# Microsoft Corporation (MSFT) Distinguished as High Quality

March 18th, 2013 Posted by No Comment yet

Microsoft Corporation (MSFT) which is said to be as one of the best companies in America distinguished themselves as high quality.

## MSFT Value Investing Approach

This model is prepared in a very simple and easy way to value a company, it adopts the investment style of the Father of Value Investing Benjamin Graham. The essence is that any investment should be purchased at a discount, meaning the true value should be more than the market value. Graham believed in fundamental analysis and was looking for companies with a sound balance sheet and with little debt. The basis for this valuation is the company’s five years of historical financial records, the balance sheet, income statement, and cash flow statement. We calculated first the enterprise value as our first step. We believed this is important because it measures the total value of the company.

## MSFT Discounted Cash Flow (DCF) Model

This model will show us how to calculate the value. I will walk you through every step of the calculation. The table below shows the historical value of Microsoft. With the formula, here’s how:

Where:

• Vo is the value of the equity of a business today.
• CF1 to CFn represent the expected cash flows (or benefits) to be derived for periods 1 to n.  The discounted cash flow model is based on time periods of time of equal length.  Because forecasts are often made on an annual basis in practice, we use the terms “periods” and “years” almost interchangeably for purposes of this theoretical discussion.
• r is the discount rate that converts future dollars of CF into present dollars of value.

The equation above is the basic discounted cash flow (DCF) model.

This model shows the historical equity, net income and the retained earnings per share together with the projected equity, net income, and the retained earnings. Return on investment, growth and the price to earnings were also calculated and can be seen in the table.

#### Explanation

The above cash flow spreadsheet was based on the ten-year historical data of income and expense as well as the equity and dividends of Microsoft Corporation. The capitalization rate that used was 15 percent and the return on investment was 38.46 percent, which is the average ROI from the period 2008.  The price to earnings that was used was \$13, which is the average from the period 2008. The computed present value of MSFT was \$64.60 per share for a total amount of \$549 million.  For the calculated 5th year income, the result was \$11.40 per share for a total amount of \$96,974 (in million), discounted at present value. On the other hand, the present value of net income was \$42 million.

#### Interpretation

The calculated present value of equity was \$9.00 per share at the rate of 26.92 percent, while the future value at year 6 was \$29.64 per share which is equal to the present value of \$9.00 per share. You could have taken the money today at \$29.64 per share instead of waiting six periods to have it. You would have a chance to reinvest the money today, at the same rate and will have a chance to double the amount, In addition, the future value of equity was \$1.3 billion.

## MSFT Investment in Enterprise Value

The concept of enterprise value is to calculate what it would cost to purchase an entire business.

#### Explanation

The market capitalization of MSFT was trending up and down at a rate of 5 percent average. The total debt represents 4 percent of the enterprise value, while the cash and cash equivalent represent 25 percent average of the enterprise value, therefore the enterprise value was lesser of 21 percent of the market capitalization. Purchasing the entire business of Microsoft, the investor will be paying 100 percent of its equity and zero debt because the debt has offset by cash and cash equivalent.

The purchase price of the entire business of Microsoft to date, March 15, 2013, will be \$181.5 billion at \$21.36 per share.  The market price to date was at \$28.14 per share.

### Net Current Asset Value (NCAV) Method

Net Current Asset Value (NCAV) method is well-known in the value investing community.  Studies have all shown that the Net Current Asset Value (NCAV) method of selecting stocks has outperformed the market significantly.

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 stock was trading at a bargain, and it is worth buying.

The concept of this method is to identify stocks trading at a discount to the company’s Net Current Asset Value per Share, specifically two-thirds or 66 percent of net current asset value.

#### Explanation

The net current asset value valuation indicates that the stock price of MSFT was overvalued from the period 2008 to the trailing twelve months of 2013 because the 66 percent ratio represents only 11 percent of the market price. This means that the stock of Microsoft Corporation was trading above the liquidation value of the company.

### Market Capitalization/Net Current Asset Value (MC/NCAV) Valuation

Showing the results of MC/NCAV valuation for MSFT, the stock was trading at overvalued prices from 2008 up to the trailing twelve months of 2013 because the result of the ratios exceeded the 1.2 ratios. Further, the 1.2 ratio represents only 16 percent of the average computed ratios.

### The Margin of Safety (MOS)

The Margin of Safety requires knowing when the buying price is low in absolute terms, rather than merely relative to the market as a whole. This formula is used to identify the difference between company value and price. The enterprise value was used because it takes into account the balance sheet since it is a much more accurate measure of the company’s true market value than market capitalization.

#### Explanation

The margin of safety for MSFT was an 80 percent average at \$111 average. The enterprise value was at \$22 average which represents 17 percent of the intrinsic value, while on the other hand, the intrinsic value was at \$132.33 average.

Let us find out how to calculate the intrinsic value of MSFT. The formula 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 is the constant represents the appropriate P-E ratio for a no-growth company as proposed; and 2 for the average yield on high-grade corporate bonds.

#### Explanation

Now, that we have learned the formula and the explanation of the calculation, let us now see the results by looking at the table below.

The earnings per share (EPS) and the sustainable growth rate (SGR) factor the calculation of the intrinsic value. The Earnings Per Share was \$2 average from 2008, while the annual growth rate was \$64 average and calculated through:

#### Sustainable Growth Rate (SGR)

To calculate the sustainable growth rate for a company, you need to know how profitable the company is as measured by its return on equity (ROE). You also need to know what percentage of a company’s earnings per share is paid out in dividends, which is called 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.

To simplify, the formula would be: Sustainable growth rate = ROE x (1 – dividend-payout ratio)

#### Return on Equity (ROE)

Return on Equity (ROE) is an indicator of a company’s profitability by measuring how much profit the company generates with the money invested by common stock owners. In other words, ROE shows how many dollars of earnings result from each dollar of equity.

#### Explanation

The return on equity was average 39 percent and the payout ratio was 30 percent average from the period 2008. Sustainable growth rate resulted in 28 percent. The other way of calculating the sustainable growth rate was the average approach, using the average ROE.  The table below will show us the difference between the two approaches.

As seen in the table,  the average approach produced a higher result because it takes into consideration the previous period’s performance. In addition, the margin of safety in an average approach was 82 percent.

#### The Intrinsic Value Graph

The graph above shows that the enterprise value line was stable at \$21 average and was trending at 10 percent average, while the intrinsic value has an erratic movement of ups and down. As we can see, in the period of 2010 and 2011, the intrinsic value line soared up at 57 and 34 percent, respectively. For the reason, during those periods, the growth went up high which resulted in a higher intrinsic value.

Now, the question is “Where is the margin of safety?” The margin of safety is the space in between the two lines, which is the true value line and the price line. To calculate for the margin of safety, simply get the difference of the intrinsic value and the enterprise value and that is your margin of safety.  The average margin of safety was 80 percent.

Price to Earnings/Earning Per Share (P/E*EPS)

This valuation will determine the status of the stock price because stocks may be undervalued or overvalued. One way to do this is by simply multiplying the Price to Earnings (P/E) ratio with the company’s relative Earning per Share (EPS) and comparing it to the enterprise value per share.

#### Explanation

The P/E*EPS valuation shows that the price was undervalued because the enterprise value was lesser by 18 percent against the P/E*EPS ratio.  The price represents 82 percent of the P/E*EPS ratio.

It tells us that the stock price of Microsoft Corporation was cheap using this valuation.  Another way of calculating this valuation is by the use of the average approach.  Below is the difference between the two approaches.

The average approach marked a higher result because it takes into consideration past performance.

### 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 represents the price (P/E) and the difference represents the earnings (EPS).

#### Explanation

The EV/EPS valuation, tells us that the price (P/E) that was 51 percent, while the earnings (EPS) was 49 percent.  This might indicate that the stock is trading at an almost fair price.

### 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 gives us an idea of how long it would take the earnings of the company to pay off the price of buying the entire business, including debt.

#### Explanation

The EV/EBITDA valuation tells us that it will take 7 years to cover the cost of buying the entire business of Microsoft Corporation.  In other words, it will take 7 times of the cash earnings of the company to cover the purchase price.

This valuation also shows the profitability of the company.  The EBITDA represents only 14 percent of the enterprise value; therefore it will take a long period of waiting to cover the purchase price of the entire company. The gross margin and the net margin of Microsoft were 78 and 27 percent average, respectively.

#### In conclusion,

The present value of MSFT was \$64.60 per share for a total amount of \$549 million.  The calculated present value of equity was \$9.00 per share at the rate of 26.92 percent, while the future value at year 6 was \$29.64 per share which is equal to the present value of \$9.00 per share. You could have taken the money today at \$29.64 per share instead of waiting six periods to have it. You would have a chance to reinvest the money today, at the same rate and will have a chance to double the amount. In addition, the future value of equity was \$1.3 billion.

#### Enterprise Value Approach

The total debt was 4 percent while the cash and cash equivalent were 25 percent. Thus the enterprise value was lesser of 21 percent of the market capitalization.  Buying the entire business is paying 100 percent of its equity.  Meanwhile, the purchase price of the entire business to date, March 15, 2013, was \$181.5 billion at \$21.36 per share.  The market price to date was at \$28.14 per share.

#### Current Asset Value

The net current asset value approach shows that the stock of MSFT was trading at overvalued prices from 2008. The stock price was expensive because it was trading above the liquidation value of the company. The price was overvalued since the results exceeded the 1.2 ratios.

#### Margin of Safety

The margin of safety shows that there was a margin of safety at an 80 percent average at \$111. The enterprise value was at \$22 average which represents 17 percent of the intrinsic value. While the intrinsic value was at \$132.33 average. The Earnings Per Share was \$2 average from the period 2008, while the annual growth rate was \$64 average. In addition, the return on equity was average 39 percent and the payout ratio was 30 percent average. The sustainable growth rate was 28 percent.

#### The Relative Valuation Approach

Furthermore, the relative valuation method shows that the stock was trading at an undervalued price. The enterprise value represents 82 percent of the P/E*EPS ratio. The EV/EPS valuation shows that the price (P/E) was 51 percent and the earnings (EPS) was 49 percent. This might indicate that the stock is trading at a fair value.

#### The EV/EBITDA

EV/EBITDA tells us that it will take 7 years to cover the cost of buying the entire business of MSFT.  The gross and net margins were 78 and 27 percent average, respectively.

Overall, the stock of MSFT was trading at fair value, although there was a margin of safety of 80 percent. Therefore, I recommend a BUY in the stock of Microsoft Corporation (MSFT).

Research and Written by Cris

# DryShips Inc (DRYS) as a Global Shipping Transportation Company

March 13th, 2013 Posted by No Comment yet

DryShips Inc (DRYS) is a global shipping transportation company specializes in the transportation of dry bulk cargoes. Not only, but they also provide reliable and trusted transportation services at competitive cost.

## Who started the company and why?

DryShips Inc. is a Marshall Island registered company which was formed on September 9, 2004. The company is located at Omega Building, 80 Kifissias Avenue, Amaroussion GR 151 25, Greece. Its stock is listed on NASDAQ. The core of the business is building and maintaining enduring relationships with charterers of dry bulk carriers and providing reliable seaborne transportation services at competitive cost.

The company’s current CEO, Mr. George Economou, has been active in shipping since 1976 and formed the company’s related technical and commercial ship-management company, Cardiff Marine Inc.

It found in the suburb of Maroússi, 12km/7.5mi north of Athens that occupies the site of the ancient deme of Athmonia, where there was a sanctuary of Artemis Amarysia. In more recent times it has become known through Henry Miller’s “Colossus of Maroussi”.

## What is the nature of DryShips Inc. business?

Offshore drilling refers to a mechanical process where a wellbore is drilled through the seabed. It is typically carried out in order to explore for and subsequently extract petroleum which lies in rock formations beneath the seabed. Also, offshore drilling presents environmental challenges, both from the produced hydrocarbons and the materials used during the drilling operation.

DryShips Inc. is a holding company affianced in the ocean transportation services of dry bulk cargoes and crude oil worldwide. The company is a global shipping transportation company specializing in the transportation of dry bulk cargoes through its majority owned subsidiary, Ocean Rig UDW Inc. It owns and operates dry bulk carrier vessels and oil tankers and offshore drilling services through the ownership and operation of ultra-deep-water drilling units. Company’s vessels are able to trade worldwide in a multitude of trade routes carrying a wide range of cargoes for a number of industries. Their cape size and Panamax dry bulk carriers carry predominantly coal and iron ore for energy and steel production as well as grain for feedstocks. The handymax and handy size dry bulk carriers carry iron and steel products, fertilizers, minerals, forest products, ores, bauxite, alumina, cement, and other construction materials. The company’s common stock is listed on the NASDAQ Global Select Market where it trades under the symbol “DRYS.”

## Who is running DryShips Inc and their background?

The chief financial officer is the CFO of a company and the chief executive officer is the CEO of a company. The CFO is responsible for a company’s financial affairs and reports to the CEO. To differentiate between the two, think of the CFO as the head of the company’s financial departments and the CEO as head of the entire company. Meriam and Karla will now introduce to us the people running the company and bits of information on their background.

Mr. George Economou served as chairman, president, and chief executive officer of DryShips Inc. since its inception in 2004. He has overseen the company’s growth into the largest US-listed dry bulk company in fleet size and revenue and the second largest Panamax owner in the world. From 1981-1986, he held the position of general manager of Oceania Maritime Agency in New York. He has been a director and the president of All Ships Ltd. and since 2010; he has been a member of the board of directors of Danaos Corporation. Mr. Economou was born and raised in Athens, Greece and a graduate of Athens College completed his higher education in the United States at the Massachusetts Institute of Technology in Boston. He is a graduate of the Massachusetts Institute of Technology and holds both a Bachelor of Science and a Master of Science degree in Naval Architecture and Marine Engineering and a Master of Science in Shipping and Shipbuilding Management.

Mr. Ziad Nakhleh is the chief financial officer of DryShips Inc., since November 2009 and he had 12 years of finance experience. He served as a chief financial officer of Aegean Marine Petroleum Network Inc. He was extensively involved in maintaining investor confidence and contributing to the expansion of the company by way of corporate and asset acquisitions. Mr. Nakhleh was engaged in a consulting capacity to various companies in the shipping and marine fuels industries. He was employed at Ernst & Young and Arthur Andersen in Athens. He is a graduate of the University of Richmond in Virginia and is a member of the American Institute of Certified Public Accountants.

## Who is directing the company? How are the committees structured?

Dry Ships Inc. has three committees namely: audit, compensation and nominating. The role of the compensation committee is to set appropriate and supportable pay programs that are in the organization’s best interests and aligned with its business mission and strategy. With the adoption of the executive and director compensation disclosure rules by the SEC, changes to the accounting for certain equity awards, and more active shareholder groups wanting a “say on pay,” the compensation committee is working harder to meet the requirements of all observing parties.

Mr. Harry G. Kerames. He is the chairman of the audit committee and member of the compensation committee and an independent director of DryShips Inc.,since July 29, 2009. He has over 22 years of experience in the transportation industry. He has been the managing director of Global Capital Finance where he was responsible for the firm’s shipping practice. Mr. Kerames served as chief marketing officer of Charles R. Weber Company Inc., a ship broker and marine consulting firm, where he brokered tanker freight derivatives, and co-founded a freight derivatives hedge fund. He received a Bachelor of Science from the University of Connecticut.

Mr. Evangelos Mytilineos, the chairman of compensation committee and member of nominating committee. He is an independent director since December 2008. He has over 20 years of experience in the shipping industry. He served as a senior executive in the Peraticos and Inlessis group of companies, which are involved in the drybulk and tanker shipping sectors. Mr. Mytilineos studied at the Athens University of Economics. Mr. George Demathas is an independent director of DryShips Inc., since July 18, 2006. He was also a director of Ocean Rig ASA from 2008 to 2010. He has been the chief executive Officer and a director of Stroigasitera Inc. He has been involved in Malden Investment Trust Inc. in association with Lukoil, working in the Russian petrochemical industry. Mr. Demathas is based in Moscow and travels widely in Europe and the United States. He has a Bachelor of Arts in Mathematics and Physics from Hamilton College in New York and a Master of Science in Electrical Engineering and Computer Science from Columbia University.

## How do they make money?

Voyage charter is a charter where a contract is made in the spot market for the use of a vessel for a specific voyage for a specified freight rate per ton. If a charter agreement exists and collection of the related revenue is reasonably assured, revenue is recognized as it is earned ratably during the duration of the period of each voyage. A voyage is deemed to begin upon the completion of discharge of the vessel’s previous cargo and is deemed to end upon the completion of discharge of the current cargo.

The company has three reportable segments from which it derives its revenues: Dry bulk, Tanker and Drilling segments. Currently, revenues in the offshore drilling segment depend on two ultra-deepwater drilling rigs and four drill ships. DRYS makes most of its profits by chartering its vessels to other companies that pay a contracted daily rate to use the ships. It is also derived from contracts including day rate based compensation for drilling services.

They generate all revenues in U.S. Dollars in the drybulk and tanker segments but incur approximately 26.7 percent of operating expenses and the majority of general and administrative expenses in currencies other than the U.S. Dollar, primarily the Euro.

## How do they fit in the industry they operate in?

Dry bulk cargo is cargo that is shipped in quantities and can be easily stowed in a single hold with little risk of cargo damage. The company faces competition in Dry Bulk, Tanker and Drilling Industry. Competition for the transportation of dry bulk cargo by sea is intense and depends on price, location, size, age, condition and the acceptability of the vessel as well as company’s reputation as an owner and operator. It also competes with other owners of dry bulk carriers in the Capesize, Panamax and Supramax size sectors.

The tanker industry is highly competitive, arises primarily from other vessel owners, some of whom have substantially greater resources than DRYS. Offshore contract drilling industry is highly competitive with several industry participants, none of which has a dominant market share and is characterized by high capital and maintenance requirements. Major competitors are: Navios Maritime, Eagle Bulk, Excel Maritime, Genco Shipping and Diana Shipping.

## Who are their suppliers and customers?

Offshore drilling simply means the process of exploiting mineral resources in the seabed; most of those resources are related to the oil and gas industries. Drilling is conducted by several kinds of specialized vessels, some with a planing hull supporting huge legs and a drilling platform, some with legs more than 300 feet long that rest on the seabed to support a drilling platform, and some that are ships, either purpose-built or converted from other forms of commercial vessel, with a drilling rig on top.

DRYS has three reportable segments such as; the Drybulk , Tanker, and Drilling, which reflects the international organization of the company and are strategic business that offers different products and services. DryBulk fleet mainly carries a variety of dry bulk commodities including major bulk items such as coal, iron ore, and grains, and minor bulk items like bauxite, phosphate, fertilizers and steel products. Drilling business segment is consists of trading of the drilling rigs and drill ships through ownership and trading of such drilling rigs and drill ships. Tanker business segment is consists of vessels for the transportation of crude and refined petroleum cargoes. Its customers generally fall within three categories: national oil companies, large integrated major oil companies and medium to smaller independent exploration and production companies. DRYS and its predecessor, Ocean Rig ASA, both have an established history with 121 wells drilled in 13 countries for 23 different customers.

## What is their workforce like?

A skilled worker is any worker who has some special skill knowledge, or ability in their work. They may have attended a college, university or technical school or, a skilled worker may have learned their skills on the job. DRYS only requires highly skilled personnel to work in their company. They are the ones who operate and provide technical services and support for its business in the offshore drilling sector worldwide.

As of December 31, 2011, the company employed 1,305 employees, the majority of whom are full-time crew employed on drilling units. Continued operations depend upon on key management personnel, particularly chairman and chief executive officer Mr. George Economou. DRYS has an agreement with TMS Bulkers, as a successor to Cardiff, which was in the business of providing commercial and technical management for over 22 years, and continue to provide competitive employment opportunities on company’s vessels in the future.

## How do they treat their employee? Its pay and working condition like?

Equity Incentive Plan Agreement is a legal contract between a corporation and its employees to provide the employee with an interest in the corporation. The purpose of an Equity Incentive Plan is to strengthen the financials of the corporation by providing incentive stock options to its employees. The Plan serves as a means to attract, retain, and motivate corporate personnel. DRYS has a strong commitment topromoting honest and ethical business conduct by all employees in compliance with the laws that govern the conduthe ct of the company’s business worldwide. It developed a code of business ethics and conduct, the code, which applies to all affiliates of the company and all employees, directors, officers, and agents of the company.

On January 16, 2008, the company’s board of directors approved the 2008 Equity Incentive Plan. This plan has three retirement benefits plans for employees and managed as well as funded through Norwegian Life insurance. The company renders a stock-based compensation which represents restricted common stock granted to employees and directors for their services. On January 18, 2008, the company entered into a Stockholders Rights Agreement in which declared a dividend payable of one preferred share purchase right.

CITATION

Who started the company and why?

What is the nature of the business?

How do they treat their employee? What is the pay and working condition like? http://dryships.irwebpage.com/files/dryscoe.pdf http://www.sec.gov/Archives/edgar/data/1308858/000119312511099671/d20fa.htm http://www.sec.gov/Archives/edgar/data/1308858/000119312511099671/d20fa.htm

Researched and Written by Meriam and Karla
Edited by Cris

# ITT Educational Services Inc (ESI) Investment Valuation

March 12th, 2013 Posted by No Comment yet

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

The concept of enterprise value is to calculate what it would cost to purchase an entire business. Enterprise  Value (EV) is the present value of the entire company.  Market capitalization is the total value of the company’s equity shares. In essence, it is a company’s theoretical takeover price, because the buyer would have to buy all of the stock and pay off existing debt, and taking any remaining cash.  The formula is given below:

Enterprise Value = Market Capitalization + Total Debt – (Cash and Cash Equivalent + Short Term Investment)

#### Explanation

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.

#### Explanation

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.

#### Explanation

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)

#### Explanation

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

#### Explanation

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).

#### Explanation

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.

#### Explanation

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.

Conclusion

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

# Is there Safety in Buying BBVA Banco Frances S.A. ADR (BFR)

March 7th, 2013 Posted by No Comment yet

BBVA Banco Frances S.A. ADR (BFR) Value Investing.

This model is prepared in a very simple and easy way to value a company, it adopts the investment style of the Father of Value Investing Benjamin Graham. The essence is that any investment should be purchased at a discount, meaning the true value should be more than the market value. Graham believed in fundamental analysis and was looking for companies with a sound balance sheet and with little debt. The basis for this valuation is the company’s five years of historical financial records, the balance sheet, income statement, and cash flow statement. We calculated first the enterprise value as our first step. We believed this is important because it measures the total value of the company.

## BFR Value Investing Approach

This method of valuation approach for BBVA Banco Frances SA (ADR) was based on the Discounted Model.  The historical data were calculated and then we come up with the projected financial data and ratios to come up with the present value of the 6th year period. Net present value is one way to decide if an investment is worthwhile by looking at the projected cash inflows and outflows.  Cash inflows are the expected cash that the company can generate for the period. Cash outflows are the expenditures to be incurred from generating cash inflows.

The model does not predict the future. However,  it uses the historical financial data of the company to project a future financial picture so that readers may understand parameters that are not easily understood without using a spreadsheet model.

### Discounted Cash Flow Model

We’ve mentioned the Discounted Model on the above statement. What is this really? As I’ve found out, this model will show us how to calculate the value.  We used the formula:

Where:

• Vo is the value of the equity of a business today.
• CF1 to CFn represent the expected cash flows (or benefits) to be derived for periods 1 to n.  The discounted cash flow model is based on time periods of time of equal length.  Because forecasts are often made on an annual basis in practice, we use the terms “periods” and “years” almost interchangeably for purposes of this theoretical discussion.
• r is the discount rate that converts future dollars of CF into present dollars of value.

The table below shows the historical value of BBVA Banco Frances SA (ADR).

#### Explanation

The above-discounted cash flow spreadsheet was based on ten-year historical data for revenue, expense, and equity plus the dividend data together with its ratios. I used a capitalization rate of 15 percent and the return on investment that was used was 25.39 percent, which is the average ROI for 5 year periods, 2008 to 2012. The price that was used, on the other hand, was the current price of 2012, which is \$4.24.

#### Present Value

The calculated present value of BFR’s equity was \$36.98 per share with a total amount of \$6.6 billion, at a rate of 25.39 percent. The future value was \$114.62 per share with a total amount of \$20.5 billion.  This future value is equal to the present value of \$36.98 per share. This means, leaving you a choice of having \$36.35 today or wait for the 6 time periods to have the \$114.62 per share. If you take the \$36.98 today, you will have a chance to reinvest the money at 25.39 percent, with the equal time periods and will end up having more than \$36.98 per share.

On the other hand, the future price of its equity was \$48.16 per share with a total amount of \$8.6 billion. Furthermore, the calculated 5th-year income was \$29.10 per share with a total amount of \$5.2 billion, discounted today at the present time.

#### Data Used

I used the company’s five years of historical financial records, the balance sheet, income statement, and cash flow statement as our basis for this valuation. In this model, the enterprise value was calculated first as our first step in the valuation. I consider this important because this is a great measure of the total value of a firm and is often great starting points for negotiation of a business.

## BFR Investment in Enterprise Value

The concept of enterprise value is to calculate what it would cost to purchase an entire business. Enterprise  Value (EV) is the present value of the entire company.  Market capitalization is the total value of the company’s equity shares. In essence, it is a company’s theoretical takeover price, because the buyer would have to buy all of the stock and pay off existing debt, and taking any remaining cash.  The formula is given below:

Enterprise Value = Market Capitalization + Total Debt – (Cash and Cash Equivalent + Short Term Investment)

#### Explanation

The market capitalization of BFR was erratic in movement and trending at a rate of 23 percent average. There was zero debt and the cash and cash equivalent was 131 percent of the enterprise value, and its market capitalization was 24 percent of cash and cash equivalent. As a result, the enterprise value was negative. The investor will pay 100 percent of BFR’s equity, no debt if he/she buys the entire business of the company.

The purchase price to date, February 27, 2013, of the entire business of BFR, is negative \$7.8 billion because cash and cash equivalent are greater than the market value. In essence, this is the company’s takeover price. The buyer will pay all the total debt and pocket any remaining cash. Since the company has zero total debt, the investor will pocket all the remaining cash left, it is like buying the company for free. The market price to date was \$4.24 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.  Studies have all shown that the net current asset value (NCAV) method of selecting stocks has outperformed the market significantly. 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 at a discount to the company’s net current asset value per share, specifically two-thirds or 66 percent of net current asset value.

#### Explanation

Above table tells us that the stock price of BBVA Banco Frances, S.A. ADR was undervalued. The reason is that the 66 percent ratio was greater than the market price, thus, indicating the stock price was cheap.

The NCAVPS indicates that the stock of BFR is trading below the liquidation value of the company. Therefore the stock has passed the stock test of Benjamin Graham. Hence, the stock is a candidate for buying.

### Market Capitalization/Net Current Asset Value (MC/NCAV) Valuation

By calculating market capitalization over the net current asset value of the company, we will know if the stock is trading over or undervalued. 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)

#### Explanation

The MC/NCAV approach shows that the stock price was undervalued because the ratio has not exceeded the 1.2 ratios. The average ratio was only 0.16, representing only 13 percent of the 1.2 ratios. It indicates that the stock of the BFR stock price was cheap from 2007 to the trailing twelve months 2012.

### Benjamin Graham’s Margin of Safety (MOS)

The margin of safety is used to identify the difference between company value and price. Which are the market price and the company’s business value or true value. Graham called it the intrinsic value. 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 (MOS)

The Margin of Safety =  Enterprise Value – Intrinsic Value.

Since the enterprise value was negative at 8 percent over the intrinsic value, the margin of safety for BFR was over 100 percent which is 118 percent average. It indicates that buying the stock of the company will have an ample margin of safety, meaning the stock is a good candidate for buying.

#### The Intrinsic Value

The formula was:  Intrinsic Value =  Current Earnings x (9 + 2 x Sustainable  Growth Rate)

The explanation in the calculation of intrinsic value was as follows:

EPS is the company’s last 12-month earnings per share;  G is the company’s long-term (five years) sustainable growth estimate; 9 as 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 of high-grade corporate bonds.

#### Explanation

The intrinsic value was average \$252, while the annual growth rate was 45 percent average. The earning per share was \$4.7 average. The term earnings per share (EPS) represent the portion of a company’s earnings, net of taxes and preferred stock dividends. The figure can be calculated simply by dividing net income earned in a given reporting period by the total number of shares outstanding during the same term.

#### Earnings per Share

Below is the formula for the earnings per share:

#### Sustainable Growth Rate

On the other hand, the sustainable growth rate (SGR) shows how fast a company can grow using internally generated assets without issuing additional debt or equity. To calculate the sustainable growth rate for a company, you need to know its return on equity (ROE). 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 below will make us easily understand the parameters.

#### Explanation

The return on equity and a payout ratio factor the calculation of the sustainable growth rate. The average return on equity on the above table was 26 percent, while the payout ratio was 32 percent average. In addition, the average sustainable growth rate was 18 percent average. Return on Equity (ROE) is an indicator of a company’s profitability by measuring how much profit the company generates with the money invested by common stock owners. In addition, Return on Equity shows how many dollars of earnings result from each dollar of equity.

#### Return on Equity

Now, there are two ways of computing the sustainable growth rate; the relative approach and the average approach. I computed both approaches for us to know the difference.

#### Explanation

The average approach takes into consideration the prior period’s performance. As a result, the table shows that the relative approach produces a higher result, except for the margin of safety, where the average approach was greater by 1 percent.

The graph below which I have prepared to make it more understandable.

#### Explanation

The graph shows two lines; the enterprise value line and the intrinsic value line. The enterprise value represents the market price, while the intrinsic value is the true value of the stock of BFR. The market value line was below line zero.  It was stable at an average of negative \$20. On the other hand, the true value of the stock of BFR was erratic in movement; trending at an average of 163 percent.  During the period of 2011, it dropped at a rate of 67 percent and managed to rise in the trailing twelve months at a rate of 486 percent.

The margin of safety was the space in between these two lines, from 2007 to the trailing twelve months. In order to get the figures for a margin of safety, we have to get the difference between the true value and the market value of the stock, then the result is the margin of safety.  The graph above indicates an average of 118 percent margin of safety. I hope the graph makes you fully understand the real meaning of the margin of safety.

## BFR Relative Valuation Methods

The concept of relative valuation methods for valuing a stock is to compare market values of the stock with the fundamentals (earnings, book value, growth multiples, cash flow, and other metrics) of the stock.

### Price to Earnings/Earning Per Share (P/E*EPS)

By multiplying the Price to Earnings (P/E) ratio with the company’s relative Earning per Share (EPS) and comparing it to the enterprise value per share.

#### Explanation

The stock price of BFR was undervalued because the PE*EPS ratio is greater than the enterprise value. The enterprise value was average 83 percent, negative against the ratio. This indicates that the stock price of BFR was trading at a cheap price.

#### The Relative and the Average Approaches

There are two approaches in calculating the PE*EPS valuation, the relative approach and the other one is the average approach.  For the calculation above, I have used the relative approach. The table below shows a summary of the results of the two approaches.

As shown in the table above, the average approach produced a higher result than by using the relative approach. The reason behind this is that the average approach takes into considerations the prior period’s performance.

### The Enterprise value (EV)/Earning Per Share (EPS) or (EV/EPS)

The use of this ratio is to separate the enterprise value per share by its projected earnings. To do this, we divide the enterprise value per share to earning per share, then the result represents the price (P/E) and the difference represents the earnings (EPS). This separates the price to earnings ratio and the earning per share.

#### Explanation

The EV/EPS valuation tells us that the price (P/E) was 28 percent average While the earnings (EPS) was a 72 percent average. Because the price was only a little bit over one-fourth of the enterprise value.

The result of this valuation is upon the analyst’s own discretion. Whether the analyst thinks 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 gives us also an idea of how long it would take the earnings of the company to pay off the price of buying the entire business, including debt.

#### Explanation

The EV/EBITDA tells us a result of negative 1. This means that the investor will not wait to cover the cost of buying the entire business. The company has ample cash greater than the market capitalization, thus making the enterprise value a negative amount.

Results showed that BFR was profitable and was able to generate revenue much greater than its operational expenses. The gross margin and the net margin of the company were 86 percent and 61 percent, respectively. The EBITDA was average \$2.8 billion, representing -88 percent of the enterprise value.

In conclusion,

The Discounted Cash Flow spreadsheet shows that the present value of BFR’s equity was \$36.98 per share. Or a total amount of \$6.6 billion, at a rate of 25.39 percent. The future value was \$114.62 per share or a total amount of \$20.5 billion.  This future value is equal to the present value of \$36.98 per share. Having a choice of taking the \$36.98 today. Or the investor can wait for a 6 time period to have the \$114.62.

The future price of its equity was \$48.16 per share with a total amount of \$8.6 billion. Furthermore, the calculated 5th-year income was \$29.10 per share with a total amount of \$5.2 billion.

#### Market Capitalization

Moreover, the market capitalization of BFR was erratic in movement and trending at a rate of 23 percent average. There was zero debt and the cash and cash equivalent was 131 percent of the enterprise value. And its market capitalization was 24 percent of cash and cash equivalent. Therefore, the enterprise value was negative.  Buying the entire business the investor will be paying 100 percent of its equity, no debt.

The purchase price to date, February 27, 2013, of the entire business, was negative \$7.8 billion. Because cash and cash equivalent are greater than the market capitalization. The market price to date was \$4.24 per share.

#### Net Current Asset Value Approach

The stock price was undervalued  because the stock was trading below the liquidation value of the company. Therefore the stock has passed the stock test of Benjamin Graham. On the other hand, the stock was also undervalued. Because the ratio was only 0.16 average which is below the 1.2 ratios. Therefore, the price was cheap because it passed the stock test of Benjamin Graham.

#### The Margin of Safety

Furthermore, the margin of safety was 118 percent average, meaning there was safety in buying the stock of BFR.  Intrinsic value, on the other side, was \$252 average. The sustainable growth rate was 18 percent and the annual growth rate was 45 percent average.  In addition, the return on equity was averaging 26 percent and the payout ratio was 32 percent average.

#### Relative Valuation

The stock price was undervalued because the P/E*EPS ratio was greater than the enterprise value. While the EV/EPS shows that the stock price might indicate an undervalued price. Because the price (P/E) was 28 percent, while the earnings (EPS) represents the 72 percent average.

#### EV/EBITDA

It shows us a result of negative 1, meaning, the investor will not need to wait to cover the costs. This is because the company’s cash and cash equivalent is greater than the market capitalization. And the investor will pocket the remaining cash.  This shows the profitability of the company. Because the management was able to generate revenue which is more than what the company needs for the operation.

#### Overall

The stock of BFR was trading at an undervalued price from 2007 up to the trailing twelve months. Further, there was huge safety in buying the stock with its margin of safety of 118 percent. The value indicates a yearly increase in the value of 42 percent from its present value to its future value.  Therefore, I recommend a BUY on the stock of BBVA Banco Frances SA ADR (BFR).

This recommendation is good only to date, February 27, 2013. Until there are changes in the market price that affect the calculations above. Thank you.

Research and Written by Cris