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How to Value a Business

A reader sent me this email:

Hi Geoff,

I have an investment idea at the moment, but am very new to actually valuing businesses so it may take some time to learn how to do it properly.

Thanks,
Ryan

The basic approach to valuing a business is very simple.

Try to start without looking at the stock price. Instead value the entire business. You want to start by using some written in stone valuation ratios without letting concerns about quality, future prospects, etc. cloud your initial judgment. That comes later.

When appraising a business, you want to use the real estate appraisal principle known as “highest and best use“.

You can easily rank a non-financial company’s possible uses from lowest to highest:

1. Liquidation Value
2. Net Current Asset Value
3. Tangible Book Value
4. Earning Power Value

In almost all cases, liquidation value is not the highest use for a business, because even very bad businesses are usually worth more than they can be immediately liquidated for. So normally you skip a liquidation analysis completely and go straight to analyzing the net current asset value, tangible book value, and earning power value.

A business is almost always worth its net current asset value (Net Current Asset Value = Current Assets – Total Liabilities). A business is worth its tangible book value if it earns a return on capital equal to or greater than the future return expected in the stock market. So, if you think the stock market will return 7% a year from now on, any business that earns an 11% pre-tax return on invested tangible capital should be worth its tangible book value or higher since 11% pre-tax is greater than 7% after-tax (assuming a 35% tax rate). Businesses that can’t earn 10%+ on capital may actually not be worth tangible book value. It depends.

The highest and best use for many stocks is #4: Earning Power. Two good rules of thumb here are that a business is normally worth about 10 times EBIT (Earnings Before Interest and Taxes) and 15 times free cash flow. These are just round numbers. It’s not an exact science. I use 10-year average real EBIT and free cash flow. Don’t worry about adjusting for inflation right now. But always make sure you use long-term averages for EBIT and free cash flow (unless we’re talking about super fast growers – which I’m a total dunce at valuing anyway).

I like to use enterprise value instead of market cap to value a stock both in terms of EBIT and free cash flow.

Also, unlike a lot of folks, I always split cash and debt off from the operating business. Cash and debt are just the financial scaffolding around the business. They’re not inherent to the business itself. And they’re not permanent. Just a choice made by the current owner. So, I value cash at 100% and separate it from the invested tangible book value.

That means I appraise …

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Where to Find Micro Cap Stocks

In yesterday’s GuruFocus article “Warren Buffett: How to Make 50% a Year in Micro Cap Stocks”, I mentioned this Ben Graham quote:

The chief practical difference between the defensive and the enterprising investor is that the former limits himself to large and leading companies whereas the latter will buy any stock if his judgment and his technique tell him it is sufficiently attractive…The field of secondary stocks cannot be delimited precisely. It includes perhaps two thousand listed issues and many thousands more of unlisted ones which are not generally recognized as belonging in the category of “large and prosperous market leaders”…The intelligent investor can operate successfully in secondary common stocks provided he buys them only on a bargain basis.

So how do you find these secondary common stocks?

Here are 6 places to start:

1. Greenbackd – Toby Carlisle writes this great blog about Ben Graham bargains or “undervalued asset situations with a catalyst” as he calls them. I interviewed Toby last year.

2. Cheap Stocks – Jon Heller writes this equally great blog about Ben Graham net current asset bargains. Actually, as Toby mentions, Jon was part of what inspired him to write his own value investing blog. I also interviewed Jon last year.

3. Interactive Investor Blog – Richard Beddard writes this U.K. centric Ben Graham style value investing blog. He runs a model portfolio called The Thrifty 30. “It’s thrifty because the shares are all cheap, usually in comparison to their average profits over the last ten or-so years.” The Thrifty 30 is a double whammy of off the beaten path stocks for American investors since Richard focuses on secondary stocks and he focuses on the United Kingdom. Most American investors aren’t even familiar with leading U.K. companies. They’re totally clueless about the ones Richard covers.

4. Value Uncovered – This value investing blog covers “mostly small-cap, obscure stocks trading at a large discount to intrinsic value” as well as “merger arbitrage, going private transactions, self-tender offers, (and) bankruptcy plays”. Things you won’t see covered by financial journalists or stock analysts.

5. Shadow Stock – This is a micro cap value investing blog. It gives you a steady steam of quick posts about almost totally unknown value stocks. No matter how much you think you know about micro caps, you’re bound to find a couple stocks here you’ve never heard of.

6. Whopper Investments – This is another value investing blog that often features micro caps. Last year I was searching for any mentions of some micro caps I owned and twice found this blog was one of the only places that mentioned the stock. Whopper Investments often covers stocks you won’t hear about elsewhere.

The other reason a stock can be neglected is because of a special situation. A good example is Ascent Media (ASCMA) – a John Malone investment – selling one business and buying another, all while remaining the same publicly traded stock. That can cause investors …

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How I Got Started In Value Investing

I started investing in stocks when I was 14. I didn’t have any real strategy or philosophy. I just tried to buy simple businesses for below average prices. I bought shares of grocery stores, snack food companies, etc. Examples of stocks I bought back then include Village Supermarket (VLGEA), J&J Snack Foods (JJSF), and Activision (ATVI). This was around the time the dot com bubble reached it’s height (like 1998-2000). Many of the stocks I bought were in my home state of New Jersey. I tried to stick to things I was familiar with. I was completely buy and hold back then.

My Dad read an article about Ben Graham. At this point, I was picking all the stocks for my Dad’s portfolio and he thought Ben Graham’s approach sounded like mine. I always started with the balance sheet. Mostly because as a teenager, I had no accounting experience, so the income statement was harder for me to understand. I was pretty much a balance sheet and cash flow statement guy. Mostly, I still am.

Anyway, when my Dad told me about Ben Graham I went out and bought Security Analysis and The Intelligent Investor. I read them and was hooked. After that, I tried to learn everything I could about Warren Buffett’s partnership days and Graham-Newman’s actual operations. I collect Moody’s Manuals from the 1910s to 1940s so I can look at the stocks Ben Graham mentions in his memoirs and Graham-Newman lists in their annual reports. Things like that.

I realized that Buffett and Graham both did best when buying really tiny, illiquid, unknown stocks. Graham did better than 20% a year just in net current asset stocks. And Buffett really does seem to have done 50% in his personal portfolio in the early 1950s. Their better known investments were good – but with the exception of GEICO – never really on the level of those kind of returns they were getting in tiny, unknown stocks.

So that’s become my focus over the years. I turn over my portfolio much more now. I’m willing to sell anything when I find something clearly cheaper. I’m not buy and hold. But I try to own very, very few stocks. Basically, I try to copy Warren Buffett’s approach to his own personal portfolio.

Unfortunately, what I invest in and what I write about doesn’t always match. Most readers are interested in bigger stocks. So I write about them most of the time.

My true love is really tiny, off the map stuff. Bancinsurance is probably the best example of what I invest in. I only managed to buy about 0.5% of the company. So, it wasn’t a huge financial success. But it’s the clearest example of what I look for these days.

Talk to Geoff About How He Got Started In Value Investing…

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International Value Investing: PaperlinX (PPX:AU) – Australia

A reader responded to my post asking for stock ideas from other countries, with this email:

Hi Geoff,

Below is a quick and simple analysis of one of the stocks in my portfolio which your readers might be interested in.

Regards,

Danny

PaperlinX (PPX:AU) – Reports

Below is Danny’s write-up on PaperlinX…

***

PaperlinX is the world’s largest paper merchant. It sources and distributes fine paper ranges, specialty paper, sign and display and graphics solutions and industrial packaging materials worldwide. PaperlinX is based in Melbourne, Australia and listed on the Australian Stock Exchange with a market capitalization of A$253m. The current share price is A$0.42 which is close to its all-time low and compares with a peak share price of approximately A$5.85 in 2003. PaperlinX is a deep value idea trading at 0.9x net tangible assets with a 49% margin of safety to my intrinsic value of $0.82.

The paper industry is highly competitive and PaperlinX has undergone significant transformation over the years, closing and selling its manufacturing facilities.  Volumes in the paper industry have been impacted by the weakening global economy and the structural decline in paper use with increased use of electronic communication. Industry participants have responded to the industry downturn by cutting capacity which has mitigated the fall in prices. As you can see below, PPX price/tonne increase in 2009 although dropping again in 2010. I have ignored the impact of the rising A$ which has a negative impact on PPX earnings.

PaperlinX’s very low margins are evidence of the highly competitive industry and its business model has significant operating leverage (a 25% decline in volume from 2006-10 led to a 70% decline in EBIT/sales margin). Increased volumes from current depressed levels will generate significant earnings growth. I have only shown the operating earnings from the Merchant business above which excludes the discontinued manufacturing business, various asset sales and restructuring costs.

An estimate of normalized earnings would be to take an average of the trading EBIT for the last four years which is A$126.1m. This is of course very simplistic and ignores price forecasts, foreign exchange, the benefit of the cost reduction programs etc which have both negative and positive impacts of earnings. If we assume that corporate costs are A$30m (in line with historical numbers), interest expense is A$20m (estimate from company) and corporate tax is 35%, applying a 10x PE multiple, the implied valuation is A$0.82 which represents a 49% margin of safety to the last share price of A$0.41.

The main catalyst for PaperlinX is an improvement in the economy. The Company’s most recent results announcement shows that leading indicators are improving however remain volatile.

I believe that at the current price level, downside risk is limited.  The EBIT implied by the current share price, applying the assumptions above and a 10x PE is approximately A$89m which is half FY2008 EBIT. In addition, at the current share price, PPX is trading at 0.9x net tangible assets.

The risk is a …

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Report: Stanley Furniture (STLY) – $5.25 Price Target

A reader of this blog sent me a report he wrote on Stanley Furniture (STLY). The stock currently trades at $4.50 a share. Mason has a $5.25 price target on the stock. Plus, there’s the possibility of additional payments from the Continued Dumping and Subsidy Offset Act (CDSOA).

Mason originally wrote the report before the rights offering. I apologize for not posting it sooner.

Mason would love to get feedback on his report from readers of the blog. So, please send him your thoughts.

Mason Wartman’s Report on Stanley Furniture (STLY)

 Send Geoff Your Investment Ideas…

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International Value Investing: Compagnie Industrielle et Financiere d’Entreprises – France

In response to my post asking for stock ideas from other countries, Pierre sent in an idea about a French stock. The stock is called “Compagnie Industrielle et Financiere d’Entreprises” or CIFE for short.

Compagnie Industrielle et Financiere d’Entreprises (INFE:FP) – Reports

Hello,

I’m a small individual investor in France. Here is an example of an interesting stock listed on NYSE Euronext/Paris. The company is involved mainly in construction (bridges, public works, etc.). Financial Statements are published only in French, on the French equivalent of the Edgar system. The company website and annual reports are in French.

However condensed financial statements can be found in English on MSN Money with the quote FR:INFE.

With a last quote of 59.49 euros, market cap is 70 (million) euros. If you have a look at the balance sheet cash and short term investments 48 Me there is also long term investments 37 Me (those are actually excess cash that was invested in certificates of deposit) long term debt is around 2 Me short term debt is around 11 Me. So basically the company is valued for its net cash. As you can see in the MSN link the company is profitable (has been for 11 years, my records don’t go before that, distributes a dividend, buys back some shares but not each year) 2009 PE ratio is 7. FCF is less good (mean value is ~ 8 Me for the last 6 years, but fluctuates and negative in 2005).

Only 30 % of the stock is public, the rest is owned by the current CEO and his family.

The stock has been moving sideways for a long, long time (MSN, Bloomberg).

Given the sorry state of the French government finances, obviously some major public infrastructure projects will be cancelled.

So here are my questions. I wonder what’s your view on this.

Is it a fantastic opportunity or a trap and why?

Regards,
Pierre

Read my Response

Talk to Geoff About International Value Investing…

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International Value Investing: Crown Van Gelder (CVG:NA) – Netherlands

A Dutch individual investor who read my post asking for stock ideas from other countries, posted a write-up on Crown Van Gelder over at GuruFocus.

Crown Van Gelder (CVG:NA) – Reports

Investment thesis 
The equity of CVG is available at a discount to its value in liquidation.

The opportunity exists because 

• Earnings are depressed due to rising pulp prices. 
• The company is managed with many interests in mind; just one of which is the interest of shareholders. 
• This is perceived to be a commodity business with no opportunity for differentiation. 

Valuation of Assets and liabilities (numbers in EUR) 

• Current assets (mostly inventory at cost and receivables) => 50m
• PP&E (two paper mills, a modern gas fired power plant and a harbour) => 65m 
• Total liabilities => 30m 
• A 50% stake in IFO BV. A logistics company that pays a 1m dividend. 

Market cap is 30m so the facility, with a book value of 65m, is available for say….15m net. This is one of the cheapest publicly traded companies in the Netherlands…

…CVG managed about 5% net margin over the past decade (excluding 2009 and 2010). The huge losses in recent years were mainly write downs of the assets; CVG is not bleeding cash….3% net margin over a full cycle => 5m.

The author also gave me the name of another interesting Dutch stock: DOCdata.

DOCdata (DOCD:NA) – Reports

By the way, I realized in my response to Pierre’s question about finding foreign microcaps, I kind of skirted the issue of finding small stocks in countries where you don’t speak the language. Instead, I just gave a list of interesting stocks from the U.K.

To prove even Americans can find small stocks in France, here are two French micro caps worth looking at: Poujoulat and Precia.

Poujoulat (ALPJT: FP) – Reports

Precia (PREC:FP)

Talk to Geoff About International Value Investing…

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How to Find Foreign Stocks: 13 Promising Companies from the U.K.

An individual investor from France sent me an email about finding great small cap stocks in other countries:

“These kind of stocks are I think virtually impossible to find for a non-local investor. I would be delighted for instance to find some German small caps but I don’t even know where to start…”

Maybe an example will help.

Let’s put aside the language difference. And just focus on the foreign stock part of the problem.

I’m from the United States. In my entire life, I’ve spent all of 15 days in the United Kingdom. My knowledge of the country is limited to cultural exports from the BBC – half of them sitcoms – and whatever I can glean from the Financial Times and The Economist.

The point is: I know nothing about the United Kingdom.

Like any investor looking at foreign stocks, I’m starting from a position of complete ignorance.

So here’s how I started looking for stocks over there.

I went to the London Stock Exchange website. And browsed the stocks alphabetically.

I went through the A’s and B’s and found 13 potentially promising companies:

1. Admiral Group (ADM:LN) – Reports

2. A.G. Barr (BAG:LN) – Reports

3. Aggreko (AGK:LN) – Reports

4. Andrews Sykes (ASY:LN) – Reports

5. Babcock International (BAB:LN) – Reports

6. Best of the Best (BEST:LN) – Reports

7. Booker (BOK:LN) – Reports

8. Braemar Shipping Services (BMS:LN) – Reports 

9. BrainJuicer (BJU:LN) – Reports

10. Brulines (BRU:LN) – Reports

11. Bunzl (BNZL: LN) – Reports

12. Burberry (BRBY:LN) – Reports

13. N Brown Group (BWNG:LN) – Reports

These stocks may or may not be good buys at these prices. I was just looking for potentially promising companies – regardless of price.

That’s how I start looking for stocks in another country. I’m only interested in good businesses I think I can understand. There are always plenty of cheap, mediocre businesses over here in the U.S. There’s no reason to hunt for them overseas. So the bar is a little higher with a foreign stock. Anything that isn’t a good business I throw out right away.

In this case, I used the following steps to find potentially promising companies:

1. I clicked on the “fundamentals” tab in the LSE page for each stock and scrolled down to the return on invested capital. I looked for a positive number that had been in the double-digits each year. Ideally, the company tended to have 20%+ returns on invested capital for the last few years.

2. I looked up the companies that passed step #1 over at Bloomberg. I read Bloomberg’s business description. If it sounded like a business I couldn’t understand (for example, it was a tech company or investment bank) I threw it out. If it sounded like a business that had the potential to earn …

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International Value Investing: Danier Leather (DL:CN) – Canada

A reader sent me this email:

Hey Geoff,

I saw your call for non-US value ideas. One of my favourite ideas right now is Danier Leather, a Canadian retailer that is really cheap and has its downside limited due to its asset-rich and debt-free balance sheet.

Cheers,

Michael

Below is Michael’s write-up on Danier Leather…

***

Danier Leather is a vertically integrated designer, manufacturer and retailer of leather goods in Canada. Danier principally sells leather outerwear (53% of sales) and accessories (37%) through 90 locations in Canada (59 shopping mall and street front stores and 31 power centre stores). Its target market is “value-oriented, fashion-conscious” men and women aged 35-55 with middle to upper class household incomes.

Danier trades under the symbol “DL” on the Toronto Stock Exchange. With a current market price of $13.50 and 4.6mn shares outstanding (1.2mn multiple voting shares and 3.4mn subordinate voting shares), Danier has a market cap of ~$61mn.

The market seems to ignore Danier because of its small market cap, lack of equity research coverage, limited liquidity and dual share structure. However, these factors allow an investor to buy an asset rich, debt-free company at substantially less than its intrinsic value.

Asset Perspective

Looking at Danier from an asset perspective, an investment presents limited downside due to the cash, inventory and real estate on the balance sheet. While cash currently represents ~15% of the company’s market cap, after the Christmas shopping season, much of the company’s inventory should convert into cash and I would expect Danier’s cash level to increase to 30-40% of its current market cap. In addition, Danier owns a 130,000 sf facility in Toronto where it conducts some manufacturing, warehousing and administrative operations. I believe there are a number of options to monetize this facility should the Company wish to do so, including:

• A sale/leaseback transaction.
• An outright sale, which could involve the Company shifting additional production to Asia and warehousing and administrative functions to leased premises. Currently, over 80% of Danier’s production is from Asia, with the remainder from its Toronto facility.
• Conversion to higher use. This facility is located in a predominantly residential area of Toronto and could be sold for, or co-developed into, residential properties.

The following is an estimate of Danier’s book value and liquidation value at September 25, 2010. While I do not think one should value Danier on a liquidation basis, I have included an estimate anyways:

Earnings Perspective

Looking at Danier from an earnings perspective, it is significantly undervalued as it is currently trading at only 2.3x LTM EBITDA. (Note: Given that we are currently in the Christmas shopping season when Danier’s cash is unusually low, I adjusted Danier’s cash balance to be the average of its cash balances over the last four quarters, thereby smoothing out the variance.) Investors can and will argue over what is an appropriate multiple but all would agree that 2.3x is too low, especially for a stable and growing company with a rock-solid balance …

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