In early December 2013, Vera Yuan wrote an article for GuruFocus that covered several valuations of Credit Acceptance Corporation (CACC). The company specializes in car loans and thanks to its technology can establish rates for every individual applicant within seconds and provide credit to virtually everyone.
At the time Yuan wrote "Credit Acceptance Corporation (CACC, Financial) Analysis," shares were trading at $124.70.
When she consulted a Peter Lynch chart, it calculated the company’s valuation at $253.95, slightly more than double the price at that time.
When she calculated the company’s discounted cash flow (DCF) fair value, she arrived at $260.48, which again is more than double the stock’s price at that time. In addition, she checked on the price-to-book ratio and price-to-earnings ratio, which produced valuations of $90.30 and $152.40.
What struck me while looking at a recent price chart for Credit Acceptance was how close, at least relatively close, the Lynch and DCF Fair Value calculations came to the share prices in July 2015, about a year and a half later:
According to historical prices at Yahoo! (YHOO, Financial) Finance, Credit Acceptance topped out at $277.98 on July 9, 2015. Right after hitting that high, it started moving into “Gee-I-wish-I'd-sold-it-sooner” territory, shedding nearly $100 before becoming somewhat rangebound. It might not have been an exact doubling but certainly enough for what Peter Lynch would call a double-bagger.
As it turned out, both valuations, the Lynch and DCF Fair Value, as reported by Yuan, had been quite prescient about the prices of Credit Acceptance. Not that there had been anything supernatural about these valuations; rather the stock price moved consistently along its previous path. Let’s look at how the two valuations work, and then ask if they can help us find potentially big capital gains in this stock again.
Behind the Peter Lynch chart
As a GuruFocus tutorial points out, the Peter Lynch strategy works well when there is a strong historical correlation between a stock’s price and its earnings.
More specifically, Lynch said (cited on GuruFocus), “A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies when the stock price fell well below the earnings line and sold them when the stock price rose dramatically above it, the chances are you'd do pretty well.”
We might think of this as something like a reversion to the mean. In this case, the share price tends to follow the earnings line. That makes intuitive sense since investing (as compared with trading) is always about the ongoing value of the earnings.
We follow that ongoing value with the P/E, or price-to-earnings, ratio. It tells us how many years it would take to get back what we paid for a share or multiple shares. For example, if we buy a share of XYZ for $100 and the company earns $10 per share per year, then the P/E would equal 10.0 ($100/$10 = 10).
When you see an earnings line on a Peter Lynch screen, it’s drawn at P/E of 15. For example, follow the blue line in this GuruFocus chart:
As the chart shows, there’s a strong relationship between the earnings line and the share price line. Actually, it’s a relationship between investors and anticipated earnings. When investors believe in higher earnings potential, they bid the share price up until it gets above the earnings line. On the other side of the coin, if they expect lower earnings they bid the price down until it falls below the earnings line.
So long as the company can continue to consistently deliver increasing earnings, the share price will get pulled upward.
Discounted cash flow fair value
For this valuation we turn to the GuruFocus DCF Fair Value Calculator, as shown last week:
The values in each of the cells are filled in automatically by GuruFocus (the current price shown near the bottom of the right cell comes from several days ago). Simply enter a company name or symbol in the search box at the top of the page and then click the DCF button in the navigation bar. The calculator pops up, fully populated.
Although the cells are filled, you can change them. If you feel more optimistic or pessimistic about the company’s prospects, you can change the growth rates. Altogether there are seven different fields that you can change if you wish.
In each case, in the box on the right side, the end product is a fair value number. In this case, we see the estimated fair value of Credit Acceptance Corporation is $412.79.
That comes from adding together the anticipated growth value and the anticipated terminal value. The former is based on the first three cells in the left-side box while the latter comes from the three cells in the bottom half of the box. In the right-side box, the two numbers are added together to give us $412.79.
Again, the key to confidence in the DCF value comes from investor confidence in a company’s ability to continue growing its earnings. Let’s look at a chart of Credit Acceptance’s revenue, earnings per share and EBITDA for the past 10 years:
As the chart shows, this company has, with one notable exception, grown its earnings quite consistently or predictably.
What’s ahead?
Is there another double-bagger waiting in the wings for Credit Acceptance Corporation? Could be, according to the DCF Fair Value calculator. The Peter Lynch chart, while suggesting Credit Acceptance is undervalued, is not so bullish; its current valuation comes in at $217.50 versus the July 12 closing price of $187.03.
Don’t expect the two prognosticating procedures to necessarily come to the same conclusions. More importantly, think of the calculator value or the Lynch chart, or any other indicator, as being a green signal for further research, rather than an end in itself.
Looking behind the numbers
Starting with the top line, we know that the company has room to grow its revenue. As this excerpt from the 10-K for 2015 shows, Credit Acceptance has just a fraction of the estimated 60,000 auto dealers in the U.S.:
(“Active Dealers are dealers who have received funding for at least one loan during the period.”)
In this table, both the Dealer Enrollments and the Active Dealers columns show good growth, which accounts for at least some of the steadily growing revenue we saw in an earlier chart. Other factors include the average loan size, the average profitability of loans and ability to help consumers keep their payments up to date.
Can Credit Acceptance turn that revenue and invested capital into ongoing earnings? To answer those questions, we look at its margins, as shown on the CACC Summary page at GuruFocus:
The mostly green icons indicate that Credit Acceptance has strong margins, both compared with its own history and with its competitors.
As for turning invested capital into ongoing earnings, consider this mini-chart of its return on invested capital (ROIC) and its weighted average cost of capital (WACC):
Note that the ROIC is more than double the WACC; as a GuruFocus note says, “Credit Acceptance Corp. generates higher returns on investment than it costs the company to raise the capital needed for that investment. It is earning excess returns.”
Overall, this company has room to grow both its top and bottom lines. As I noted in an article about the company two years ago, “There appear to be no reasons why Credit Acceptance should not continue to grow profitably. It has a strong history of profitable growth, a good management team and the tools needed to survive in what can be, at times, a highly competitive environment.”
Conclusion
Credit Acceptance Corporation is an auto finance company. It underwrites loans by dealers and specializes in consumers with poor or limited credit histories.
It is also a company with the potential to double in price. As we saw, the share price did double between December 2013 and July 2015, before falling back significantly. The Peter Lynch and Discounted Cash Flow Fair Valuations cited by Yuan did predict where the price might go (but not necessarily stay).
Our confidence in a future double-bagger lies not so much in the current DCF Fair Value estimate of $412.79 (compared with the July 12 closing price of $187.03) as in the numbers underlying it.
Continued strong earnings from this 5-Star Predictable company should lead to strong growth in the share price over time, although we cannot predict how long it would take to double, if it does. In any case, Credit Acceptance Corporation is worth a closer look for investors who want capital gains.
Disclosure: I do not own shares in this company, nor do I expect to buy any in the foreseeable future.
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