The Basics of Intrinsic Valuation
A relatively short guide on the rationale and steps with a practical example
We will go through the basic concepts of valuation, and why this tool can be of use for investors even in what appear to be risky and overvalued markets.
My goal in writing this, is to show you that you already have a good intuition and can understand all of the concepts that investment bankers use, as well as provide you with the basic tools on doing a simple, yet full valuation.
If you want just the key points, there is a recap after every section.
During the discussion, we will make an example valuation for Sanderson Farms, Inc. (SAFM) - A very simple seller and producer of chicken.
I chose this company because it has a business model that is quite easy to follow, and is in a non-discretionary field, which I feel has enough pricing power to withstand and possibly benefit from inflation.
I will do my best to explain terms, concepts, and will answer additional questions in the comments.
Non-discretionary means not selling luxury goods. Chicken is a consumer staple good, something that is essential or non-cyclical, consumed widely all year-round. Discretionary products are things people buy with the “extra” money they have: high-end PCs, Sports cars, Jewelry etc.
Pricing Power means the ability of a company to dictate or sustain a price in good times and bad. Usually this means passing on the costs to other parties such as businesses (extending credit) or consumers (rising prices for products and services). When a good is essential for people, it is much easier to sustain higher prices. Other factors that help are: Brand name, barriers to entry in a business, competitive advantage, business scale/size, monopolistic position (services defended by regulation) etc.
The Basics of Intrinsic Value
It is the company’s ability to produce cash for investors.
It is not just cash, it is your cash.
Cash can be produced in a variety of ways that may ultimately destroy value. A company may move cash from the future to the present (get a loan), sell (issue) shares to investors, withhold paying suppliers, refrain from reinvesting etc.
That is also why we sometimes call this Free Cash Flow - it is what is left over after most other obligations.
However, there is something missing from this term.
It is not enough, just to say FCF, we must point out who the FCF is meant for.
There are two types of FCF:
Free Cash Flows to Equity
Free Cash Flows to the Firm
I will briefly explain, and continue with the valuation only in regard to one type of cash flows.
Free Cash Flows to Equity, are the cash flows that are left over for shareholders - equity investors.
Free Cash Flows to the Firm are the cash flows that are left over for both debt and equity investors.
Why is this important?
When looking from the FCFE perspective, we must make assumptions about what is left after debt repayments, and we value only that - this may add complexity to the valuation, because firms may have different and irregular approaches to repaying debt (they may decide to extend/refinance instead of paying off principal amounts).
When looking at FCFF, we imagine that lenders (banks) and investors are in a partnership that help the firm operate by providing funds.
This (FCFF) gives us a more resilient and simple approach to compute cash flows.
Which is better?
I personally found that using the FCFF is simpler, and gives a very good overview of what to expect in cash flows.
The key to a good valuation is, regardless of the approach we use, we should get roughly the same value for a company. If the results widely differ, we need to revisit our model.
When thinking of cash flows, some people may feel that it’s an old and immoral concept, responsible for the suffering of people. In a short article (honestly), I offer a moral defense for value maximization and the difference from maximizing profits.
Now, let’s get back to the core concepts.
Valuation
When buying a stock, we are buying a small portion of the company that gives us certain rights.
However, implied in that, is that we are actually buying the whole business at once and in secret.
The “in secret” part just assumes that our transaction does not move the stock price. This is a key concept when thinking of a stock. You are buying (part of) the whole business: cash, debt, business model, expenses, future, profits, brand name, risk, employees, etc.
As prof. Damodaran can be loosely paraphrased, “lock, stock and mickey included”.
Therefore, if you are buying the whole business, you need to be able to estimate what is attributable to you.
As an investor, your stake, entitles you to the free cash flows from the business. That is the only thing you value.
The image above attempts to roughly clarify what actually is attributable to investors. You may notice I don’t say what investors are owed or get - that is because the company may choose to return cash to investors in one form or another, but doesn’t have the obligation to pay out anything.
Investors don’t get employee salaries or benefits, they don’t get R&D patents, the bankers get their interest payments and the state gets taxes, investors don’t even get profits or earnings per share.
Investors are effectively last in line for the cash of the company.
The further down you go, the riskier the investment proposition becomes. That is why, for example, senior debt is called senior because it has a contractual claim that is high up in the obligations of the company. Long-term debt is usually accompanied by a decent collateral value against physical assets, intellectual property and the right to convert to a controlling portion in stock.
- - - - - I am argumenting against some multiples, you can skip this - - - - -
I brought up this image because analysts frequently asses the value of Earnings Per Share or use metrics such as EV to EBITDA. All of these metrics are a proxy for cash flows, but not actually cash flows.
In the EPS case, we strongly imply that the earnings will convert to cash flows, but that is not necessarily the case - Companies can sometimes do irresponsible things with accrual (what is written down when something is sold) earnings, and it is up to investors to hold them accountable (usually) by selling or staying away from a stock.
Conversely, EV to EBITDA is used similarly, but it is my opinion that it has become a perverse version of itself, because it is used in statistical comparative models, that are too far removed from cash flows.
If you ever open an investor’s presentation, you will frequently find an adjusted EBITDA metric, this is even riskier, as companies define how they adjust EBITDA liberally, and can even change the definition from year to year. Most adjusted EBITDA metrics are not comparable to peer companies, and are used by management to present a firm in the best possible light to investment analysts with a vested interest.
The initial rationale behind EV to EBITDA, before it turned into something completely different, was the following: When a (young) company is growing, it has additional expenses used to fund that growth, these should not exist when the company matures. With EBITDA, we are attempting to value the cash flows as they would appear down the line when it matures.
In my opinion, EBITDA is too far up the line, to be considered as a good proxy for cash flows.
- - - - - Section resumes from here - - - - -
The question being answered with a valuation is: What is the current value of the future cash flows of the firm, today.
We value cash flows, because that is the only thing attributable to investors.
If you were a potential employee, you would estimate the value of the current and future salary and bonuses.
Why are current and today in the same sentence above?
The current value of future cash flows has the assumption that the cash today, is worth more than cash received in the future. So, even if a company is projected to create billions in future cash flows, that can sometimes mean little to investors that are looking to buy a stock today.
Additionally, we are valuing a company as of today, not tomorrow and not a year after that. If you want to value a company as of one or ten years of now (assuming that you are interested in a company with high technological potential - perhaps like Tesla), you must take into account the money you would be making had you been invested in another comparable instrument - for stocks, that is the market portfolio (e.g. S&P 500). You cannot just say I will invest now because the company will be worth a lot in 10 years - you must adjust for the money you are not making in those 10 years of waiting.
For example, every Tesla investment, has the implication that the company will make up in the future, (somehow) over and above the value it has today. It may not be a wrong assumption, but the further in the future you are betting, the riskier your bet becomes.
RECAP: Valuation is something we use to estimate the value of future cash flows that are attributable to investors (us), as of today.
The Discounted Cash Flow Valuation
This is just an approach/tool, to get to the closest value we can for the free cash flows to the firm (or equity).
There is no obligation to use a DCF model when valuing a company. If you can come up with a better way to estimate the value of future cash flows for a company, feel free to use that.
In my opinion, the DCF using the Capital Asset Pricing Model is superior to other current methods.
CAPM
The CAPM, is a simple way to assess how risky is a stock, and helps us price that risk by demanding a higher (%) return from riskier stocks.
We use a % rate as a measurement for risk, with which we penalize the value of the future cash flows.
Imagine someone wants to borrow $1000 from you:
You know the person and are very confident that they will pay the money back. For your trouble, you tell him, that you need a fair return for what the money would have made in a year had you invested them somewhere else (this is the level of respect with which you should treat your cash), and you attach an interest of 10%, asking your friend to give you $1100 in a year. The logic behind this, is that you are wasting your money if you just demand the $1000 back without interest.
Now imagine that same situation, but this friend has a gambling problem. Not only would you ask him, but you would make him sign a legal agreement to pay you back, with some hard assets as collateral.
But how much will you ask for?
$1500, $2000?
Implied in that number is -Your- price for risk.
This is what the CAPM does, it helps you ask for a fair return against your estimate of the risk in a stock.
Is it subjective?
You, as an investor have every right to disagree with the current price of risk, and as an analyst it is your job to justify your price of risk, not just copy it from Bloomberg.
However, when valuing a publicly traded company, your opinion dosen’t matter. You need to try to estimate how the future marginal investors view the price of risk.
You can place a 15% discount rate on a stock because you feel that way, but as long as your goal is to invest and not engage in pointification, you should strive to assess the price of risk of people/institutions that have the power to move the price. In investing, your job is to find out how the market will view the company’s risk, since that will move the price, not how risky you think it is.
How does the CAPM work?
You need to come up with a % of risk which you will use to penalize/discount your estimates of future cash flows.
If the company is projected to make $100 in future cash flows, and you come up with a 10% discount based on the risk of that stock, then the present value of the future cash flows will be $100*10%=$90
If the Market Capitalizes (values) the stock at $45, you can conclude that the future cash flows are actually worth double than that, and you have potentially an undervalued stock in front of you.
RECAP: DCF is just a tool to compute the present value of future cash flows. There are 2 main components: future cash flows and risk. One option to estimate risk, is to use the CAPM, that gives us a discount %, which we use to penalize the future cash flows in order to see how much their sum is worth TODAY.
With the next example we will go over the basic mechanics of a DCF.
Valuating Sanderson Farms (SAFM)
There are 2 things we do when valuating a company. Researching and Modeling.
You will find, that as you research a company, your models will change. Which is a testament to the subjectivity of the analysis.
Now, that doesn’t mean that the way we do the models is subjective and there are some core mechanics that we use in order to come up with an intrinsic value.
Understanding the future of the business is still probably one of the largest assets in your analysis, that is why there is a good deal of research going on before doing a model. Conversely, it is why people with industry expertise, that can predict the future of a company may also be successful in investing.
Sitting down and putting the numbers in, may give you a baseline, but there is an array of decisions you will need to make before you can make a conclusion.
Additionally, going in too deep is not the point of a DCF, and if you find yourself adjusting decimals, you may be wasting your time.
Step 1 - Research
The go-to place for starting your research of a U.S. based company is the sec.gov. You can look up any publicly traded company there.
Try to stay away from news before you get your own sense of the company, this will help you see things from an independent angle - but remember that it is ok to adjust your opinion as you get new information.
For SAFM, we got the 2020 Annual Report as it is the latest. In the business section. you can find what the company does.
We see that Sanderson produces and sells Chicken. Additionally, we find that they process around 657 million chickens and self reports to be the third largest processor of chickens in the U.S.
This gives us a clue that there are other large producers and we might also want to consider them when making our final analysis.
For now, lets assume that we don’t need to compare peers and just do one valuation.
The company sells the product mostly in grocery stores, both under the store name and their brand name. They used to be specialized for selling to fast food chains but switched their strategy some years ago. What does this imply? It implies that the main customer are grocery store chains and the success of the company is tied to consumer retailers. Knowing who is the primary customer gives us an idea of where a business might be headed in the future and the perspective risks.
For example, if we assume that the grocery business will consolidate in coming years, by big chains buying out little ones, and opening new locations, we will envision a landscape where a business is dependent on a few possible customers. The less available customers one can sell to, the smaller the pricing power. If Walmart is 90% of your business, and they decide to ask for a credit extension or lower prices, then the choices are limited as to what a business can do to escape the tight spot.
In our case, the company believes that it has a diverse portfolio of customers, and we can see on page 12 in the report that 2 customers account for 14.9% and 12.7% of the revenues, respectively. This alleviates some of the pricing power risk, and puts Sanderson in a resilient position.
Risk Factors
Next is the risk section. Unfortunately, this is primarily a legal-jargon list that contains every standard possible risk item. In most cases, this is not informative, and you will be forced to think outside of it.
It is not in the interest of management to disclose real risks, if they can plausibly deny that they didn’t know, or couldn’t predict something, they will not include it.
When reading risk factors, skip the standard items, and look for something unusual, and something that they are trying to justify or defend. Example, I just read that the CEO of Beyond Meat has increasingly started using the phrase “unclear landscape”, for investors this can be a red flag that the company is exhausting growth opportunities.
Another example, starting a few months ago, some companies (legally) had to include inflation as a risk factor. When doing this, they usually add paragraphs explaining how their business is protected and will not be materially affected. Zero-in on those arguments and see if they warrant any merit, because there is a probability they are trying to minimize the impact of the problem.
The biggest risks however, are the unstated ones. These are the factors, that neither the company or the regulators had the foresight to predict. One way to gauge them is to look at history and see if there are any repeating mistakes that management is making, the other way is to look for leading indicators that might predict risks down the line, which management does not want to acknowledge because it might mean the loss of a significant portion of business.
An example of this, is innovation that might replace a product. Think Airbnb and Booking vs Hilton and other traditional hotel chains. Better yet, think about what you don’t like in a product and what would an alternative look like. Chances are, someone is working on it.
The risk evaluation is crucial, and the killer of traditional value investing. Because a stock may be fundamentally undervalued, but the market keeps the price low because of something coming down the line, and sometimes as investors we are so proud of our valuations that we fail to see the storm.
In the case of Sanderson, there is a lot of debate against animal friendly activists and the power of their (social)media campaigns. The company has been involved in multiple PR campaigns to present their point of view. We can see that there are some general trends working against chicken consumption, and a shift of interest to synthetic meat distributors.
What is the counter-weight to this?
Inflation.
(I have an older article on inflation here, will migrate it to SubStack)
Rising inflation changes consumer preferences from high-end products such as bio/organic/vegan to their cheaper variants, like chicken, soup, processed food etc.
In effect, a large part of our thesis will be the assumption that the rising costs of living will be (as usual) externalized to employees and the lower working class, who will react by lowering their standards and turn to cheaper, factory produced food.
Governance
Another risk factor you may want to consider is governance. I will keep this short: If the person running the company and the person whose job it is to keep management in-check are the same. You have bad governance.
The CEO and Chairman of the board shouldn’t be the same person if you are looking for a company that has shareholder’s interests at heart. There is an alleviating circumstance, because the Sanderson family seems to hold some 8% of their own stock. This represents satisfactory “skin in the game” and they are partly aligned with the interests in shareholders.
The feedback problem still remains, the CEO will never have better ideas than the chairman because they are the same person. It is the Chairman’s job to ask for more and not to be satisfied with current performance.
RECAP: Research is the first step. Start at the official filings, estimate your own risk factors, take a general look at the macro or economic cycle, and look for conflicts of interest in governance.
Step 2 - Modeling the DCF
The basic value drivers that help us project free cash flows to the firm for the next 10 years in a DCF consist of the following items:
The revenue growth for the next 10 years
The profitability margin at which the company will converge in 10 years
The discount rate during those 10 years
Additionally, in order to see how will growth translate to free cash flows, we will need to estimate the efficacy of reinvestments by setting a sales to capital ratio.
In order for you to follow along with this valuation, I suggest you download the simple DCF model spreadsheet from prof. Damodaran and type in your estimates for the company.
You can copy the numbers from my model, but try to decide on the value drivers for yourself.
We are going to start with the financials here. First, we will get an overview for the revenue and cost structure of the business.
The top line are revenues, and we can see a steady increase over the years. The rest are expenses, and as you can see, they take out a substantial part of the income.
Note: I almost always use trailing twelve month numbers. Meaning that when you look at a column, embedded in that, are the last 12 months of financial performance per date point. So for example if you see 7/31/2021, you are seeing the last 12 months of performance ending on that date. This smooths out the noise in quarterly numbers and gives me an up-to date annual report for every quarter.
We can see that the company made $4.3b in ttm revenues and had total costs of $3.9b. Almost 85% of the cost structure is accounted for by COGS (cost of good sold). This includes the running of processing, hatching, machines, worker salaries, raw material purchasing etc. For a chicken plant, a major cost consists of bird feed, primarily made from corn and soybean meal, and stemming from that, are fuel and chemical (fertilizer, pesticide) costs.
This implies that the major cost structure for this company is tied to the prices of these raw materials: corn and soybean meal.
In this case, it would be prudent for the producer (company) to be consistently hedging against spikes in prices of these raw materials. For SAFM, the company makes short term purchasing of raw materials and does not hedge them (page 46).
The reliance on these raw materials necessitates that we at least examine the one needed in the highest quantity, in the SAFM case it is corn with 124.7 million bushels purchased in 2020.
In the chart below, we will see that the price of corn has substantially increased throughout 2020. These costs will be realized upon the sale of the end products in 2021.
Note: In this case, hedging is a contract that allows buyers to freeze the future price of a commodity for an upfront premium. This shields companies from large price spikes of commodities. Think of it like paying a car dealer $100 to reserve a car for you that you would like to buy in six months - since you have a contract guaranteeing the price, you don’t care that the rest of the car prices rose 30% before your contract expired.
Value Driver 1 - Growth
Make sure you have updated the financials in your spreadsheet and lets start with the first value driver.
Now for a positive aspect. The last 12 months marked an increase in revenue of 23% and an increase in costs of 8%. This means that revenues scaled up better than costs by about 15%. This means that the company grew better than its costs, which is a sign of value creating growth.
We can see how SAFM grew revenues in the chart below.
I wanted to outline the importance of the informational quality of ttm charts. Instead of quarterly or annual metrics. With this chart we see the growth from 12 months ago in every quarter. This usually gives us a better gauge of the trends and cyclicality of growth in a business, and can help us define a range when making future projections.
We see that SAFM peaked growth in the last quarter, and the trend is probably due to a reversal both because of the cyclicality of their sales and the outlier growth rate in the last 5 years.
The company will probably sustain growth based on changing consumer preferences, but may revert down the line if the economy stabilizes.
There is also another way to look at growth, and that is to compute a fundamental growth rate.
The fundamental growth rate is what we expect to see in EBIT growth next year, based on how much the company reinvests and how well it generates returns.
The computation takes a bit of work, but luckily for us, the answer will be quite intuitive.
The company did not reinvest meaningfully in the last 12 months. Their net Capital Expenditures (investing more than you have to) are negative. Which poises the question:
Can a company that doesn’t reinvest, grow?
The answer is, that in most cases, if you do not invest more that your depreciation, you cannot grow. And it is simple to see why, a company like SAFM needs to expand hatcheries, open new processing plants, upgrade logistics etc. So, if they do not engage in that, over the long term, they will reach a cap on what they are able to output and ultimately sell.
Now to address the “most” part.
Here comes the concept of growth by increasing efficiency. Let’s jump to an example.
If your firm is using an accounting software for $1000 per year, and instead of renewing your licence you switch for a better software that is in the cloud and has an ERP, logistics and analytics services as part of the package, and that new software also sells for $1000 per year. Then you just merged 4 systems in 1, possibly reducing costs and propagating efficiencies to sales.
This one-time decision will have lasting effects on your income, but will not change beyond that. You can’t switch software every year and expect the same results.
Thus, companies need to reinvest in order to grow, and sometimes engineers and new technologies come along the provide a one-time permanent improvement to income.
Earlier, I mentioned that Sanderson does not hedge input prices. The reason they are able to come out of this relatively unsaved is that they have likely been able to pass on the costs to the customers.
In the chart below, we see that products involving chicken (poultry) had their prices rapidly increase.
The risk in these situations is that retailers may decide to squeeze Sanderson, and ask for extended payment terms, or opt for different suppliers that have previously hedged and can now afford to retain old prices.
Now, we need to apply this to our valuation.
In a DCF you need to estimate the growth for the next 10 years, and the perpetual growth rate after that.
Let’s start for the next 10 years. Many analysts try to compute the individual growth rates, but beyond year 1, it is quite hard and time consuming to do.
Instead, take a step back, and ask yourself how much do you see this company growing in 10 years?
The last 12 months give us a revenue figure of $4.3b.
What do you think the revenues will look in 10 years?
$4.5b, $5b, $7b?
For every estimate you make, you need to justify the figure with a plausible story.
Also, that story needs to be consistent. If you expect the company to nearly double revenues, then I would expect to see very high reinvestment and possible working at a loss for a few years - similarly to a young growth company.
If you see opportunities for improvement (efficacy growth), you need to estimate the probability that management also sees these opportunities and delivers on them (you do not run the company). In the case of Sanderson, perhaps management may be too rigid, but there might be a chance for new management to step in (more on that later).
Or there is a macro story you might be telling, like the case with inflation. There, we speculated that growing inflation will change consumer preferences for low cost chicken meat and the company is in a good position to externalize costs while keeping growth.
Or perhaps you are looking at historical cash flows and see a steady decline in the bottom line, and while the company may grow on the short term, it is in fact maturing and about to enter a decline as competitors and distuptors start taking over market share.
Think of the possible scenarios for your company, and when you are ready, give them the revenues you expect in 10 years from now. Once you do that, it is easy to work back on what revenue growth needs to look like for you to achieve the final estimate.
Personally, I do not see the company making more than $5.2b in 10 years, so I worked back the growth rates from that.
Value Driver 2 - EBIT Margins (Profitability)
The reason we start with EBIT margins, is because that is how we get the cash flows to the firm.
To get from EBIT to FCFF here is what we need to do:
Take EBIT and pretend we pay taxes, using the effective tax rate. This nets us NOPAT: Net Operating Profit After Tax.
We subtract reinvestments. Which is computed as (CapEx - Depreciation and Amortization) - change in working capital.
Fortunately for us, the spreadsheet does an approximation for this, but if you want to get into it, it would be good if you compute this at least once for yourself.
Note, that real reinvestments consist of the value of research assets as well as any acquisitions the company has made - everything that results in the long-term growth of a company is a reinvestment.
This build down, gives us the free cash flows to the firm.
We need to estimate the EBIT margin in order to convert revenues to EBIT, so that we can get to the FCFF.
The first place to start are historical EBIT margins.
As you can imagine I use ttm numbers.
From the picture above, we can start to speculate on a few options about margins.
Margins have been mismanaged in the last 3 years, and are about to revert to an average value around 10%.
Margins are growing back, and will expand as the company increases in efficacy.
The company has been growing at the expense of margins and their expansion comes with costs that have not been appropriately addressed.
It seems to me, that given everything we discussed, the company will implement some efficiencies, but will have a hard time sustaining an EBIT margin above 10%. The farming industry had an average margin of 6.5% in 2020.
In the end, I opted to give the company an EBIT margin that converges on 9% in 10 years.
Next, we give it the effective tax rate and we assume that the company is neutrally efficient when reinvesting. We will skip these concepts as they go a bit beyond what you need to do a basic valuation.
Value Driver 3 - The Discount Rate
The discount rate is the % we use to penalize future cash flows for the costs and risk associated with being invested in that company every year.
The discount rate, in our case will be the cost of capital for the business.
When choosing a discount rate, we have the choice between using the cost of equity and the cost of capital.
FCFE uses the cost of equity discount rate and FCFF uses the cost of capital.
In our case, the discount rate is the cost of capital.
Even though the company does not have much debt. The discount rate should match the type of cash flows, this is not a big mystery. However, we can change the discount rate over the 10 year projection period, because a company is expected to stabilize as time goes forward and thus change the risk, which would change the discount rate.
What is the structure of the cost of capital?
The cost of capital is constructed from 2 sources of risk. The risk carried from the stock and the cost of borrowing long term today. We take the weighted average of these 2 costs (%) and construct a weighted average cost of capital, which is meant to represent the total risk of investing in the company.
What are they weighted by?
They are weighted by the market values of equity and the market value of debt. The market value of equity is just the market cap of the company, and the market value of debt can be approximated by treating the long term debt (along with operating leases) as a large bond.
We use market weights of equity because we are valuating the risk of the company in relation to market prices. So, we cant choose book values and impose our estimate.
Because our valuation is in relation to the market, our weights are market weights.
How is the cost of equity constructed?
The cost of equity is the required return for investing a stock.
We start by establishing the rate for a risk-less investment. Why? Because it doesn’t make sense to require a lesser rate than an investment that is without risk (Completely? Yes, completely and that is a big if).
So, lets assume that a 10-year t-bond rate is a good approximation for a risk-less rate and the rate today is .86% but the 3 year average rate is 2.2%
Which rate you should choose?
The logic pushing you to use an average rate is two-fold. One, it seems to be a better representative of a risk-less rate on the long term, and two, you may think that the rate will move closer to 2% in a few months/years.
The problem with this, is that you are trying to estimate the company value as of today. Not tomorrow, not a year from now, this is a not a target rate.
If you do decide to value a company as of 6 months from now, keep in mind that everything becomes a moving part, and you need to do differentials on all elements - so you can’t just pick and choose what you think is right, and leave the rest alone.
Take the current risk-free rate, from the 10-year t-bond rate and move on.
So we are taking the rate of a risk-less investment and add on top of that the risk of the specific stock.
Cost of Equity = Riskfree Rate + Risk of a Stock
The way we get the risk of a particular stock is in relation to all stocks within a market. Basically, we are estimating the risk of investing in stocks in general and we adjust for the risk of an individual stock.
You can get a very good estimate of the risk for all stocks in a particular market by looking up “enterprise risk premium”, or visiting Damodaran’s website.
For the 1st October, the ERP rate is 4.84%
To get the risk for our stock, we need to adjust the current risk for stocks in general (4.84%) by the specific risk of the stock.
We can measure how risky a stock is relative to its movements compared to an index (e.g. the S&P 500).
If the stock moves in lock-step with an index it carries the same amount of risk with the market, and we assign it a factor of 1.
If the stock moves more than an index, in a generally positive direction, we compute a >1 factor. If the stock is moving in the opposite direction of the index - with the same intensity, we observe a value of -1.
These values are called a Beta - and you don’t even need to use to use a beta, you just need to define how much more or less is a stock risky than an index.
When you decide on a number, just use the ERP * Risk of Stock
In the case of Sanderson we estimate that the company has a (bottom up) beta of 0.71. This comes from the estimated risk of the Farming/Agriculture industry + the risk that debt brings into the stock.
To bring that in, we calculate a cost of equity as:
Cost of Equity = Riskfree Rate + ERP * Beta
= 1.68% + 4.72% * 0.71 = 1.68% + 3.36% = 5.05%
5% is the (yearly) return that equity investors require for investing in the stock.
Since a company is funded both by equity and debt, we also need to bring in the cost of debt in order to produce a full picture of the cost of capital - the required return on the stock.
Because I am trying to stick to the concepts in this article, I just wish to remind you that the cost of debt is the cost of borrowing long term debt, today. Not the rate at which a company borrowed 2 years ago, or yesterday. The cost of borrowing today.
We get it by taking the risk free rate (1.68%), adding a default spread (the AAA rating you can find from rating agencies), add a country default spread (if any), and adjust for taxes.
Cost of Debt = (1.68% + 0.69% + 0) * (1-0.27) = 1.73%
The stock is comprised of 99% equity and 1% debt, giving us a weighted average cost of capital of 5%.
This is our discount rate - the rate which we will use to penalize future cash flows in order to estimate what the company is worth today.
Value Driver 4 - The Terminal Value
The terminal value is the value of the cash flows after year 10.
There are a few options for calculating the terminal value.
If you think that the company will shut down after year 10, you will want to assign a liquidation value, which values the total assets of the company.
If you think the company will mature and stabilize, you can assign a perpetual growth rate and discount the cash flows based on that.
The latter option is what I use in most cases. As the business will continue to exist in one form or another and keep generating cash flows.
When estimating a terminal value, we must choose a perpetual growth rate of revenues after year 10. This growth should be justifiable in terms of “forever”. I know that is too much, but don’t worry, there is a mechanism to bring the theoretical into practice.
First, we need to assign the perpetual growth rate, and there are a few mistakes you really should avoid when doing this.
A mature company is very likely to grow in lock-step with the economy, thus we need a perpetual growth for the economy. The safest way to do this, is to use the 10-year T.Bond rate as of today. Not an average 3, or 5 year rate. Why? because we are assuming that the economy will revert to the average. This could be the case, but it usually stems from our wishes, not an analytic estimate. If you set this rate at 3%, while the economy is projected to grow 1.6% today, you are in effect estimating that the company will grow larger than the economy, which can lead to amazingly large terminal values. You are also implying that you know the direction of economic growth - and I would ask you to pause for a second and consider Europe’s and Japan’s economies. Their rates are low to negative as they are mature markets with declining populations, what makes you think that the USA will have positive growth in the long-term?
The last argument for using the 10-year T.Bond rate is that you are estimating the growth rate as of today, and that rate takes into account the supply and demand dynamics of the market. Not what academics say, not what experts think, not even what the CPI measures. It is a rate that comes from supply and demand as of today.
You can get away with rates that are 0.5% to 1% higher than that of the economy, but going beyond that creates “impossible” valuations.
The formula for the Terminal Value is:
Terminal Value = Terminal Cash Flows / (Terminal Cost of Capital - Revenue Growth Rate in Perpetuity)
In the example of Sanderson farms, our terminal cash flows are $297.6 million, the terminal cost of capital is equalized with the risk of mature markets (USA) + the risk-free rate today and comes to 6.27%, and the perpetual growth rate I used is 0.8% (which is less than the current risk-free rate of 1.65% - because I think that is too generous for a mature and possibly declining company). Our resulting terminal value comes to:
$297,587,574 / (0.0627 - 0.008) = $5.5b
As you will see in the chart below, the terminal value is very sensitive to small changes in the perpetual growth rate, and we can easily add a few billion just by playing with fractions of a percent.
After we decide on the terminal growth rate, we need to estimate the present value of the cash flows in perpetuity.
To do that, we multiply our terminal value by the cumulative discount rate from year 10 - Imagine that the further you go on in the future, the less your cash flows are worth.
In year 10, our discount factor is 59%, which means that $1 in year 10 is worth 0.59 cents today.
We take our $5.5b and discount them by 59%, arriving at at present value of our terminal value at $3.2b
$5,445,462,551 * 0.593 = $3,226,798,057
Congratulations, we are now ready to wrap up!
RECAP: The growth drivers you need to estimate in a valuation are: revenue growth rates, EBIT margins, the discount rate, and check the terminal value. In essence, you need to build a 10 year model for how you see the future cash flows of your company.
Valuation Result
We estimated a long term revenue growth rate of 3% next year and 2% in the 4 years after that, a 9% EBIT margin at which the company will converge to in 10 years, and a 5% discount rate as measured by our cost of capital.
If we use these metrics to compute our cash flows in the next 10 years, here is what we get (start from the top row and move down):
We can also illustrate the cash flows with the following chart:
We get the intrinsic value by summing the present value of future cash flows, as well as the present value of the expected cash flows in perpetuity. We also adjust for debt, cash, outstanding employee option contracts and other loose ends.
For Sanderson, these are the final results:
Present value of future cash flows: $1,925,202,299
Present value of terminal value: $3,212,091,687
Sum of present values: $5,137,308,958
Intrinsic Value of Sanderson: $5,351,816,958
Current Market Capitalization: $4,195,172,520
Undervalued by 22%
Compared to the current price, this is how our value line looks like today:
Now we have a good foundation to suspect that the market is incorrectly valuing the cash-flows of Sanderson Farms (SAFM).
Considering that we have a basis, we can explore the possible ways in which this situation can progress.
RECAP: Using a DCF we valued Sanderson at $5.3b, 22% undervalued from today’s pre-open price.
Investment Approach
Just because something might be undervalued, doesn’t mean that the market will wake up tomorrow (or in a few years) and the price will jump up.
When building an investment thesis we must think about the factors that are keeping the price under current levels and possible catalysts for change.
We can speculate, that the reason why Sanderson is not reaching a higher market price is the perception of management incompetence, lack of discovery by institutional money managers, the added risk stemming from not being a market leader in their segment, the general stagnation of the industry, the perceived low margin business model, the lack of prestige from making an investment thesis on a farming company, the general allocation of funds in other industries by institutional investors which are perceived to have higher returns, possible competitive pressures on the market share and profit margins.
It is important not to fall in love with our investment thesis, and be our own critic when thinking where to invest hard earned money.
After we understand that things may not go our way, we can think of possible catalysts that are going to bring attention to the stock and move the price up.
While we discussed a few possible cyclical and inflation scenarios for Sanderson, there is one I saved for the end: Merger Arbitrage.
As always, this fancy jargon has a very simple concept behind it.
Merger arbitrage simply means that there is a possible price difference we can exploit if a merger deal goes through.
Sanderson just announced that its shareholders have approved the merger with Cargill and Continental Grain Company.
They struck a deal to merge the company for $203 per share paid in cash, which totals some $4.5b.
The price difference from today (21st, Oct 2021) can net investors some 6.8%, assuming that the deal goes through.
That 6.8% difference from the current price and the agreed upon price of the merger deal is your price arbitrage, and it can be a very good catalyst for the rise of the stock.
Given the merger deal, there is no reason whatsoever to buy Sanderson stock above $203 per share. If you are interested in the new merged entity, you will have to make a separate valuation for that company!
Conclusion
My goal was to present the logic behind the concepts of intrinsic value and doing a full discounted cash flow valuation.
I am sure you don’t agree with everything, and the model is far from perfect, but I hope you will find it to be a good tool that helps you better your investment ideas.
If you have any questions, ask them in the comments, and I will be happy to explain or talk with you more.
You can get the Fundamental Report HERE.
Try out the valuation yourself from Damodaran’s spreadsheet HERE.
Thank you for reading and all the best!