ITT Educational Services Inc (ESI) with a return on equity and a sustainable growth rate of 165 percent, can we consider the stock a buy?
ESI Investment in Enterprise Value
Enterprise Value = Market Capitalization + Total Debt – (Cash and Cash Equivalent + Short Term Investment)
The market value of ESI was dropping from 2008 to the trailing twelve months. Total debt was 9 percent while its cash and cash equivalent were 18 percent. Therefore, enterprise value was lesser by 9 percent against the market capitalization. If you decided to buy the entire business of ESI, you would be paying 100 percent of its equity since its cash was greater than the total debt. The buying price to date, March 9, 2013, of the entire business of ESI, will be $216 million at $9 per share. The market price to date was $12.89 per share.
Benjamin Graham’s Stock Test
Net Current Asset Value (NCAV) Method
Benjamin Graham’s net current asset value (NCAV) method is well known in the value investing community. According to Graham when a stock is trading below the net current asset value per share, they are essentially trading below the company’s liquidation value and therefore, the stocks are trading in a bargain, and it is worth buying. The concept of this method is to identify stocks trading below the company’s net current asset value per share, specifically two-thirds or 66 percent of net current asset value.
Market Capitalization/Net Current Asset Value (MC/NCAV) Valuation
In this method, we will know if the stocks are trading over or undervalued by calculating market capitalization over the net current assets. The result should be less than 1.2 ratios. Graham will only buy if the ratio does not exceed 1.2 ratios.
Market Capitalization / NCAV = Result (must be lesser than 1.2)
The MC/NCAV approach of Benjamin Graham tells us that the stock of ESI was overvalued from 2008 to the trailing twelve months because the ratio was greater than the 1.2 ratios. The average ratio was 13 which is 106 percent over 1.2 ratios. This indicates that the stock did not pass the stock test by Benjamin Graham because the stock price was expensive.
Benjamin Graham’s Margin of Safety (MOS)
The margin of safety is used to identify the difference between company value and price. Value investing is based on the assumption that two values are attached to all companies – the market price and the company’s business value or true value. Graham called it the intrinsic value. The difference between the two values is called the margin of safety. According to Graham, the investor should invest only if the market price is trading at a discount to its intrinsic value. Value investing is buying with a sufficient margin of safety. Graham considers buying when the market price is considerably lower than the intrinsic or real value, a minimum of 40 to 50 percent below. The enterprise value is used because I think it is a much more accurate measure of the company’s true market value than market capitalization.
The margin of safety was 98 percent average. This means there is a sufficient margin of safety in buying the stock of ESI. This is more than the required 40-50 percent below the intrinsic value. Let us walk further on how to calculate the intrinsic value. The formula for intrinsic value was:
Intrinsic Value = Current Earnings x (9 + 2 x Sustainable Growth Rate)
The explanation in the calculation of intrinsic value was as follows:
EPS or the company’s last 12-month earnings per share; G as the company’s long-term (five years) sustainable growth estimate, 9 for the constant represents the appropriate P-E ratio for a no-growth company as proposed by Graham (Graham proposed an 8.5, but we changed it to 9); and 2 for the average yield on high-grade corporate bonds.
The average intrinsic value for ESI was $2946, from the period 2008 to the trailing twelve months. The earning per share and the sustainable growth rate factors the calculation of intrinsic value. In the table above shows, that the average earnings per share were $7.9 and the annual growth rate was 340 percent.
The term earnings per share (EPS) represent the portion of a company’s earnings, net of taxes and preferred stock dividends that were allocated to each share of common stock. The figure can be calculated by simply dividing net income earned in a given reporting period by the total number of shares outstanding during the same term. Because the number of shares outstanding can fluctuate, a weighted average is typically used.
Earnings per Share
The formula for earning per share was:
Sustainable growth rate (SGR), on the side note, shows how fast a company can grow using internally generated assets without issuing additional debt or equity. Return on equity (ROE) is a factor in calculating the sustainable growth rate of a certain company. You also need to know the dividend payout ratio. From there, multiply the company’s ROE by its plow back ratio, which is equal to 1 minus the dividend payout ratio.
Sustainable growth rate = ROE x (1 – dividend-payout ratio)
The table above shows that the average sustainable growth rate was the same as the return on equity at 165 percent because there was a zero percent payout ratio. The sustainable growth rate of ESI was decreasing in general at a rate of 3 percent average for the period 2008 up to the trailing twelve months.
Let’s proceed with return on equity or ROE. When we speak of this, we are referring to an indicator of a company’s profitability by measuring how much profit the company generates with the money invested by common stock owners. ROE shows how many dollars of earnings result from each dollar of equity. The formula is:
Now, there are two ways of computing the sustainable growth rate, they are the relative approach and the average approach. I have used the relative approach in the computations above.
Relationship of the Intrinsic Value and Margin of Safety in Graph
The intrinsic value line was very much higher than the enterprise value line. During 2010, the true value of the stock of ESI soared up high at a rate of 111 percent. Then it dropped at a rate of -21 percent in the following year and dropped again in 2012 at a rate of -75 percent. Then it remained stable for the trailing twelve months. On the other hand, the price was average $49 dropping at a rate of 31 percent average. The space between these two lines, which is the true value of the stock and the price, is the margin of safety. After getting the difference between the true value and price, it resulted in 98 percent and that is the margin of safety.
ESI Relative Valuation Methods
The relative valuation methods for valuing a stock is to compare the market values of the stock with the fundamentals (earnings, book value, growth multiples, cash flow, and other metrics) of the stock. Let’s get into this P/E*EPS.
Price to Earnings/Earning Per Share (P/E*EPS)
ESI was undervalued because the price was lesser than the P/E*EPS ratio.
The approach applied in computing the P/E*EPS valuation above was the relative approach. That is by using the average approach. I have prepared a table to compare the two approaches.
The Enterprise value (EV) /Earning Per Share (EPS) or (EV/EPS)
The use of this ratio is to separate price and earnings in the enterprise value. By dividing the enterprise value of projected earnings (EPS), the result will then represents the price (P/E) and the difference represents the earnings (EPS).
The EV/EPS valuation tells us that the price (P/E) was 14 percent average. And also, the earnings (EPS) was an 86 percent average. The result of this valuation is either over or undervalued, depending upon the analyst’s discretion; whether the ratio is appropriate or not.
Enterprise Value (EV)/ Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) or (EV/EBITDA)
This metric is used in estimating business valuation. It compares the value of the company inclusive of debt and other liabilities to the actual cash earnings exclusive of non-cash expenses. This metric is useful for analyzing and comparing profitability between companies and industries. It shows us how long it would take the earnings of the company to pay off the price of buying the entire business, including debt.
The EV/EBITDA valuation tells us that it will take 4 years to cover the costs of buying the entire business. In other words, buying ESI will take 4 times the cash earnings of the company to cover the purchase price.
This approach also shows the profitability of the company and the ability of the management in generating cash. Considering this, ESI’s gross margin was 62 percent average while its net margin was 18 percent average.
Overview, the relative value indicates that the stock price was cheap. Further, the margin of safety was high at a 98 percent average. Furthermore, the return on equity was 165 percent. Therefore, I recommend a BUY on the stock of ITT Educational Services Inc (ESI).
Researched and Written by Cris