Intrinsic Value Calculation

 

 

Intrinsic value and the margin-of-safety multiple calculations for selected companies.

 

Google, Inc., (GOOG) (As of 7/31/05) founded by Larry Page and Sergey Brin, is a leading Internet search engine company that offers advertising services and approximately 8 billion searchable Web pages for its users. Google announced plans to partner with libraries and publishers to digitize and make searchable many classic books no longer under copyright protection. Google, Inc. (GOOG) begins trading as an Initial Public Offering (IPO) during August, 2004 at approximately $96 per share, and as this is written the stock is about $300 per share.

Select Google, Inc. for analysis. Please go to  http://investor.google.com/pdf/2004_AnnualReport.pdf for a copy of the 12/31/2004 annual report used in this analysis. Also, www.zacks.com is useful when analyzing annual reports. Results since 2002: sales revenue is growing by approximately 165% per year; 2) net income is increasing by nearly 100% per year; and 3) free cash flow (FCF) is on the rise by about 65% per year (over the last three years FCF has increased from approximately $217 to $599 million dollars).

Taking the smallest percentage increase for sales, income and free cash flow (FCF) growth, it is assumed that FCF will increase by 65% for the next two years, than 50% for two years, 25% for the two years after that and for the final four years of this ten year forecast, FCF will grow at 20% per year. With the 30-Year Treasury Bond interest rate low, the risk free discount rate is 5% which is used to determine the present worth factors. Intrinsic value for the first stage is $39,505 million dollars and the second stage $241,319 million dollars, giving a total intrinsic value for Google, Inc. of $280,824 million dollars.

Market value capitalization includes the total number of diluted shares, 273 million shares, multiplied by the July, 2005 stock price of $300 per share, equaling $81,900 million dollars. Google’s bargain value ($280,824 - $81,900) is positive at $198,924 million dollars.

The margin-of-safety multiple is the intrinsic value of $280,824 million dollars divided by the market value capitalization of $81,900 million dollars, equaling 3.43 which is comfortably over the 2.0 minimum value; therefore, by the margin-of-safety multiple method Google is considerably undervalued and an excellent investment.

 

Ten additional crucial factors to be checked prior to investing in Google:

1) Current Ratio: 7.92 – with a value over two considered good, this measure is very good indeed.

2) Debt-to-Equity Ratio: 0.13 – Google is using 0.13 of liabilities for every dollar of shareholder equity which is very conservative.

3) Return-on-Equity: 13.6% - this is low, would prefer to have this measure over 20%.

4) Operating Profit Margin: 20% - this seems low for a dot com company, would prefer to have operating profit margin in the 30-40% range. A more experienced operations management team may be required.

5) Diluted Net Earnings Per Share: $1.46 – up approximately 80% per year. This does not match the increase in net income growth (+100%) because the number of diluted shares outstanding (even without a stock split) is growing by about 11% per year.

6) Continued good service is apparent. Google is a leader as an Internet search engine provider and as Philip Fisher says, Google is both prosperous and gifted.

7) Google’s management is having trouble translating enormous top line sales growth (+165%) into consistently huge bottom line net income growth (+100%). As mentioned previously, a more experienced operations management team may be required.

8) Google’s marketing/sales/distribution organization is judged to be superior with sales growing by 165% per year.

9) Google, along with Yahoo, is a leader in the relatively new Internet search engine category which is a rapidly expanding industry which is free to grow at a phenomenal rate.

10) Any interviews with customers, vendors, employees, etc. are reported positive.

 

Conclusion: Google’s margin-of-safety multiple of 3.43 easily surpasses the margin-of-safety multiple minimum of 2.0, and with the additional crucial factors being mostly excellent – investors, at this time, should be highly encouraged to make a long-term stock investment into Google, Inc. – even after the stock’s explosive run-up over the previous 11 months from $96 at the IPO in August, 2004 to $300 dollars per share during July, 2005. 

 

 

 

General Motors (GM) (As of 10/31/05) and the automobile industry are in the news due to the recent bankruptcy filing by Delphi Corporation (DPH), an auto supplier spun off from GM six years ago. A major downside for GM in Delphi’s troubles is that GM will experience increased retirement liabilities, potential increased costs and supply disruptions for parts, and possible problems during upcoming UAW labor negotiations.

 

Standard & Poor’s downgraded further into junk bond status GM’s credit rating from BB to BB- on its $285 billion dollars in outstanding debt, thus increasing GM’s borrowing costs. GM’s stock declined and is trading at $27.40 per share, down approximately 32% from $40.50 at the beginning of 2005.

 

On the positive side GM is paying dividends of $2.00 per share resulting in a  dividend yield of approximately 7.30% at the current stock price, and has approximately $56 billion dollars of cash and equivalents on the balance sheet. The question for investors is, “has all the bad news come out on GM and is now the right time to invest.”

 

To properly answer this question, astute investors should separate the company itself from its stock. GM is a wonderful company making excellent products; however, industry economics often outweigh an excellent company’s specific circumstances to make its stock a poor investment. Astute investors recognize that they are investing in the stock first and the company second. Please go to Morningstar’s website listed below for GM’s ten-year income statement.

 

http://quicktake.morningstar.com/Stock/income10.asp?Country=USA&Symbol=GM&stocktab=finance

 

Over the last ten years from 1995-2004, GM’s sales revenue increased approximately 1.5% a year from $169 billion dollars to $194 billion dollars. Net income over this same time period decreased by approximately -9% a year from $7 billion dollars to $3 billion dollars. In addition, net income reported for the first nine months of 2005 total a negative -$3 billion dollars. Meager top line growth in revenues for GM and negative bottom line net income growth indicates operations management trouble. Lets look at the all important free cash flow each year that is easily calculated from Zacks’ website below.          

 

http://www.zacks.com/research/report.php?type=cfs&t=GM

 

Free cash flow (FCF) in billions of dollars for each year (YR) from 2000 to 2004 is calculated from the cash flow statement and is defined as “cash from operating activities (COA) minus total capital expenditures (TCE),” and is reported as (YR: COA – TCE = FCF). The calculations for FCF are: (2004: $13 – $32 = - $19 billion dollars); (2003: $8 – $51 = - $43 billion dollars); (2002: $17 – $12 = $5 billion dollars); (2001: $9 - $21 =  -$12 billion dollars); (2000: $20 - $26 = -$6 billion dollars).

 

GM’s FCF averages a negative -$15 billion dollars per year from 2000 to 2004. GM is not generating enough money from internal operations to support itself. GM over the past five years issued an average of $28 billion dollars of new debt each year as well as paying an average of $1.2 billion dollars per year in dividends, thus the continued need for outside financing is a long-term detriment for GM’s stock price. As a negative intrinsic value is not an option when FCF is negative; therefore, GM’s intrinsic value is zero. 

 

Market value capitalization includes the total number of diluted shares outstanding, approximately 567 million shares, multiplied by the October 31, 2005 closing stock price of $27.40 per share, equaling approximately $16 billion dollars. GM’s bargain value ($0  - $16) is a negative  -$16 billion dollars.

 

The margin-of-safety multiple is the intrinsic value of $0 dollars divided by the market value capitalization of $16 billion dollars, equaling zero which is no where near the 2.0 minimum value required for investment; therefore, by the margin-of-safety multiple method GM’s stock is considerably overvalued and not a good long-term investment for astute investors.

 

Ten additional crucial factors for General Motors are checked next: (from the 2004 financial statement).

1) Current Ratio: 0.70 – The current ratio is a test for short-term solvency, creditors would like a safety cushion value of 2.00, this measure for GM is poor. 

2) Debt-to-Equity Ratio: 16.30  – GM is using $16.30 dollars of liabilities for every $1.00 dollar of shareholder equity which makes GM a hyper-leveraged company. This is a very precarious state of affairs and could seriously affect the viability of GM as a going concern if future U.S. political-economic conditions turn very negative. An effective limit for manufacturing companies is often set at a one-to-one debt to equity ratio.

3) Return-on-Equity: 10% - this is low, astute investors  would prefer to have this measure over 15% for a manufacturing company.

4) Operating Profit Margin: 6.8% - this is low for a manufacturing company, would prefer to have operating profit margin in the 15% - 25% range. A more experienced operations management team may be required.

5) Diluted Net Earnings Per Share: $4.95 – Over the past five years diluted EPS have averaged $4.35: thus, the diluted EPS growth rate is flat. EPS turned negative in 2005.

6) Continued good service is apparent. GM is a leader in U.S. automotive manufacturing and as Philip Fisher says, GM is prosperous because they are gifted.

7) GM’s management is having trouble translating top line sales growth (+1.5% per year) into bottom-line net income growth (negative -9% per year). As mentioned previously, a more experienced operations management team may be required.

8) GM’s marketing/sales/distribution organization is judged to be acceptable, with sales growing by approximately 1.5% per year in a very difficult automotive industry sector.

9) GM is a leader in the automotive manufacturing category in North America: however the U.S. automotive industry is highly competitive.

10) Any interviews with customers, vendors, employees, etc. are reported positive.

 

Conclusion: GM’s margin-of-safety multiple of zero does not approach the margin-of-safety multiple minimum value of 2.0, and with the additional crucial factors being mostly poor – astute investors, at this time, should consider GM an excellent company but with an over valued stock price and thus a poor long-term investment.

 

 

 

SanDisk Corporation (NASDAQ: SNDK) (As of 1/31/06) founder and chief executive, Eli Harari, brought the company public in November of 1995. SanDisk is a leader in supplying flash memory cards and chips for use in digital cameras, cellular phones and personal digital assistants, as well as in producing their own MP3 music players. Over the past year, SanDisk’s common stock price has increased by approximately 185% — making it one of the best performing companies in the semiconductor index (SOX).

 

On January 27, 2006, in the company’s market outlook, SanDisk executives predict “a seasonally soft first quarter in retail.” To ensure strong market demand for their products, SanDisk management announce price cuts on flash cards of up to 35%. This unexpected announcement causes SanDisk’s stock price to decline by 6.5% in one day. In addition, market analysts announce expected increased SanDisk competition from Hynix Semiconductor and Micron Technology. The question, going forward, is whether SanDisk is a good long-term investment.      

 

Over the past seven years, from 1999-2006, SanDisk’s sales revenue increased approximately 45% a year from $247 million dollars to $2,306 million dollars. Net income, over this same time period, increased by approximately 55% per year from $27 million dollars to $386 million dollars. Strong top line growth in revenues for SanDisk and even better bottom line net income growth indicate an effective and efficient operations management team is in place. Lets look at the all important yearly free cash flows calculated from SanDisk’s annual reports found on their website below.          

 

http://investor.sandisk.com

 

Free cash flow (FCF) in millions of dollars for each year (Yr) from 1999 to 2006 are calculated from the cash flow statements and defined as “cash from operating activities (COA) minus total capital expenditures (TCE),” and are reported as (Yr: COA – TCE = FCF). The calculations for FCF are: (2005: $481 – $128 =  $353 million dollars); (2004: $228 – $153 =  $75 million dollars); (2003: $273 – $60 = $ 213 million dollars); (2002: $107 - $40 =  $67 million dollars); (2001: -$72 - $11 = -$83 million dollars); (2000: $85 - $162 =  -$77 million dollars); (1999: $17 - $21 = -$4 million dollars).

 

A) Over the past four years, SanDisk FCF has increased FCF by approximately 75% per year. Taking the smallest percentage increase per year, to be conservative, for sales (45%), net income (55%) and FCF (75%) growth; it is projected that FCF will increase by 45% per year for the next two years, 30% per year for the next two years after that, then 20% per year for two years, and 15% per year for the final four years of this ten year forecast. With the 30-year Treasury bond (T-bond) interest rate low, 5% percent present worth factors are used to discount FCF’s to today’s price. Intrinsic value for the first stage is $12,338 million dollars and the second stage is $64,167 million dollars, giving a total intrinsic value for SanDisk of $76,505 million dollars.

 

B) Market value capitalization includes the total number of diluted shares outstanding, approximately 197,486,000 shares, multiplied by the January 31, 2006 closing stock price of $67.36 per share, equaling $13,303 million dollars. SanDisk’s bargain value ($76,505 - $13,303 million dollars) is a positive $63, 202 million dollars.

 

C) The margin-of-safety multiple is the intrinsic value of $76,505 million dollars divided by the market value capitalization of $13,303 million dollars, equaling 5.75 which is much higher than the 2.0 minimum value required for investment; therefore, by the margin-of-safety multiple method, SanDisk’s stock is considerably undervalued. The following ten additional crucial factors are checked prior to investing.

 

D) Ten additional crucial factors for SanDisk Corp. are investigated below: (from the 2006 financial statements).

1) Current Ratio: 4.56 — The current ratio is a test for short-term solvency, creditors prefer a safety cushion value of at least 2.00; this measure for SanDisk is excellent. 

2) Debt-to-Equity Ratio: 0.23  — SanDisk uses 23 cents of total liabilities for every $1.00 dollar of shareholder equity which makes SanDisk a reasonably leveraged company.

3) Return-on-Equity: 17% - which is good, astute investors prefer to have the ROE measure over 15% for a manufacturing company.

4) Operating Profit Margin: 17% — this is good for a manufacturing company, astute investors prefer to have operating profit margin in the 15% - 25% range.

5) Diluted Net Earnings Per Share (EPS): $2.00 — Over the past four years, Diluted Net EPS average $1.18. The Diluted Net EPS growth rate, over four years, for SanDisk is 100% per year which is excellent.

6) Continued good service is apparent. SanDisk is a leader in supplying flash memory cards and chips which is a growth industry, and as Philip Fisher says, SanDisk is both “prosperous and gifted.”

7) SanDisk management’s integrity, intelligence and vitality are judged to be of the highest quality. Top management develops, implements and communicates good policies and strategies, and is effective and efficient in running the day-to-day operations of the company.

8) SanDisk’s marketing/sales/distribution organization is judged to be excellent, with sales growing by approximately 45% per year.

9) SanDisk is a leader in the semiconductor industry for flash memory cards and chips, however, the U.S. semiconductor industry is highly competitive. Nonetheless, top line growth of 45% per year is being exceeded by bottom line growth of 55% per year. Consequently, a knowledgeable and experienced operations management team is in place. Research and development are ongoing and judged to be effective in bringing new products to market.

10) Interviews with customers, vendors, employees, etc. are reported as positive.

 

Conclusion: SanDisk’s margin-of-safety multiple of 5.75 is excellent and vastly exceeds the margin-of-safety multiple minimum value of 2.0, and additional crucial factors are mostly excellent. Astute investors, at this time, should consider SanDisk Corporation to be an excellent company with an undervalued stock price and, thus, a good long-term investment.

  

 

Marathon Oil Corporation (NYSE: MRO) (As of April 21, 2006)  headquarters are located in Houston, TX, the oil capital of the world. Marathon Oil operates worldwide in oil and natural gas exploration and the production of petroleum based products.

 

The cost of oil has been steadily climbing since 2003, as a result of the U.S. invasion of Iraq, the drop in the value of the U.S. dollar, tight oil and gas supplies, increased worldwide demand for oil and gas, and with the pickup in inflation in the U.S. economy. On Friday, April 21, 2006, light sweet crude for June, 2006 delivery closed at a record price of $75.17 dollars per barrel on the New York Mercantile Exchange, after having peaked at an intraday high price of $75.35. Marathon Oil benefits from the steep increase in the price of oil and natural gas.

 

Marathon Oil’s share price in 2003 went from approximately $20 per share to closing at an all time record high of $86.04 on April 21, 2006. Marathon’s last all-time share price high occurred during 1977, at approximately $50 per share, as a result of the 1973 OPEC oil embargo. Marathon Oil recently experienced a 126% increase in year-over-year diluted earnings per share (DEPS) in 2005 over 2004.

 

In 2001, the United States Steel Corporation (NYSE: X) separated from Marathon Oil. Because Marathon Oil is a changed company since the spin-off of U.S. Steel, the examination of the financial data begins in 2002 when calculating free cash flow below. Annual reports are available on Marathon’s website:

 

http://www.marathon.com/

 

Free cash flow (FCF) in millions of dollars for each year (Yr) from 2002 through 2005 are calculated from the cash flow statements and defined as “cash from operating activities (COA) minus total capital expenditures (TCE),” and are reported as (Yr: COA – TCE = FCF). The calculations for FCF are: (2005: $4,738 – $3,265 =  $1,473 million dollars); (2004: $3,766 – $2,171 =  $1,595 million dollars); (2003: $2,765 – $905 = $ 1,860 million dollars); (2002: $2,405 - $2,582 =  - $177 million dollars. Because 2002 FCF is negative, the 2002 and 2003 FCF values are averaged, resulting in a 2002 FCF value of $841 million dollars that is used to estimate FCF growth over four years.

 

A) Over the past four years, Marathon Oil FCF increased FCF by approximately 20% per year. Taking the smallest percentage increase per year, to be conservative, for sales growth (25%), net income growth (80%), diluted earnings per share growth (70%), and FCF (20%) growth; it is projected that FCF will increase by 20% per year for the next three years, 15% per year for the next three years after that, then 10% per year for the final four years of this ten year forecast.

 

With the 30-year Treasury bond (T-bond) interest rate a low 5.16 percent, present worth factors of 5.00% are used to discount FCF’s to today’s price. Intrinsic value for the first stage is $26,688 million dollars and the second stage is $115,040 million dollars, giving a total intrinsic value for Marathon Oil of $141,728 million dollars.

 

B) Market value capitalization (MVC) includes the total number of diluted shares outstanding, approximately 359,081,000 shares, multiplied by the April 21, 2006 closing stock price of $86.04 per share, equaling MVC of $30,895 million dollars. Marathon Oil’s bargain value, calculated by subtracting MVC from intrinsic value ($141,728 - $30,895 million dollars) is a positive $110,833 million dollars.

 

C) The margin-of-safety multiple is the intrinsic value of $141,728 million dollars divided by the MVC of $30,895 million dollars, equaling 4.59 which is much higher than the 2.0 minimum value required for investment; therefore, by the margin-of-safety multiple method, Marathon Oil’s stock is considerably undervalued. The following ten additional crucial factors are checked prior to investing.

 

D) Ten additional crucial factors for Marathon Oil Corp. are investigated below: (from the December 31, 2005 MRO financial statements).

 

1) Current Ratio: 1.15 — The current ratio is a test for short-term solvency, creditors prefer a safety cushion value of at least 2.00; this measure for Marathon Oil is poor. The Quick Ratio, also called the acid test ratio, is 0.75 which is also below the standard of 1.00 and is also considered poor. The Accounts Payable account seems high at $5,353 million dollars, a call to Marathon’s investor relations representative failed to satisfactorily resolve this issue. 

2) Debt-to-Equity Ratio: 1.40  — Marathon Oil uses 1 dollar and 40 cents of total liabilities for every $1.00 dollar of shareholder equity which makes Marathon Oil a highly leveraged company. This is a poor measure for debt-to-equity.

3) Return-on-Equity: 26% - which is good, but reflects the highly leveraged balance sheet.

4) Operating Profit Margin: 8.3% — this is mediocre, astute investors prefer to have operating profit margin in the 10% - 15% range.

5) Diluted Net Earnings Per Share (EPS): $8.44 — Over the past four years, Diluted Net EPS average $4.52. The Diluted Net EPS growth rate, over four years, for Marathon Oil is 70% per year which correlates with the strong commodity price increases for oil and natural gas.

6) Continued good service is apparent. Marathon Oil is ranked fifth among U.S. petrochemical companies, and as Philip Fisher says, Marathon Oil is both “prosperous and gifted.”

7) Marathon Oil management’s integrity, intelligence and vitality are judged to be of the highest quality. Top management develops, implements and communicates good policies and strategies, and is effective and efficient in running the day-to-day operations of the company.

8) Marathon Oil’s marketing/sales/distribution organization is judged to be good, with sales growing by approximately 25% per year.

9) Marathon Oil should experience increasing worldwide demand for oil and natural gas, tight supplies, and firm to increasing long-term product pricing. However, the lack of political stability in the middle east, Nigeria, and Venezuela, and future natural disasters will make for volatile energy prices.

10) Marathon Oil has compulsory liabilities associated with Ashland which could be material. The spin off of U.S. Steel requires Marathon Oil to be responsible to pay significant obligations if U.S. Steel can not perform which could, as it says in Marathon’s 10K report, “materially reduce our cash flows and profitability and impair our financial condition.”

 

Conclusion: Marathon Oil’s margin-of-safety multiple of 4.59 is good and exceeds the margin-of-safety multiple minimum value of 2.0. Additional crucial factors however are on balance poor: a substandard current ratio, a highly leveraged debt-to-equity ratio, a low operating profit margin, being ranked fifth in the industry, however, Marathon is a good long-term investment.

 

 

 

Continental Airlines Inc. (NYSE: CAL) (As of July 26, 2006) headquarters are located in Houston, TX. Continental Airlines operates worldwide, flying to most of the major domestic and international destinations in the Americas, Europe and Asia. Transportation hubs are located in Houston, Newark, Cleveland and Guam. Continental won awards as the best airline for workplace, management and operations for the years 2004 and 2005. Continental is a time tested company, celebrating its 72 birthday during July 2006.

 

The cost of oil has been steadily climbing since 2003, as a result of the U.S. invasion of Iraq, the drop in the value of the U.S. dollar, tight oil and gas supplies, increased worldwide demand for oil and gas, and the pickup in inflation in the U.S. economy. Consequently, jet fuel costs in the airline industry have skyrocketed putting a crimp on airline profits.

 

Continental Airlines’ share price in 2003 went from approximately $5 per share to closing at $28.30 on July 26, 2006. Continental’s all-time share price, over the past ten years, occurred during 1998 at approximately $65 per share. Continental Airlines was last profitable in 2003, however, operating income turned profitable again during the first quarter of 2006, signaling that management is on the right track toward recovery after the devastating September 11,  2001 terrorist attacks and recent rapidly increasing jet fuel costs.

 

Continental Airlines’ financial data begins in 2000 when calculating free cash flow below. Annual financial reports are available on Continental’s website at:

 

http://www.continental.com/

 

Free cash flow (FCF) in millions of dollars for each year (Yr) from 2000 through 2005 are calculated from the cash flow statements and defined as “cash from operating activities (COA) minus or plus total capital expenditures (TCE) which turn positive upon the sale of assets, and are reported as (Yr: COA –/+ TCE = FCF). The calculations for FCF are: (2005: $457 + $37 =  $494 million dollars); (2004: $373 + $63 =  $436 million dollars); (2003: $342 + $73 = $415 million dollars); (2002: -$78 - $393 =  - $471 million dollars; (2001: $545 - 663 = -$118 million dollars); (2000: $906 - $574 =  $332 million dollars  Because 2001 and 2002 FCFs are negative, the calculation for FCF growth begins in 2000 at $332 million dollars growing to $494 million dollars in 2005.

 

A) Over the past six years, Continental Airlines increased FCF by approximately 8% per year. Sales revenue growth is also approximately 8% per year, calculated by averaging sales revenue for years 2000 to 2002, equaling $9,090 million dollars, and increasing to $11,208 million dollars three years later in 2005.

 

Net income growth and  diluted earnings per share growth are both negative due to the extraordinary circumstances of the September 11th terrorist attacks and rapidly increasing fuel costs over the past three years. On the plus side, sales revenue increased by 17.6% and FCF increased by 325% from the first quarter of 2005 to the first quarter of 2006. Consequently, it is assumed that Continental’s FCF will increase by 8% per year for the next ten years.

 

With the 30-year Treasury bond (T-bond) interest rate a low 5.06 percent, present worth factors of 5.00% are used to discount FCF’s to today’s price. Intrinsic value for the first stage is $5,777 million dollars and the second stage is $21,660 million dollars, giving a total intrinsic value for Continental Airlines of $27,437 million dollars.

 

B) Market value capitalization (MVC) includes the total number of diluted shares outstanding, approximately 70,300,000 shares, multiplied by the July 26, 2006 closing stock price of $28.30 per share, equaling MVC of $1,990 million dollars. Continental Airlines’ bargain value, calculated by subtracting MVC from intrinsic value ($27,437 - $1,990 million dollars) is a positive $25,447 million dollars.

 

C) The margin-of-safety multiple is the intrinsic value of $27,437 million dollars divided by the MVC of $1,990 million dollars, equaling 13.79 which is significantly higher than the 2.0 minimum value required for investment; therefore, by the margin-of-safety multiple method, Continental Airlines’ stock is considerably undervalued. The following ten additional crucial factors are checked prior to investing.

 

D) Ten additional crucial factors for Continental Airlines Inc. are investigated below: (from Continental’s December 31, 2005 financial statements, except where indicated).

 

1) Current Ratio: 1.01 — The current ratio is a test for short-term solvency, creditors prefer a safety cushion value of at least 2.00; this measure for Continental Airlines is poor. The Quick Ratio, also called the acid test ratio, is 0.65 which is also below the standard of 1.00 and is also considered poor.

2) Debt-to-Equity Ratio: 45.60  — Continental Airlines uses 45 dollars and 60 cents of total liabilities for every $1.00 dollar of shareholder equity which makes Continental Airlines a hyper-leveraged company. A one-to-one debt-to-equity ratio limit is considered appropriate. This is a very poor measure for debt-to-equity and should be closely monitored.

3) Return-on-Equity: 0% — Continental lost -$0.97 per diluted share in 2005 and has averaged a loss of -$1.68 per diluted share over the past six years. Continental has a hyper-leveraged balance sheet, consequently, once earnings do turn positive ROE should be a very high percentage. Continental’s Price to Book Value (P/BV) is $28.30 to $86.57 meaning that one dollar of physical property and capital leases may be purchased for only 33 cents on the dollar which signifies that Continental is significantly undervalued by the P/BV measure. 

4) Operating Profit Margin: 0% — this is very poor. Earnings before interest and taxes are a negative -$39 million dollars for 2005 and net income is a negative -$68 million dollars. However, operating income is profitable at $11 million dollars in the first quarter of 2006 which is expected to be the start of a new positive earnings trend.

5) Diluted Net Earnings Per Share (EPS): -$3.61 — Over the past two years. Diluted Net EPS average for Continental were last positive during 2003 at $0.41 per share. The Diluted Net EPS growth rate, over four years, for Continental Airlines is negative which reflects a continued difficult market due to rapidly increasing jet fuel prices.

6) Continued good service is apparent. Continental Airlines is ranked number one in their industry by Zacks Equity Research, and as Philip Fisher says, Continental Airlines is “prosperous because they are gifted.”

7) Continental Airlines management’s integrity, intelligence and vitality are judged to be of the highest quality. Top management develops, implements and communicates good policies and strategies, and is effective and efficient in running the day-to-day operations of the company. Airline awards for excellence in 2004 and 2005 attest to this fact.

8) Continental Airlines’ marketing/sales/distribution organization is judged to be good, with sales growing by approximately 8% per year in a very difficult airline market.

9) Continental Airlines should experience increasing worldwide demand for domestic and international flights. Continental is a leader in the domestic and international airline industry with excellent operations management.

10) Any interviews with Continental’s customers, vendors, subcontractors, government, university scientists and employees at other companies are all positive.

 

Conclusion: Continental Airlines’ margin-of-safety multiple of 13.79 is exceptionally good and exceeds the margin-of-safety multiple minimum value of 2.0. Additional crucial factors, however, are on balance poor: i.e., substandard current and quick ratios, a hyper-leveraged debt-to-equity ratio, ROE equal to zero, and negative average diluted net earnings per share over the past six years. Two crucial factors are positive however: price-to-book value is one-to-three and Continental is an industry leader with excellent management. Continental Airlines is a good long-term investment.

 

Ford Motor Company (NYSE: F) (As of October 26, 2006) is selected for analysis and financial information from Ford’s annual reports are available by clicking on the following website at:

 

http://www.ford.com/en/company/investorInformation/companyReports/annualReports/default.htm

 

Ford reported a $5.8 billion dollar loss for the third quarter of 2006 and has lost $7.24 billion dollars during the first nine months of 2006. The fourth quarter’s financial results should further deteriorate as restructuring costs due to plant closures and employee reductions are implemented to cope with a lower demand for Ford’s products due to foreign competition and higher gasoline prices.

 

Moody’s during July of 2006 downgraded further into junk bond status Ford’s credit rating from Ba3 to B2 on its $154 billion dollars in outstanding debt, thus increasing Ford’s borrowing costs. Ford’s stock has been in a trading range during 2006, from $6.06 to $9.48 dollars per share. Ford’s stock price during the first quarter of 2001 was $31.50 and has been in a long-term downtrend ever since.

 

On the positive side, Ford is paying dividends of $0.20 per share resulting in a  dividend yield of approximately 2.36% at the current stock price and has approximately $39 billion dollars of cash, cash equivalents and short-term investments on its balance sheet. The question for investors is, “has all the bad news come out on Ford and is now the right time to invest.”

 

To properly answer this question, astute investors should separate the company itself from its stock. Ford is a wonderful company making excellent products; however, industry economics often outweigh an excellent company’s specific circumstances to make its stock a poor investment. Astute investors recognize that they are investing in the stock first and the company second. Please go to Morningstar’s website listed below for Ford’s ten-year income statement.

 

http://quicktake.morningstar.com/Stock/Income10.asp?Country=USA&Symbol=Ford&stocktab=finance&pgid=qtqnnavfinstate

 

 

Over the last ten years from 1996-2005, Ford’s sales revenue increased approximately 2% a year from $147 billion dollars to $177 billion dollars. Net income over this same time period decreased by -8% a year from approximately $4 billion dollars to $2 billion dollars per year. Top line growth in revenues for Ford and negative bottom line net income growth indicates that operations management specialists should be called in to review operations. Lets look at the all important free cash flow each year that is calculated using cash flow data from Morningstar’s website.            

 

Free cash flow (FCF) in billions of dollars for each year (YR) from 2001 to 2005 is calculated from the cash flow statement and is defined as “cash from operating activities (COA) minus total capital expenditures (TCE),” and is reported as (YR: COA – TCE = FCF). The calculations for FCF are: (2005: $22 – $10 =  $12 billion dollars); (2004: $25 – $7 =  $18 billion dollars); (2003: $17 – $7 = $10 billion dollars); (2002: $19 - $8 =  $11 billion dollars); (2001: $23 - $10 = $13 billion dollars).

 

Ford’s FCF averages $13 billion dollars per year from 2001 to 2005. Ford during this time period is generating enough money from internal operations to support itself. Ford over the past five years reduced debt by an average of -$4 billion dollars each year. Ford is paying $0.20 per share or approximately $0.39 billion dollars per year in dividends. It is judged that Ford’s FCF is declining by approximately -0.75% per year. Ford’s intrinsic value is $90 billion dollars for stage one and $74 billion dollars for stage two for a total of $164 billion dollars.

 

Market value capitalization includes the total number of diluted shares outstanding, of approximately 1,928 million shares, multiplied by the October 26, 2006 closing stock price of $8.48 per share, equaling approximately $16 billion dollars. Ford’s bargain value ($164  - $16) is $148 billion dollars.

 

The margin-of-safety multiple is the intrinsic value of $164 billion dollars divided by the market value capitalization of $16 billion dollars, equaling approximately ten which is much higher than the two minimum value required for investment; therefore, by the margin-of-safety multiple method Ford’s stock is considerably undervalued and a good long-term investment for astute investors.

 

Ten additional crucial factors for Ford are checked next: (from the 2005 financial statement).

1) Current Ratio: 1.18 – The current ratio is a test for short-term solvency, creditors would like a safety cushion value of 2.00, this measure for Ford is poor. The Quick Ratio, also called the acid test ratio, is 0.83 which is also below the standard of 1.00 and is considered poor. 

2) Debt-to-Equity Ratio: 19.80  – Ford is using $19.80 dollars of liabilities for every $1.00 dollar of shareholder equity which makes Ford a hyper-leveraged company. This is a very precarious state of affairs and could seriously affect the viability of Ford as a going concern if future U.S. political-economic conditions turn very negative. An effective limit for manufacturing companies is often set at a one-to-one debt to equity ratio.

3) Return-on-Equity: 15.6% - this is appropriate but has turned negative for 2006. Ford has a hyper-leveraged balance sheet, consequently, ROE is very volatile. Ford’s Price to Book Value (P/BV) is $8.48 to $21.11, meaning that one dollar of physical property may be purchased for only 40 cents on the dollar which signifies Ford as significantly undervalued by the P/BV measure.

4) Operating Profit Margin: 4% - this is low for a automotive manufacturing company, would prefer to have operating profit margin in the 10% - 15% range. Operations management consultants to improve the operating profit margin are suggested for Ford.

5) Diluted Net Earnings Per Share: -$0.58 – Over the past five years diluted EPS have averaged negative - $0.58: thus, the diluted EPS growth rate is poor. EPS is also negative for 2006.

6) Continued good service is apparent. Ford is a co-leader in U.S. automotive manufacturing and as Philip Fisher says, Ford is prosperous because they are gifted.

7) Ford’s management is having trouble translating top line sales growth (+2% per year) into bottom-line net income growth (negative -8% per year). As mentioned previously, a more experienced operations management team may be required.

8) Ford’s marketing/sales/distribution organization is judged to be acceptable, with sales growing by approximately 2% per year in a very difficult automotive industry sector.

9) Ford is a co-leader in the automotive manufacturing category in North America: however, the U.S. automotive industry is highly competitive.

10) Any interviews with customers, vendors, employees, etc. are reported positive.

 

Conclusion: Ford’s margin-of-safety multiple of ten exceeds the margin-of-safety multiple minimum value of two, however, Ford’s additional crucial factors are mixed. Astute investors should consider Ford a good company with an undervalued stock and is a better investment than General Motors, however, the industry is under tremendous pressure at this time and Ford is considered a neutral long-term investment opportunity.

 

Vail Resorts, Inc. (NYSE: MTN) (As of January 26, 2007) is selected for analysis and financial information from Vail Resorts’ annual reports are available by clicking on their website:

 

http://www.vailresorts.com/

 

Vail Resorts, Inc. is a public holding company, their initial public offering (IPO) debuted in 1997. Vail Resorts is organized into three subsidiaries: 1) Mountain Segment (including ski resorts at Vail, Breckenridge, Keystone, Heavenly and Beaver Creek); 2) Lodging Segment (including Rock Resorts, Park Resorts, Jackson Hole Golf & Tennis Club, and six additional hotels and resort golf courses); and 3) Real Estate Segment (including an extensive number of properties located in Summit and Eagle counties in Colorado, as well as in Teton county, Wyoming).

 

Over the last six years from 2001-2006, Vail Resorts’ sales revenue increased approximately +9 percent per year from $544 million dollars to $839 million dollars. Net income over this same time period increased by approximately +11% per year from $11.5 million dollars to $45.8 million dollars.            

 

Free cash flow (FCF) in millions of dollars for each year (YR) from 2001 to 2006 is calculated from the cash flow statement and is defined as “cash from operating activities (COA) minus total capital expenditures (TCE),” and is reported as (YR: COA – TCE = FCF). The calculations for FCF are: (2006: $193 – $57 =  +$136 million dollars); (2005: $220 + $37 =  +$257 million dollars); (2004: $181 – $55 =  +$126 million dollars); (2003: $155 – $128 = +$27 million dollars); (2002: $132 - $305 =  -$173 million dollars); (2001: $109 - $103 = +$6 million dollars).

 

Vail Resorts averages +$63 million dollars per year in FCF from 2001 to 2006. Consequently, Vail Resorts is generating enough money from internal operations to support itself. Vail Resorts, over this time period, has average debt of $685 million dollars. It is judged that Vail Resorts’ FCF is increasing by approximately +12 percent per year. Vail Resorts’ intrinsic value is +$1,676 million dollars for stage one and +$6,546 million dollars for stage two for a total of $8,222 million dollars.

 

Market value capitalization includes the total number of diluted shares outstanding, of approximately 38.450 million shares, multiplied by the January 26, 2007 closing stock price of $45.20 per share, equaling approximately $1,738 million dollars. Vail Resorts’ bargain value ($8,222  - $1,738) is a positive +$6,484 million dollars.

 

The margin-of-safety multiple is the intrinsic value of +$8,222 million dollars divided by the market value capitalization of +$1,738 million dollars, equaling 4.73 which is much higher than the minimum value of two required for investment; therefore, by the margin-of-safety multiple method, Vail Resorts’ stock is considerably undervalued and a good long-term investment for astute investors.

 

Ten additional crucial factors for Vail Resorts are checked next: (from their 2006 financial statement).

 

1) Current Ratio: 1.28 – The current ratio is a test for short-term solvency, creditors would like a safety cushion value of 2.00, this measure for Vail Resorts is poor. The Quick Ratio, also called the acid test ratio, is 0.98 which is close to the standard of 1.00 and is considered adequate. 

2) Debt-to-Equity Ratio: 1.63  – Vail Resorts is using $1.63 dollars of liabilities for every $1.00 dollar of shareholder equity which makes Vail Resorts a leveraged company. An effective limit for most companies is often set at a one-to-one debt to equity ratio. However, interest expense is decreasing and is considered manageable at this time.

3) Return-on-Equity: +7.1% - this is low, would rather have ROE at approximately +15 percent. Vail Resorts’ Price to Book Value (P/BV) is $45.20 to $22.13, meaning that one dollar of physical property may be purchased for $2.04 which signifies Vail Resorts is overvalued by the P/BV measure.

4) Operating Profit Margin: +12.6% - this is good for a mountain resort company.

5) Diluted Net Earnings Per Share: +$1.19 for 2006 – Over the past six years, diluted EPS have averaged + $0.22: thus, the diluted EPS growth rate is acceptable.

6) Continued good service is apparent. Vail Resorts is a mountain resorts leader and as Philip Fisher says, Vail Resorts is prosperous because they are gifted.

7) Vail Resorts’ management is translating top line sales growth  of +9% per year into increased bottom-line net income growth of +11% per year. Consequently, operations management at Vail Resorts is very capable.

8) Vail Resorts’ marketing/sales/distribution organization is judged to be acceptable, with sales growing by approximately +9% per year.

9) Vail Resorts is a leader in a difficult mountain resort industry that is highly competitive.

10) Any interviews with customers, vendors, employees, etc. are reported positive.

 

Conclusion: Vail Resorts’ margin-of-safety multiple of 4.73 exceeds the margin-of-safety multiple minimum value of two. Vail Resorts’ additional crucial factors are acceptable. Astute investors should consider Vail Resorts an excellent company with an undervalued stock.