DryShips Inc (DRYS).
The significance of investment valuation is such that an investor would know if this is the right time to buy considering the market value of the company. It’s like knowing and understanding the opportunity ahead of you. Of course, it’s not only the market price but also the financial health, as well as the management and background of the company, that we should consider.
DryShips Inc was the leader among its peers however the company is experiencing a tough period in the past five years. The global trade was extremely slow resulting in a miserable time in the shipping industry.
DRYS 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. I calculated first the enterprise value as our first step. I believed this is important because it measures the total value of the company.
DRYS Investment in Enterprise Value
The concept of enterprise value is to calculate what it would cost to purchase an entire business. In essence, EV is the company’s theoretical takeover price, because the buyer would have to buy all of the stock and pay off existing debt while pocketing any remaining cash. Further, this gives the buyer solid grounds for making an offer.
The enterprise value approach shows that the market capitalization of DryShips Inc was high during 2010 and went down by 58 percent the following period. The result was erratic in movement. When it comes to total debt, the average was 82 percent of the enterprise value while cash and cash equivalent were an 8 percent average. This makes the enterprise value greater than the market value by 379 percent. Buying the entire business of DRYS the investor will be paying 73 percent of total debt and 27 percent equity. This is the equation that an investor is willing to pay.
Likewise, the purchase price for the entire business of DryShips Inc, to date April 16, 2013, was $4.8 billion at $12.63 per share. The market price to date was $1.82 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.
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.
The net current asset value approach indicates that the stock price of DryShips Inc was overvalued from the period 2008 up to the trailing twelve months because the price was greater than the 66 percent ratios.
Market Capitalization/Net Current Asset Value (MC/NCAV) Valuation
We can know if the stock is trading over or undervalued by simply calculating market capitalization over the net current asset value of the company. The result should be less than 1.2 ratios.
Market Capitalization / NCAV = Result (must be lesser than 1.2)
The MC/NCAV valuation shows that the stock price of the company was overvalued from 2008 up to the trailing twelve months because the ratio was over the 1.2 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. In my calculation, I used the enterprise value because it takes into account the balance sheet so it is a much more accurate measure of the company’s true market value than market capitalization.
The margin of safety was calculated as Margin of Safety = Enterprise Value – Intrinsic Value.
The table above shows that the average margin of safety for DryShips Inc was 27 percent. As indicated in the table, there was zero margin of safety from 2009 up to 2012. It tells us that the stock did not pass the requirement of at least 40 percent below the intrinsic value. Therefore, the stock may not be a good candidate for a Buy
Intrinsic Value = Current Earnings x (9 + 2 x Sustainable Growth Rate)
The explanation in the calculation of intrinsic value was as follows:
- EPS: the company’s last 12-month earnings per share;
- G: the company’s long-term (five years) sustainable growth estimate;
- 9: 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: the average yield of high-grade corporate bonds.
The calculated average intrinsic value was $76, while the annual growth rate was -6 percent. In addition, the earnings per share were -$1.53 average. The net earnings of DryShips Inc were negative from 2008 up to the trailing twelve months except in 2010. The company was very unprofitable and was not efficient in generating sufficient revenue for its business operation.
The formula for earning per share was:
Sustainable Growth Rate
On the side note, 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 calculated average sustainable growth rate was -8 percent and same with the return on equity because there was zero payout ratio from 2008 up to the trailing twelve months. This means that DryShips Inc is not paying dividends to its shareholders.
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. Return on Equity shows how many dollars of earnings result from each dollar of equity.
There is another way of calculating the sustainable growth rate and that is by using the average approach. This average approach takes into consideration the prior year’s performance. Walking further, the table below will show us the results of using the two approaches.
Relative and Average Approach
By using the relative approach, the margin of safety is higher than by using the average approach.
Further, let us walk a little closer on the intrinsic value through this graph.
The intrinsic value line which is the true value of the stock was very much higher than the price in 2008, then it drops by 98 percent the following period. Then it continuously drops up to the trailing twelve months nearing the line of zero. The margin of safety is the space in between these two lines and if we put it in figures, the average would be 27 percent. The difference between the true value and the price is the margin of safety. These two lines cannot be separated; it is the company value and the market value.
DRYS 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)
This valuation will determine whether the stock is 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.
The P/E*EPS ratio was only 18 percent of the price, therefore the price was expensive.
Using two approaches, the table below will show us the difference.
The relative approach produces better results as seen above.
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).
The EV/EPS valuation tells us that the price (P/E) that was separated from the enterprise value was -118 percent, while the earnings (EPS) was 218 percent. The result was negative because the net earnings were also negative.
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 tells us that it will take 21 years to cover the costs of buying the entire company. It will take 21 times of the cash earnings of DRYS to recover the cost of purchasing. The EBITDA/EV was 10 percent. It also shows that DryShips was unprofitable in generating cash for the business operation.
The market capitalization of DRYS was erratic in movement. Further, its total debt was averaging 82 percent of the enterprise value. While its cash and cash equivalent were 8 percent average, thus enterprise value is greater than the market value by 379 percent. Buying DRYS, an investor will be paying 73 percent of total debt and 27 percent equity. This is the equation that an investor is willing to pay.
The purchase price for the entire business to date April 16, 2013, was $4.8 billion at $12.63 per share. The market price to date was $1.82 per share.
Net Current Asset Value
The net current asset value approach shows that the stock price was overvalued. Because the stock was trading above the liquidation value of the company. Consequently, the MC/NCAV approach tells us that the stock was overvalued due to the ratio exceeded the 1.2 ratios.
Margin of Safety
Furthermore, the margin of safety was 27 percent average. The growth of DRYS represents as follows: Sustainable Growth Rate was -8 percent; annual growth rate was -6 percent; return on equity was -7.66 percent; earnings per share was -$1.53; and the intrinsic value was $76 average.
The relative valuation shows that the stock price was overvalued. Further, the price was greater than the P/E*EPS ratio. The EV/EPS tells us that the price (P/E) -118 percent and the earnings (EPS) was 218 percent.
The EV/EBITDA tells us that it will take 21 years to recover the costs of buying DRYS. In other words, it will take 21 times of the cash earnings to recover the cost of purchasing.
Bottom line, the stock price of DryShips Inc (DRYS) was overvalued and the stock has no margin of safety. In addition, the EV/EBITDA was not impressive and unprofitable. Hence, a SELL position is recommended in the stock of DryShips Inc.
Research and Written by Cris
Interested to learn more about the company? Here’s an investment guide for a quick view, company research to know more about its background and history; and value investing guide for the financial status.