Here’s a homework assignment submitted by Rick S. on September 18.
Each homework attempts to show whether a company is a good buy for a Rule #1 investor — in other words, is it a 4M company? Is it a wonderful company we understand, and can we get it at an attractive price? (A discount to value?)
I critique students’ results here on the blog to see if they’re on the right track.
The case study below is a good example of a Homework. Here’s Rick’s letter:
I’ve been working on your formula and would like you to critique my work.
The company is Smithfield Foods (SFD). Current EPS is 2.59, Current P/E is 10.6, Growth rate – Historical = 24%, Analyst = 10%. Future EPS (10 Yr) = 6.27, Future Stock price = 125 MOS = 15.68 Currently selling for 27.39. The only variable I wasn’t sure where you found it was the analyst projections. (I used the est. earnings for 5 yrs under MSN, research, earnings)
Looking forward to your response.
And here’s what I told him:
Smithfield makes pork stuff and ships it all over. People have been eating pork for about 10,000 years, so it’s likely we’ll continue. Gotta like that. I like the work you did on the numbers to verify that these guys have a Brand Moat and have a predictable future, but let me take you through it again my way:
- 1st thing is ROIC: Return on capital at MSN Money is under Financial Results, Key Ratios, Investment Returns. I like to see 10% or better. SFD is doing 6% or so. Bad news number one.
- Next is Equity or book value growth: Under Key Ratios look at Ten Year Summary: Book Value/Share. WOW! Suddenly my interest picks up. SFD equity has grown steadily from $3 to $17 in 9 years. $3 doubles to $6, $6 to $12, and half a double more. So this equity has doubled 2.5 times in 9 which means it has taken SFD about 4 years per double. By the Rule of 72 I know that a double every four years is 18%. But then I notice that in the last 5 it’s down to about 15%. So let’s say 15% is the best guess at the future growth rate.
- Now I check EPS growth rate: at MSN Financial Results, Statements then 10 year summary and look at EPS. Bouncy, isn’t it? 3 doubles in 9 years is 3 years per double or 24% as you noted. But look at the ups and downs. The 5 year rate is 50%, but the 3 year rate is 14%. Better stick with Equity growth rate as a better indicator of the future.
- Sales are growing at about 15%.
- Now let’s look at Cash. Oh oh. Free Cash Flow is a mess. Look at the negatives year after year. And sure enough, when you look at debt to see where they’re getting the money to cover the negative cash, debt is going up.
We always always always look at the whole Big Five (ROIC, Equity Growth Rate, EPS Growth Rate, Sales Growth Rate, & Cash). In this case, ROIC is low, EPS is too bouncy and Cash is negative. And that usually means debt is going up.
Now we know that the future may not be so predictable.
Let’s see what the analysts think about growth: At MSN look at Earnings Estimates and click on the far right tab: "earnings growth rates". They are guessing 10%.
You did the future value perfectly – $6.27 per share in ten years, but I think you got aggro on the PE. Historical is about 10. You used the default of 20 (2 x the EPS growth rate). Let’s use 10. That’s $62 a share. And today’s Sticker price is one quarter of that: $15 which you also got to with some sort of goof. (You have a future price of $125 which should produce a sticker of $41!).
With a $15 Sticker, we want to buy this at $7 – $8, and it’s selling for $27. No dice. If people pay $27 today and the analysts are right, in ten years they can sell this for $62. That’s a 7% return. That’s if everything goes right. If it doesn’t (see GM) then this could be a lot worse.
Remember that the value of a business is just the surplus cash it tosses off. This business is eating its surpluses. They are probably having to buy more processing machinery to keep growth moving. We’re the owner and they’re using up all the profits to just keep growth going. This is not a good thing.
Rule #1 investors are disciplined. We don’t say go until everything is obviously in our favor. SFD is not obviously a wonderful business at an attractive price.
Good job, Rick. You came to a similar conclusion regarding price.
Keep up the good work. Now go play!
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.