I have read Mohnish Pabrai considers the intrinsic value of a steady state business to be 10x FCF.
I am not sure if maybe you and Pabrai are on the same page if you are looking at a company whose FCF lags earnings due to capex/inflation etc, or if you are thinking about it a different way…. in other words 8x earnings and 10x FCF are equivalent for certain companies, but maybe you are thinking about it differently than Pabrai.
I believe Pabrai considers 10% to be his equity risk premium / cost of capital, so it makes sense that he would be willing to pay 10x FCF to earn a 10% return. Is it as simple as you personally consider 12.5% to be your equity risk premium / cost of capital?
I often have trouble deciding what the “right” multiple is. While I understand there is no “right” multiple, but rather a range of possible multiples depending on several variables, I am interested in any empirical/numerical system you may refer to (to) support whatever range of multiples you may use depending on growth, dividends, etc.
The value of a literally zero growth business is more of a theoretical concept than something that can be practically applied. In reality, a company that is growing sales at 0% a year is really shrinking because inflation is higher than 0%. A shrinking business faces all sort of nasty problems – because inertia inside the institution will prevent it from adjusting smoothly to slowly declining real sales. You can be sure the company will not “smoothly” cut jobs, freeze pay, etc. year after year. So, a 0% growth company is really not a stable company. It’s a turnaround. We need a better definition of a “no growth” business.
Let’s look at the different possibilities:
We can think of a stationary company as being one of the following:
· Literally no growth (0% annual sales growth from 2001-2011)
· Inflation pace growth (2.5% annual sales growth from 2001-2011)
· Inflation plus population growth (3.5% annual sales growth from 2001-2011)
· Nominal GDP Growth (4% annual sales growth from 2001-2011)
Here are some actual examples:
· Literally no growth: Earthlink (ELNK)
· Inflation growth: Dun & Bradstreet (DNB)
· Inflation plus population growth: CEC Entertainment (CEC)
· Nominal GDP Growth: Village Supermarket (VLGEA)
Over the last 10 years – population growth, inflation, and real output per person growth has been so low it’s hard to tell the difference between companies growing at the rate of inflation, along with the population, or along with the economy.
You have to squint really hard to see any difference in the revenue growth records of DNB, Chuck E. Cheese, and Village.
This will not be true in all countries and at all times.
A literally no growth company like Earthlink is actually shrinking. It just happens to look like it’s staying perfectly flat because inflation is hiding the company’s real decay rate. In real terms, the company has been shrinking by about 3% a year for the last 10 years. So, Earthlink is not a no growth company. It’s shrinking.
That’s a bad sign. And, frankly, I don’t know how to value Earthlink. You would need to evaluate it as a turnaround or something – not as a business that’s simplly stuck in place. I don’t know how to do that.
So, Earhtlink goes into the “too hard” pile.
Dun & Bradstreet and CEC Entertainment are actual no growth businesses. This is hidden by their constant share buy backs. So, if you look at their earnings per share growth they look kind of like Peter Lynch’s idea of a “slow growth” company or even a “stalwart”. They aren’t. They’re no growth businesses.
The same is pretty much true with Village Supermarket. Although this is complicated. The nature of their business – high volume, low cost groceries – means they can appear to be a no growth business when they are actually just keeping prices down and increasing volume. You would need to check their sales numbers more carefully. Grocery stores often discuss inflation in their annual reports. Village Supermarket always does this.
(The annual report is Exhibit 13 of the 10-K at EDGAR).
So, in reality, Village Supermarket may be a slow grower, while CEC Entertainment and Dun & Bradstreet are no growers.
So, how would I value them?
Dun & Bradstreet
Would I pay 10 times free cash flow for Dun & Bradstreet?
The 3-year average free cash flow at Dun & Bradstreet is $365 million. They have 47.72 million shares outstanding. So that’s $7.65 a share in free cash flow. DNB’s stock price is $82 a share. The company keeps buying back stock. And I don’t think they are wrong to do that.
Let’s look at what DNB’s shares would be worth at different free cash flow multiples:
8 times free cash flow: $61.20/share
10 times free cash flow: $76.50/share
12 times free cash flow: $91.80/share
15 times free cash flow: $114.75/share
Okay. So which multiple is the right multiple?
Let’s look at DNB’s 10-year history. I’m going to – as always – take the actual companywide 10-year data and then apply it to the current number of shares outstanding (which is 47.72 million for DNB) to get the per share numbers. These are actually not historical per share numbers. They are historical company data applied to today’s share count. In other words, if DNB the company gets the exact same results for 2011 to 2021 that it did for 2001 to 2011, these are what the numbers will look like for someone who buys DNB shares today.
DNB’s 10-year average earnings are $4.87. On average they paid $0.56 a share in dividends each year and used $5.36 a share to buy back stock. That means they used more cash to buy back stock and pay out dividends than they earned.
How is that possible?
Free cash flow always exceeds earnings at DNB. And they added some debt. Free cash flow averaged $6.26 a share over the last 10 years. So the company paid out about 95% of its free cash flow over the last 10 years. In other words, DNB really didn’t reinvest in its business at all.
As a result, our 8 times free cash flow intrinsic value estimate now looks downright idiotic. At $61.20 a share, DNB would be equivalent to a 12.5% bond that grows its coupon by 3% a year. That’s basically an inflation protected high yield corporate bond. The price looks wrong.
What about 10 times free cash flow? At $76.50 a share DNB would still be equivalent to a 10% bond with 3% coupon growth.
What about 12 times free cash flow? That’s an 8.33% bond with 3% coupon growth.
And at 15 times free cash flow, we would have a 6.67% bond with 3% coupon growth.
So what would I pay for DNB?
The reasonable range is about $75 to $130 a share. If you truly believed there was absolutely zero business risk in DNB – and they were going to keep paying out 95% of their free cash flow in share buybacks and dividends – then a price of $130 a share would probably be right.
That means that for every $100 you spend on Dun & Bradstreet stock the company would “return” $6 in dividends and buybacks and the company would grow that $6 coupon at a rate of 3% a year. To put it in simpler terms, you would buy something valued at $100 today. Next year, it would pay you $6. And after paying you $6, it would now be worth $103. That’s fair. I do not expect $100 invested in the S&P 500 at today’s prices to do any better than that. So, at a zero business risk assumption – remember the S&P 500 is diversified, DNB is not – Dun & Bradstreet is worth $130 a share.
Let me put this in perspective. I just said – if it was considered perfectly safe – a no growth company could be worth 25 times earnings.
That’s true. If and only if that company is growing at the rate of inflation – so not shrinking in real terms – while paying out all of its earnings (and then some).
Would I buy Dun & Bradstreet at $130 a share?
Absolutely not. There’s no margin of safety at that price. I don’t think that starting from a $130 share price, DNB would meaningfully outperform the S&P 500 over the next 10 or 15 years. I think DNB will pretty much match the overall market if you buy the stock at $130 a share.
So what about the other end of the reasonable range? Remember, I said $75 to $130 a share was a reasonable value range for DNB shares.
Would I buy DNB at $75 a share?
Well, it trades at $82 a share – so we’re pretty close to facing that question right now.
The answer is I’d consider it. Any time DNB’s 3-year average free cash flow divided by its current shares outstanding is 10% or more of the stock price – I’d consider buying it. I think the upside is limited. But if your goal is to preserve and increase your purchasing power over the next decade – buying Dun & Bradstreet at any price below $75 a share would be a very good way of doing that.
If you believe the company has a wide moat. And you believe that its competitive advantage is durable.
So, in this case the answer is that a “no growth” business like DNB is worth more than 10 times free cash flow but no more than 15 times free cash flow. And I think it’s clearly undervalued whenever it trades below 10 times free cash flow. So, you can put me down for valuing the company – not buying it, there’s a huge difference – at 15 times free cash flow.
What about CEC Entertainment?
We have the same deal here. Chuck E. Cheese has been a super predictable business long-term. It’s grown no faster than the overall economy over the last 10 years. And it pays out what it earns.
3-Year average free cash flow is $73.59 million. Shares outstanding are 18.16 million. So free cash flow per share is $4.05.
What would our range of free cash flow multiples – for a no growth business – look like at Chuck E. Cheese?
8 times free cash flow: $32.40/share
10 times free cash flow: $40.50/share
12 times free cash flow: $48.60/share
15 times free cash flow: $60.75/share
So, our reasonable range of intrinsic value estimates for the stock is about $30 to $60 a share. It currently trades at $37 a share.
By the way, $30 a share would be 11 times earnings. And $60 a share would be 22 times earnings.
Which is the right multiple for Chuck E. Cheese?
Well, over the last 10 years they had average earnings of about $3.56 a share (again, all of this is computed using past company figures and current shares outstanding – not just past per share figures). Free cash flow was lower at $3.26 a share. This is a company that invests in new electronic equipment (basically games), upgrades stores, and builds new stores at times. So, unlike DNB, free cash flow normally trails EPS here.
That’s normal for most companies.
We’ve got buybacks of $4.87 a share per year over the last 10 years. And the dividend just started this year – so it’s a non-factor. But, basically they earned $3.56 a share and paid out $4.93 a share each year. The “paid out” part was all buybacks at Chuck E. Cheese.
Is that sustainable?
No. It required adding a lot of debt.
But can CEC Entertainment keep paying out close to all of its earnings each year?
At least I think it’s quite possible. Read past annual reports and look at the company’s long-term history for a better idea of why they use capital the way they do.
So, what’s it worth?
This one’s harder. The moat is not as wide. Free cash flow conversion is not as good. But the growth prospects are better.
It would depend on what Chuck E. Cheese’s long-term prospects are. I think $60 a share is too aggressive. But I would be very interested in the stock at prices below $30 a share.
Again, if we are asking what the company is worth – rather than what I’d pay for it – I’d say around 15 times earnings/free cash flow.
In my Berkshire article I said: “A company that grows 10% a year while retaining all its earnings is worth 13 times earnings.”
I would say that a company growing 3% a year while paying out all of its earnings is also worth 13 times earnings. Let me put it this way: a company that pays out all its earnings and still grows 3% a year is not worth less than a company that grows 10% and pays out nothing. I would say they are pretty equal in my book – although I would actually value the company growing 3% a year and paying everything out more highly.
So, I’d say CEC Entertainment is worth at least 10 times free cash flow. And probably more like 13 to 15 times free cash flow.
(But there is more risk here than at DNB).
Now let’s talk about Village Supermarket. Here is a company that grew a little faster – 4.2% a year over the last 10 years.
Will I value it more highly?
Don’t count on it. Village – unlike a lot of supermarkets – doesn’t use much leverage. So while the company’s ROA is totally solid – its return on equity is only acceptable. It’s adequate. And growth is a positive here. But it’s a pretty small positive. Each time Village reinvests $1 in its business, it probably only increases the value of the business by about $1.20. Not bad. But, you see how tight the spread is between paying the shareholder that dollar and reinvesting the dollar in its business (where $1 is maybe worth $1.20).
The exact calculations here are complicated. Not difficult to do. But they’ve got so many parts. Basically, Village has surplus cash. It uses less leverage than is customary for a grocery store. You need to give the company some credit for the extra cash – or, rather, you need to not penalize them as heavily for holding cash as an asset as you would for them holding more inventories or owning more stores and earning the same amount. Folks like Joel Greenblatt take care of this problem by using EV/EBIT instead of stock price to per share earnings.
Over the last 10 years, Village returned about 50 cents per share per year. All in dividends. Shares outstanding actually rose. But so did cash. A lot. And debt dropped to nothing. So it makes sense to look at pre-tax earnings and surplus cash. Since this is a grocery store – and you normally lever them up – any cash net of debt will be considered surplus. In this case, that’s $90 million. That’s about $6.53 a share.
Operating earnings averaged $33 million a year. That’s $2.41 a share. Normally, you would put a 35% tax rate on that. However, I happen to know Village is a New Jersey corporation who pays New Jersey corporate taxes of 7% a year – so its max rate is 42%. That leaves $1.40 a share in after-tax earning power.
Village’s earning power is certainly not worth less than an equal amount in most other companies. Free cash flow conversion is good for the kind of business it is. There is some growth potential. And although it may not be obvious from the business description – Village is actually a pretty wide moat retailer.
It owns really, really big grocery stores. Some of these are 60,000 square feet and up in super high population density places like New Jersey (the most), Pennsylvania, and now Maryland. Basically, Village is the low cost operator in local markets with high GDP per square mile. I would rather open up a grocery store across from anybody but Village. Yes. I’d take a Fortune 500 retailer rather than be opposite a Village location. You can’t compete with them directly on everyday groceries – you either have to sell fancy high margin stuff or offset your grocery losses by selling lots of items Village doesn’t sell. And even then, your customers are probably going to do their once a week “big time” grocery store trips over at Village’s store – not yours.
So, the earning power is solid in my view. This is as dependable as retailers get. It’s still a retailer. But I wouldn’t consider Village’s earning power more at risk than any other retailer’s.
I’d put a 15 times multiple on Village’s 10-year average after-tax earnings. That’s $21 a share. Cash is $6.50 a share. So, we’re at $27.50. Which is close to the current stock price ($28.12).
Would I value Village that high?
I’m not sure. Normally, cash is worth less on a company’s balance sheet than in your own hands. However, Village has increased their dividend very rapidly. They know they have too much cash. And they now have no debt. They’re also very good operators. So, they can – and are – buying new stores. When they do, every $1 spent on acquisitions could easily become $1.25 (or more) in intrinsic value.
Certainly, the stock is worth $17 a share. And it’s probably not too overvalued unless it’s over $27 a share. If I owned it at today’s price – $28 a share – I’m not sure I’d sell it. Village is not a retailer I want to bet against. And it’s underleveraged. I’d probably keep the stock if I already owned it.
But what price would I be willing to actually buy the stock at?
Because it’s a retailer and a grocer, I personally wouldn’t pay more than book value for Village. I’d be very interested if it traded at its book value – which is around $16 a share. But, I wouldn’t be interested before then.
In this case, book value happens to be less than 8 times the company’s 3-year average free cash flow. So, in this case, I’m saying I wouldn’t be willing to pay more than 8 times free cash flow for a no growth business like Village. Whereas in my Chuck E. Cheese – and especially DNB examples – I said I’d be willing to pay 10 times free cash flow.
Return on Investment
Village is unleveraged. And the best possible return on asset number for a grocer is not in the double-digits. In other words, if Village doesn’t increase its leverage it won’t achieve a sustained ROE above 15%. I would accept returns in the 10% to 15% range. For me, that only justifies an investment made right around book value. Which works out to be about 8 times free cash flow. I think the stock is fairly valued around $30 a share. That’s 14 times free cash flow. But, remember Village has excess cash – CEC and DNB have the opposite (lots of debt) – so it’s really more like 12 times free cash flow after you back out the cash.
The answer to your question seems to be that a good no growth company is worth about 12 to 15 times free cash flow. Probably 15 times free cash flow – if by “worth” we mean priced to deliver the same future returns as the S&P 500.
I would be interested in a no growth business with a wide moat and very high returns on capital any time it traded around 10 times free cash flow. In fact, I think buying such a stock at 10 times free cash flow will tend to work out very well.
Where limitations on ROA entered the picture – Village Supermarket – I was less sure it made sense to pay more than book value. Certainly, 10 times free cash flow could still be a very good buy price. But I personally wouldn’t be interested at prices greater than book value.
So, there’s no simple answer.
But, I will propose this general rule:
· The best business imagineable growing in line with inflation is worth about 16 times free cash flow
· The worst business imagineable growing in line with inflation is worth about 8 times free cash flow
Every other “no growth” business falls somewhere in between.
Finally, I should mention that I cheated. You quoted Mohnish Pabrai. He’s often valuing cyclical businesses and things like that. I have no idea how to do that. Dun & Bradstreet, Chuck E. Cheese, and Village Supermarket are 3 of the most stable businesses you’ll ever come across.
So they illustrate the point that a no growth business is worth very different multiples depending on how much cash it takes to achieve that “no growth” rate. But they are somewhat misleading examples in that it is much easier to figure out what their earning power is than it would be at probably 19 out of 20 public companies in America.
So, yes, I cheated. And you should too. If you want to know what a no growth business is worth – start with a predictable company.
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