store expansion and new distribution centers. Expansion plans for 2006 consist of 155 stores, including five relocations of older stores. This planned expansion is expected to increase sales floor square footage by approximately 12%. Approximately 63% of the 2006 projects will be owned and 37% will be ground-leased properties.
Depreciation and amortization will probably average around 2 billion dollars for 2006. Subtracting this amount from the capex budget, we see that approximately 55% of the earnings are deployed in maintenance. Some of this budget is used for expansion ( around 2 billion ) and the rest is used to buy inventory and other necessities.
Let us next look at the EPV of Lowes. Assuming no growth and the yearly profit to be around 4 billion in 2006. Subtracting capex and adding back depreciation and amortization ( not including the money used for expansion ) - one gets a value of around 3.8 billion. Adding 10% of the sales, general and adminstrative cost to keep/build the brand name, we have a value of 4.8 billion. Using a cost of capital of 8%, we get an EPV of 60 billion. Subtracting debt and adding cash and inventories, one gets a value of around 63 billion. This value indicates that the stock is selling at a 29% discount to its current market price.
Another approach where one takes the book value and puts a P/E multiple of ten to the current adjusted earnings will also put the value at around the same value as calculated above.
Tuesday, September 05, 2006
SP500 closed at 1313.25 today with a trailing P/E of 18. The index has an yield of 1.8% and has gone up by about 5% thus far this year. It looks as though the index has some room to run in the next six months despite a slowing economy. If the economy doesnt tank, it is my hunch that SP500 can grow between 2 and 4% for the rest of the year. This should provide a range of 1340 to 1375 for this index. The SP500 index is also off its peak value in May.
In North America, the commodities driven Canadian index is off of its April highs and has room to run. This is also true of the Brazilian index which is also off its highs.
Another important set of indices are in Asia. The Hang Seng index in Hong Kong has hit its yearly peak and is continuing to do well. The markets in India are off its peak as are the indices in Taiwan and Korea.
In Europe, the Swedish exchange is at all time highs and some of the other exchanges are off of their yearly highs.
The world GDP is expected to grow strongly this year with growth in the rest of the world surpassing the growth in the U.S. The decline in energy prices should continue to spur economic growth around the world. The current slowdown may be termed as a mid cycle slow down and the cycle has legs to run till 2009 or 2010. This is expected to show in superior stock market gains in the rest of the world, particularly in the emerging markets. It seems that the emerging markets have 5-10% upside from their current prices in the next three - six months.