Cherokee Inc (CHKE) is an American based global apparel and footwear company, headquartered in Sherman Oaks, California. Cherokee was established in 1973 and are available in 110 countries in 12,000 retail locations and on digital commerce.

**CHKE Value Investing Approach **

**The Investment in Enterprise Value **

#### Explanation

The market capitalization for Cherokee Inc, as shown in the table above, was erratic in movement at a rate of 7 percent average. The total debt was 0.8 percent average and the cash and cash equivalent was a 7 percent average. As a result, the enterprise value was lesser by 6 percent against the market value. So, if you plan on purchasing the entire business of Cherokee Inc, you will be paying 100 percent of its equity and no debt.

The costs of buying CHKE to date, November 12, 2012is $119 at $14.88 per share. While the market price to date, on the other hand, was $14.58 per share.

**Net Current Asset Value (NCAV) Approach **

**Net Current Asset Value (NCAV) Method **

The net current asset value approach shows that the stock of CHKE was at overvalued prices from 2007 up to the trailing twelve months because the market value was greater than the 66 percent ratio. So, 66 percent represents only one percent of the market value. To analyze it more, the data show that Cherokee Inc stocks were expensive.

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

Another stock test by Graham is by using market capitalization and dividing it to net current asset value (NCAV). The idea is, if the result does not exceed the ratio of 1.2, then the stock passes the test for buying. So, let us see if the stock of VSEC passed the test.

Then MC/NCAV valuation tells us that the stock price was overvalued from 2007 to 2012 because the result of the ratio exceeded the 1.2 ratios and the price was considered expensive.

** The 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. 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 for CHKE was 7 percent on average. There was no margin of safety from 2007 to 2010 and the trailing twelve months 2012. In 2011, the MOS was 40 percent. I’m wondering why the margin of safety was zero from 2007 to 2010.

*Intrinsic Value = Current Earnings x (9 + 2 x Sustainable Growth Rate) *

The intrinsic value factors earning per share and the sustainable growth rate. The sustainable growth rate of Cherokee Inc was negative all throughout except in 2011.

The earnings per share (EPS) and the sustainable growth rate (SGR) factor intrinsic value.

#### Sustainable Growth Rate (SGR)

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.

The ROE of Cherokee was a 56 percent average, the payout ratio was 138 percent and the average SGR was negative 20 percent. The sustainable growth rate was negative because the payout ratio was greater than the return on equity.

#### 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.

There are two approaches in calculating the sustainable growth rate, these are the relative ratio approach and the average ratio approach.

The relative approach has a higher margin of safety against the average approach.

#### Explanation

As we can see in the graph, the intrinsic value line is under the enterprise value line, except in 2011 where the IV line rises up a little above the EV line by 40 percent, then it went down again in 2012. The space between these two lines is the margin of safety and we can get this by subtracting the difference between these two lines.

**ITG 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.

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

This method will determine whether the stocks are undervalued or overvalued. 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, we can determine the status of the stock price.

The stock was trading overvalued in 2007 and 2010, while in 2008, 2009 and 2011 the price was undervalued. The P/E*EPS rate was 89 percent of the enterprise value. Thus the overall price was overvalued. It means that the price was expensive.

The other approach for calculating this valuation is by using the average price to earnings ratio.

The percentage P/E*EPS ratio using a relative approach was greater by one percent against the average approach.

**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.

In the EV/EPS valuation, it tells us that the price (P/E) was 86 percent and the earnings (EPS) was a 14 percent average. On the other hand, the stock price was overvalued because the price to earnings percentage was greater than 50 percent.

**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.

The EV/EBITDA valuation tells us that it will take 9 years to cover the costs of buying Cherokee. In other words, it will take 9 times the cash earnings of the company to cover the cost of the purchase price. A very long period of waiting.

This valuation also tells us about the profitability of the company. The company’s EBITDA represents 12 percent of the enterprise value and its net earnings were 33 percent average.

**In conclusion, **

The market capitalization for Cherokee Inc was erratic in its movement at a rate of 7 percent average. While the total debt was 0.8 percent and the cash and cash equivalent were a 7 percent average. Thus, the enterprise value was lesser by 6 percent against the market value. Buying the entire business of CHKE would be paying 100 percent of its equity.

The total costs of buying CHKE to date, November 12, 2012, was $119 million at $14 per share. While the market price to date was $14.58 per share.

#### Current Asset Value Approach

The net current asset value approach shows that the stock price was overvalued from 2007 to 2012. Because the market value was greater than the 66 percent ratio of NCAV. Further, it indicates that the stock was trading above the liquidation value of CHKE. On the other hand, MC/NCAV shows price was overvalued from 2007 to 2012. Because the ratio exceeded the 1.2 ratios, thus the price expensive.

The margin of safety for CHKE was a 7 percent average. There was a zero margin of safety from 2007 to 2010 and the ttm2012. The sustainable growth rate and the annual growth rate of CHKE were negative all throughout except in 2011. The ROE was 56 percent.

#### Relative Valuation

Moreover, the relative valuation method shows that the stock was trading at overvalued prices in P/E*EPS valuation. While in the EV / EPS method shows the price (P/E) 86 percent and the earnings (EPS) was 14 percent. This indicates that the price was overvalued.

It will take 9 times of the cash earnings of CHKE to cover the cost of buying the business.

Overall, it shows that the stock of CHKE was trading at an overvalued price and expensive. There was only a 7 percent margin of safety. Therefore, a **SELL** is recommended in the stock of Cherokee Inc.

Researched and Written by Cris

Interested to learn more about the company? Here’s company research to know more about its background and history; and value investing guide for the financial status.

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