ZYNGA Inc (ZYGA), the star company of this investment valuation report is really popular to me. I can’t let a single day to passed without playing Farmville. I bet you heard that game already. The company is said to be moving away from using Facebook.com as the main way to access its game. ZYNGA INC is new in IPO, its market value had increased by 44 percent from 2012 to the trailing twelve months 2013.
ZYGA 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.
Discounted Cash Flow Model
This model will show us how to calculate the value. We will walk through in every step of the calculation. Before we move over to the table below, here’s the formula used:
- 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.
Discounted Cash Flow Spreadsheet
The above-discounted cash flow spreadsheet was based on a ten-year historical data for revenue, expense, and equity plus the dividend data together with its ratios. The capitalization rate used was 15 percent and the return on investment was 7 percent, which is the average ROI from the period 2007. The price that was used was the average of 2007 to 2012, which is $5.89.
The calculated present value of ZNGA’s equity was $2.58 per share at a rate of 7.06 percent, with a total amount of $1.6 billion. The future value was $3.39 per share for a total amount of $2.2 billion. This future value of $3.39 is equal to the present value of $2.58 per share. This means, having a choice of taking the amount of $3.39 today, you need to wait for the 6 time periods to have the $3.39 per share. If you take the $3.39 today, you will have a chance to reinvest the money with the same rate of 7.06 percent, with the equal time periods and will end up having more than $3.39.
On the other hand, the future price of its equity was $1.66 per share for a total amount of $2.2 billion. Furthermore, the calculated 5th-year income was $29.10 per share.
ZYGA 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.
ZYNGA INC was new in IPO and was operating its business since the second quarter of 2007. The market capitalization of the company had increased by 44 percent from 2012 up to the trailing twelve months. The total debt was $100 million equivalent to 10 percent of the enterprise value, while cash and cash equivalent were 349 percent of the enterprise value. Because the cash was greater than the market value during 2012, thus, this makes enterprise value negative. The market capitalization of ZNGA had increased by 44 percent from 2012 up to the trailing twelve months.
The purchase price for the entire business of ZYNGA INC to date, March 25, 2013, was $1.1 billion at $1.55 per share. This is the takeover price for ZNGA. Market price to date, on the other hand, was $3.42 per share.
Benjamin Graham’s Stock Test
Net Current Asset Value (NCAV) Approach
In 2011, the stock price of the ZYGA was undervalued because the enterprise value was negative. This means that the 66 percent ratio was greater than the price. Moreover, during 2012, the stock price was overvalued because the price was greater than the 66 percent ratio.
Furthermore, if we take the average ratio, the enterprise value which represents the price was $0.61, while the average 66 percent ratio was $2.16. So, overall the stock price was undervalued because the price was lesser than the 66 percent ratio. Thus, indicating that the stock price has passed the stock test of Benjamin Graham.
Market Capitalization/Net Current Asset Value (MC/NCAV) Valuation
The MC/NCAV approach of Benjamin Graham is another way of testing the stock; whether it was under or overvalued. 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 above table shows us that the stock price was fair valued in 2011. For the reason, the ratio was 1.2 and did not exceed the 1.2 ratios and it was not lesser. On the other hand, in 2012, the stock price was overvalued because the ratio was greater by 126 percent. Therefore, the stock did not pass the stock test of Benjamin Graham.
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 shows that there was a zero margin of safety for ZYGA from 2011 to 2012 because the intrinsic value was negative. 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 is 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);
- 2 for the average yield of high-grade corporate bonds.
The earnings per share and the growth factor the calculation for the intrinsic value. The average intrinsic value was -$11, while the growth was an average of 21 percent. In addition, the average earnings per share were $0.84.
Earnings per Share (EPS)
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.
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 the 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 (SGR)
Sustainable growth rate = ROE x (1 – dividend-payout ratio).
The sustainable growth rate was 5.92 percent average. There was a zero payout ratio because ZYGA was not paying dividends to its stockholders. While the return on equity was averaging 5.92 percent as well, the same as the sustainable growth rate because there was no 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. This shows how many dollars of earnings result from each dollar of equity. The Return on Equity formula is:
Below is the graph of the intrinsic value of ZYGA.
As what we can see, the intrinsic value line which represents the true value of the stock of ZNGA was under the zero line. This means that the true value of the stock was negative. On the other hand, the enterprise value which represents the price was higher than the true value, meaning there was no margin of safety in the stock of ZNGA. As a result of that, the stock of ZYGA did not pass the requirement of Benjamin Graham of at least 40 percent below the true value of the stock.
ZYGA Relative Valuation Methods
The purpose 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 help us 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 then we will compare it to the enterprise value per share.
The PE*EPS valuation tells us that the stock was trading at an undervalued price because the price was lesser than the PE*EPS ratio. The enterprise value was only 8 percent of the PE*EPS ratio, thus the stock was trading cheaply.
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) was -421 percent, while the earnings (EPS) was 521 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. 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. Let’s find out.
The EV/EBITDA valuation tells us that it will take 2 years to cover the purchase price of buying. In other words, it will take two times the cash earnings of the company to cover the cost of buying.
This valuation also shows whether the company is profitable or not. The average gross margin of 2009 was 68 percent. And the net margin for the trailing twelve months was 16.35 percent.
The present value was $2.58 per share at a rate of 7.06 percent, with a total amount of $1.6 billion. While the future value was $3.39 per share, a total amount of $2.2 billion. Moreover, the future price of its equity was $1.66 per share, a total amount of $2.2 billion. Further, the calculated 5th-year income was $29.10 per share.
The enterprise value approach tells us that the market capitalization had increased by 44 percent from 2012. The total debt was $100 million, equivalent to 10 percent of the enterprise value. While cash and cash equivalent were 349 percent. Thus, this makes the enterprise value negative during 2012 because cash was greater than the market value. Moreover, the market capitalization of ZNGA had increased by 44 percent from 2012 up to the trailing twelve months.
The purchase price for the entire business of to date, March 25, 2013, was $1.1 billion at $1.55 per share. This is the takeover price for ZNGA. While the market price to date was $3.42 per share.
Net Current Asset Value
The 66 percent ratio was greater than the price. Moreover, the stock price was overvalued because the price was greater than the 66 percent ratio. This implies that the stock price did not pass the stock test of Benjamin Graham.
The margin of Safety (MOS)
Moreover, the margin of safety was a zero because the intrinsic value was negative. The average intrinsic value was -$11, while the growth was an average of 21 percent. In addition, the average earnings per share were $0.84. Furthermore, the sustainable growth rate was 5.92 percent average. The payout ratio was zero because ZYGA was not paying dividends to its stockholders. While the return on equity was averaging 5.92 percent the same with the sustainable growth rate.
The relative valuation tells us that in the PE*EPS valuation tells us that stocks were trading at an undervalued price. Because the price was lesser than the PE*EPS ratio. The enterprise value was only 8 percent of the PE*EPS ratio, thus the stock was trading undervalued.
Moreover, the EV/EPS valuation tells us that the price (P/E) -421 percent, while the earnings (EPS) was 521 percent. This valuation approach depends upon the discretion of the analyst whether the ratio was appropriate or not.
The EV/EBITDA valuation tells us that it will take 2 years to cover the purchase price of buying the business. In other words, it will take two times the cash earnings of the company to cover the cost of buying.
The stock price of ZYGAwas fairly valued, and there was zero margin of safety in buying the stock. Therefore, I recommend a HOLD on the stock of Zynga Inc.
Research and Written by Cris