RTCrawford's Weblog

I don't make this stuff up. I'm not that smart.

AEO April 9th, 2008

with 8 comments

Here is my updated DCF analysis of AEO, taking into account the latest yearly figures for Fiscal Year 2008.

There was a significant drop in free cash flows during calendar year 2007 — which accounts for the change in the calculated intrinsic value from the prior year estimate. That change indicates, as expected, a decline in intrinsic value (to $57.14 per share), if applying the median free cash flow growth rate of 33.4% evidenced during the prior decade. With a 50 percent “margin of safety,” purchase of the stock as a value investment may be warranted when falling below $28.57.

American Eagle Discounted Cash Flow Analysis

Management, however, has indicated expected earnings to increase by, between, 12% and 14% yearly over the next several years. While this may strike some as conservative, given the company’s growth and expansion plans, applying a 13% growth rate renders an intrinsic value of $20.05. At today’s closing price (April 9, 2008) of $16.93, the stock is selling at a discount to intrinsic value of 15.5% — implying an upside potential of 118.43%. Even at these reduced levels, this delivers an 18 month compounded annual return on investment of 11.94%. Assuming the economy rebounds, retail reemerges, and American Eagle “reverts to the mean,” the intrinsic value calculation should improve.

AEO 04092008 @ 13% FCF Growth

[It should be noted that these calculations make several assumptions. First, it assumes growth over the next decade remains consistent with the mean of the prior decade — based on rolling five- and seven-year time frames. Second, it assumes a 5% growth rate over the second decade. Third, it uses a 15% discount rate for the net present value portion of the calculation. And, fourth, it uses current shareholders equity as the terminal value.]

While discounted cash flow analysis was created by John Burr Williams as a doctoral student at Harvard in 1938 (“The Theory of Investment Value“), it was quickly adopted by “value” investors, such as Benjamin Graham and Warren Buffett. It is not, however, the only tool these and other value investors employ when seeking to identify a company’s intrinsic value. Benjamin Graham, in “Security Analysis” (1934), for example, urges calculation of the company’s breakup or liquidation value to determine the lowest price at which a stock may reasonably trade. While Graham limited his consideration to discounted current assets minus the totality of liabilities, he did so based on his recent experience during the Great Depression — when bankrupt companies were unable to locate buyers and assets were sold at scrap value. Today, it is more likely that unprofitable companies will find buyers and sell at prices commensurate with, both, discounted short and long-term assets minus total liabilities plus some marginal premium for the purchased brand.

Using this approach, with modifications recommended by Columbia Business School Professor Bruce Greenwald (“Value Investing From Graham to Buffet and Beyond“) I estimate American Eagle’s liquidation value at $11.57 a share. Here are my calculations:

Well, $11.57 is roughly 20% of the company’s intrinsic value if calculated by discount cash flow analysis (for an adjusted price-to-book value of 4.94). Now, you can make up the difference between an ideal price-to-book of 2.5 or less with, either, projected growth or sustainable franchise value. Having already considered growth within the discounted cash flow model provided above, let’s consider the franchise value, after referencing a Motley Fool quote from an interview with Professor Greenwald that explains the concept of franchise value:

The Graham technology is starting with the most reliable information, which is asset value, then looking at the second-most reliable information, which is current earnings — with all the appropriate adjustments and getting an earnings-power value — and then looking at those two and see what they tell you about the extent to which you are buying a franchise, which is value in excess of assets. And then, only then, looking at the growth. I think that’s far superior than doing an undiscriminating cash flow analysis, where you can’t really tell what the crucial assumptions are. So good value investors then bring a first-rate valuation discipline to the market. And that’s the second part of it.

Without going into a detailed description of the calculations and logic behind quantifying “franchise value,” it is sufficient to know that the concept of franchise value is derived from the calculation of Earnings Power Value (EPV) — which is Adjusted Earnings divided by the Current Cost of Capital. The complexity in this equation relates to the adjustment of earnings, which are conceptually consistent with the Graham adjustments used in calculating liquidation value (above). Here are my calculations for Earnings Power of Value:

At American Eagle’s current cost of capital (9.25%), current intrinsic value for the stock is $30.51 — marginally above the identified purchase price ($28.57) using discounted cash flow analysis with a 50% margin of safety (also, above). Equally important, either target price in comparison to the Graham;s adjusted book value (again, above) becomes a more defensible 2.64 or 2.47, at target prices of $30.51 and $28.57, respectively.

There are several final items worth mentioning.

First, to the extent that EPV exceeds the current cost of capital, earnings growth contributes to an increasing value for the company. In the case of American Eagle, it does, but this is unusual. For most companies, the cost to finance earnings growth exceeds the return on investment for that growth.

Second, this is why, both, calculation of the liquidation value and the franchise value ignore growth entirely. This is significantly different than discounted cash flow analysis, which is entirely predicated on projected growth of free cash flows. Consequently, those who discredit discounted cash flow analysis as an exercise in crystal ball reading when projecting future growth should have no problem with basing intrinsic value on what the company would bring if liquidated.

Third, ignoring growth entirely explains the difference between the intrinsic value calculated by discounted cash flow analysis, on the one hand, and, either, EPV or liquidation value, on the other hand.

Fourth, more important than the three prior points is the recognition that, while each of the several approaches to calculating intrinsic value differ in their conclusions, each are consistent with each other when understanding the logic behind their calculations. In other words, all three come to the same conclusion — namely, that American Eagle’s stock is significantly undervalued at its current price.

If a company failed to earn another dime and its assets were sold at auction to the highest bidder, the company is worth $11.57 a share (give or take a dollar). If American Eagle continues to generate profits at its current level (sustaining its current popularity or franchise), without any future growth in profits, the stock is worth $30.51. If the company returns to its historic growth rate of 33.4% (unlikely), then the intrinsic value is $57.14.

Full Disclosure: I have a long position in the stock of American Eagle. Of the 28 stocks in my small, personally-managed portfolio, AEO is the fourth largest position.

Written by rcrawford

April 14, 2008 at 9:57 am

8 Responses

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  1. can you explain me please how you did the liquidation value calculations whit the excel ?

    guy

    October 20, 2009 at 8:52 pm

  2. Thank you for the question concerning calculation of estimated liquidation values. The calculation of liquidation value is based on the approach created by Benjamin Graham and David Dodd in “Security Analysis,” were they recommend discounting current and long-term assets at appropriate rates for mirroring what the company could reasonably garner in the open market during the liquidation effort. For example, cash and cash equivalents would be discounted at 0% (i.e., no discount), other short-term assets may be discounted at 20% (since they can more readily be converted to cash than long-term assets), while long-term assets may be discounted at 50%. Liabilities, on the other hand, are not discounted, but, instead, are carried at face value from the balance sheet. Non-cash assets and liabilities, such as goodwill, amortization, depreciation, and tax carry-forwards, are typically not included in this calculation of liquidation value.

    rcrawford

    October 20, 2009 at 9:41 pm

  3. can you post a copy of the liquidation value of the excel source.(with the calculation )please
    i understand the philosophy but i mean in the technical interpretation of the formula. as example
    in the AEO how you get to:
    in total allawed:
    short term investments 453.51
    accts rec 27.12
    inventory 257.85.
    …. et cetera.
    and why you add the marketing adust’?
    thank you for anser me quickly.

    guy

    October 20, 2009 at 10:43 pm

  4. That portion of the Excel file is programmed in Visual Basic for Applications (VBA) and, as a consequence, contains no calculations appearing on the spreadsheet, itself. This was necessary in order to speed up the process when Microsoft shifted from their earlier version of Excel. That adjustment increased from, roughly, 65,000 rows to over one million the number of cells for which it maintains calculation capabilities. Consequently, this slowed a single iteration (to include retrieval of online data) from 10 seconds to something on the order of 30+ seconds – making the adjustments necessary.

    In chapter 43 of Security Analysis, Graham and Dodd recommend the following percentage discount to convert liquidating value from the book value:

    Current assets
    Cash assets – 100%
    Receivables (less reserves) – 75%-90% (rough average 80%)
    Inventories (at lower our cost for market) – 50%-75% (rough average 67%)
    Fixed miscellaneous assets – 1%-50% (rough average 15%)
    (fixed miscellaneous assets include real estate, buildings, machinery, equipment, nonmarketable investments, intangibles, etc.)

    As for the marketing adjustment, that is not part of the calculation for liquidation value, but, rather, is a necessary component of calculating “replication value” – which uses liquidation value as its starting foundation. The calculation of replication value is contained in “Value Investing: From Graham to Buffet and Beyond” by Bruce Greenwald and others. That text also includes a description of how to calculate Earnings Power Value, which is compared to replication to determine whether capital investment in growth is warranted.

    rcrawford

    October 21, 2009 at 4:30 am

  5. can you explain to me how you get to the number 1092.90 in the rank 3 Yrs 1/2 SG&A from
    R&D and Marketing Adjustments ?

    guy

    October 21, 2009 at 7:47 pm

  6. Thank you for the question.

    The figures you reference identifying adjustments necessary to estimate what a competitor would spend in order to “replicate” the company’s marketing posture as it currently stands. On page 162, in the chapter “Three Sources of Value,” from Value Investing: From Graham to Buffet and Beyond, the authors write the following:

    1. To even out the annual variations, we take the average of MGA as a percent of sales for the most recent five years and apply that to the current sales figure.
    2. We assumed it would take three years of marketing expenses to get up to speed….
    3. We set the share of MGA spent on running the business at half the total, leaving the other half for marketing.

    Therefore, to arrive at this figure, SGA is divided by revenues for each of the years over the past decade. This provides us with the percent of revenues attributable to sales, general, and administrative expenses. Next, we take one half of the five year average and multiply those times three to get at the three years of estimated marketing expenses.

    I hope this helps.

    Robert

    rcrawford

    October 23, 2009 at 11:03 am

  7. I’m sorry i didnt understand the calculation
    in the row 48 ” 3 Yrs 1/2 SG&A ”
    i did the calculation:
    665.60+715.20+715.20 = 2096/2 = 1048
    this is the result that i get.
    i did not get the number
    1092.9.
    where my mistake ?

    guy

    October 25, 2009 at 1:01 pm

  8. Guy, thank you for the question. In order to best explain the approach/calculations, it will be necessary to run through the calculations from start to finish, creating screen captures along the way. Currently, I am grading a truckload of papers submitted by students, and there isn’t adequate time. Moreover, I stopped producing stock/equity analysis because there was no way to automate the image creation process, due to a glitch in the WordPress system. If Word Press has resolved this problem, then I’m happy to continue the educational process undertaken quite some time back. If, however, this effort cannot be undertaken efficiently, it represents a sacrifice I am not prepared to make. For example, in support of my quality improvement and marketing classes, I am currently researching the issue of covert persuasion and psychology. Both of these have significant implications for making public health advertising more effective and securing greater patient compliance with practitioner-prescribed treatment plans – issues that are closer to my heart and wallet, to say nothing of my curiosity.

    In the interim, feel free to consult the Greenwald texts. Interestingly, this past week, CNBC aired a town-hall meeting gathering of Bill Gates and Warren Buffett with students at Columbia’s business school. I noted that Greenwald was in the audience and imagine that he may have had something to do with the arrangements – since his investing class has met with Warren Buffett in the past. In fact, my brother took Greenwald’s class as a student at Columbia, which provided him with one of two opportunities to meet with Mr. Buffett.

    rcrawford

    November 22, 2009 at 12:11 am


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