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Should You Buy McGraw-Hill (MHP) at $36 a Share? Would Warren Buffett?

December 06, 2010 | About:
Geoff Gannon

Geoff Gannon

406 followers
A reader sent me this email:

“I have a question about the companyMcGraw-Hill (MHP). I checked the big 4 numbers and they all look good. The intrinsic price I calculated is at about $60 and its current price is at $35. Their textbook business seems predictable and I can comfortably make a qualitative assessment of its earnings. On the other hand, I can't do the same with their financial services (S & P Credit Ratings) and media business yet. I am not going to buy the stock until doing so but I was wondering what your assessment of it is.”

The big 4 numbers the reader is talking about are the:

1. F-Score

2. Z-Score

3. 10-Year Average Real Free Cash Flow Yield

4. 10-Year Free Cash Flow Margin Variation

And the big 4 numbers look good for McGraw-Hill.

McGraw-Hill’s Vital Signs

1. F-Score: 5

2. Z-Score: 6.87

3. 10-Year Average Real FCF Yield: 8.66%

4. FCF Margin Variation: 0.23

These are the 4 vital signs I suggested using in an earlier article. I have since expanded the list to 10 numbers a quantitatively minded value investor can calculate if he has the time. I do. So, I’ll show you how McGraw-Hill ranks on the full set of 10 numbers.

One warning: the last two numbers I’m going to show you – price to tangible book and price to net current asset value – are meaningless for McGraw-Hill.

That’s because McGraw-Hill has negative tangible equity. As we’ve discussed before, negative tangible equity is not a deal breaker for a value investor like Warren Buffett. Or me. I bought IMS Health when they had negative tangible equity. Buffett bought Gillette when they had no tangible equity. And Buffett owned Moody’s (MCO) through long periods of negative tangible equity.

It’s earning power – free cash flow – that matters. And all of these companies – IMS Health, Gillette, Moody’s, and McGraw-Hill – had huge intangible assets that made them very valuable even when they had no tangible equity.

Here are the 10 numbers I care about for McGraw-Hill. Lines marked “NMF” are just saying there is “No Meaningful Figure”.

McGraw Hill’s Vital Signs – Expanded

1. Z-Score: 6.87

2. F-Score: 5

3. FCF Margin: 15.66%

4. Return on Capital: 36.31%

5. FCF Margin Variation: 0.23

6. Return on Capital Variation: 0.22

7. 10-Year Real FCF Yield: 8.66%

8. 10-Year Real EBIT Yield: 11.51%

9. Price/Tangible Book: NMF

10. Price/NCAV: NMF

Now, do I really think you’re going to calculate all 10 of those numbers?

No.

It would be great if you did. But – even if you don’t normally calculate these numbers for stocks you’re interested in – I can at least use them as a common topic of discussion for each stock we look at together.

So – let’s talk a little about the 10 numbers. They’re really 5 sets of pairs. The 5 pairs measure:

1. Safety (Z-Score, F-Score)

2. Quality (FCF Margin, Return on Capital)

3. Reliability (FCF Margin Variation, Return on Capital Variation)

4. Earning Power (10-Year Real FCF Yield, 10-Year Real EBIT Yield)

5. Asset Value (Price/Tangible Book, Price/NCAV)

That’s it. We’re really just quantifying a stock’s: safety, quality, reliability, earning power, and asset value.

Once you get past asking “Is this safe?” with the F-Score and Z-Score – you really want to focus on the unusual bits. What makes this stock different from all the others you look at? What makes McGraw-Hill special?

A few numbers leap out. The first 2 are the “no meaningful figures” for the two measures of asset value. McGraw-Hill doesn’t have tangible book value or net current assets. The company runs on intangibles.

We have to rely entirely on the business’s earning power to get us through. The asset value won’t help. This isn’t a Ben Graham stock.

But is it a Warren Buffett stock?

Maybe. I mean – probably not – since Buffett dumped Moody’s on account of the whole credit rating thing. It seems unlikely he’d gobble up the stock of another big credit rating firm: S&P. McGraw-Hill owns S&P. So Buffett probably won’t be buying McGraw-Hill just yet.

But what if we put that concern aside? What if we just looked at the numbers? Would Warren Buffett be interested in a stock with numbers like these?

Yes.

The 2 things that matter most to Buffett – other than price – are the quality and reliability of the business. McGraw Hill scores great on both these measures.

I won’t bore you with long lists of the variation coefficients of stocks you know. I’ll just tell you that a 10-year free cash flow margin variation of 0.23 and a 10-year return on capital variation of 0.22 are incredibly low.

McGraw-Hill is way more reliable than 90% of the public companies you’ll come across. Only a handful of consumer brands companies, government contractors, subscription businesses, and maybe an ad agency or two have variation measures this low. It’s really, really rare.

I will – and I hope this won’t bore you – show you McGraw-Hill’s high-quality reliability in table form. Obviously, a 36.31% operating return on tangible assets is great. And a free cash flow margin of 15.66% is great. That means McGraw-Hill keeps more than 15 cents of every dollar they get from customers.

What may not be obvious is the reliability of both these numbers. If you don’t like the 2 variation measures I used – free cash flow margin and return on capital – then feel free to use your own. Or check GuruFocus’s slightly different reliability measure. GuruFocus gives McGraw-Hill 4.5 predictability stars out of 5.

Free Cash Flow Margin
2009 17.67%
2008 12.33%
2007 17.30%
2006 17.31%
2005 19.41%
2004 12.88%
2003 21.15%
2002 16.03%
2001 14.19%
2000 8.36%


We can see the same thing with McGraw-Hill’s consistent return on capital. Remember, this is operating income – or EBIT (Earnings Before Interest and Taxes) – divided by average tangible assets employed in the business.

Return on Tangible Capital
2009 37.89%
2008 37.37%
2007 49.43%
2006 43.05%
2005 42.28%
2004 39.22%
2003 35.91%
2002 28.20%
2001 20.74%
2000 28.99%
Together these numbers show us not just that McGraw-Hill has been a high-quality company (FCF Margin = 15.66%, ROC = 36.13%) – but also that McGraw-Hill has been a reliable business (FCF CV = 0.23, ROC CV = 0.22).

The last issues to consider are whether the past record is predictive of the future and whether the price is right.

Let’s take price first.

I like to talk about free cash flow yields a lot. Some folks would rather I use free cash flow multiples. That makes sense. Most investors are used to thinking in terms of P/E ratios rather than earning yields.

Remember: You can always convert a yield into a price multiple and vice vesa.

Here, I told you that McGraw-Hill has a 10-year real free cash flow yield of 8.66%. Divide 1 by 8.66% (1/0.0866 = 11.55) and you get 11.55. That’s McGraw-Hill’s 10-year average real free cash flow multiple. It’s basically an earning power multiple. Think of it as a much improved version of the trailing P/E ratio.

You can do the same thing with the11.51% 10-year average real EBIT yield to get that price multiple. In this case, we’re talking about a stock selling for 8.69 times its 10-year average real EBIT.

Are these number – 11.55 times free cash flow and 8.69 times EBIT – low?

Yes. McGraw-Hill is a cheap stock.

That’s obvious. Nobody is going to argue with the cheapness of the stock. What they will argue – vehemently – about is the predictive power of the past.

Why does the past matter? Hasn’t everything changed?

So, should we just throw out the past record?

That’s the problem we’re left with whenever somebody says the world is changing. I don’t doubt it. The world – and the businesses in it – are changing every day. Sometimes for the worst. But – if you stop looking at the past – what do you have to go by?

Should we try to predict the future?

Maybe you can. Some investors have that skill.

I don’t.

I just stick to buying stocks with prices that are justified by their past performance alone. I don’t bet on growth. Sometimes I beat against rapid decay. But that’s about it.

You’ll have to come to your own conclusions about McGraw-Hill’s future.

To help you come to those conclusions – I want to leave you with a couple things to look at. Things you might otherwise miss.

One is capital allocation. Look at the company’s dividend and buyback history. Go through the cash flow statements for the last 10 or 15 years. Cash flow statements are often a good place to find records of acquisitions, because a lot of them are done with cash. When you find a big acquisition, read about what management said then and what they were saying a few years later. How did the acquisition turn out?

You also want to look at dividends and share buybacks. Those will probably be big plus factors when you look at McGraw-Hill. Compared to other media conglomerates, McGraw-Hill has been real good about returning cash to shareholders and buying back stock. Especially buying back stock.

And finally, I suggest you read The Curse of the Mogul. This is the best book out there on the perils and promise – mostly perils – of investing in media conglomerates.

As a rule: capital allocation at media companies is horrific. They will find ways to blow all the money they make. They will find ways to add layers and layers of centralized and utterly useless management. In almost all cases, a collection of passively owned niche media businesses would have served the parent better than direct control.

Offsetting this you have the actual intangible assets. The media properties themselves are usually incredible businesses. The men who run them – not so much.

Finally, the reader mentioned an intrinsic value estimate of $60 a share for McGraw-Hill stock. I would put the number in the $45 to $55 range.

McGraw-Hill last closed at $35.69 a share. So that’s a 25% to 55% upside.

There’s also a 2.63% dividend yield.





About the author:

Geoff Gannon
Geoff Gannon


Rating: 3.5/5 (8 votes)

Comments

halis
Halis - 3 years ago
I think MHP is worth at least $42-43 per share giving it a 16% margin of safety. With a return of capital of nearly 19%, this would be a buy, but I'm not sure about their business. I am not very familiar with MHP, I'm going to read some 10-K's and see what their various businesses are and what % of the gross each one makes up. See if I think they can sustain the past.

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