Tag: Valuation

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British American Tobacco Valuation

Currently, British American Tobacco (BTI) is one of my largest stock holdings, a stock that I have owned since 2021. BTI is the largest tobacco company by sales, selling traditional tobacco products but also innovating in smokeless nicotine products. Tobacco stocks have been out of favor the past couple of years, with lackluster share prices. This depressed share price, and BTIs 7.5% dividend yield begs the question as to whether the company is currently trading below intrinsic value. In this post I will do a rough valuation of British American Tobacco in order to see if the stock is a bargain.

The first place I am going to start with valuing BTI is approximating their normalized operating earnings. Over the past 5 years, British American Tobacco has produced around $12B in operating earnings. This is slightly less than the 2022 figure of $12.6B, so I will use the more conservative figure of $12B. 

BTI usually pays around a 25% tax rate. Applying this rate to the estimated operating earnings produces an after tax earnings of $9B.

Next, I capitalize the estimated after tax earnings to produce an enterprise value. Typically I estimate a cost of capital based on historical P/E ratios, and also factor in the size and quality of the business. In recent years, BTI has been trading at a fairly low multiple. Prior to the large acquisition they made in 2017, British American Tobacco was regularly trading over 25 times earnings. Currently the company has an $80B market cap, which makes it a large cap. The high margins and large amount of cash produced by the company suggests some quality. On the flip side, tobacco companies are in favor with investors, which could produce higher cost of capital. For this analysis, I will use a discount rate of 6.7%. Capitalizing the $9B in after-tax earnings using this rate produces an enterprise value of $134B.

In order to convert the enterprise value into an equity valuation, the long term debt is subtracted from the EV, and the cash balance is added back. BTI has about $46.5B in debt, and about $4.1B in cash. This produces an estimated fair value market capitalization of $91.6B. 

Dividing the fair value market cap by the 2,267M shares outstanding, we arrive at a fair value stock price around $40. The current market price is around $35, indicating that BTI may be slightly undervalued. One thing that is in British American Tobacco’s favor is that they have historically paid out most of their cash flow out as dividends. Currently the stock has quite a large dividend yield, over 7.5%. Perhaps if investors bid up the stock to produce a more normal dividend yield, the stock would be worth more than my $40 estimate.

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Southwest Airlines Valuation

Southwest Airlines has recently been caught up in a software debacle that canceled thousands of flights during the holiday season. The stock price has been quite beat up even before the bad press, with the stock peaking around $64 in 2021, then sliding down to a low of $30 during the worst of the market downturn in 2022. Since I like finding stocks that have been beat up from bad news, I decided to do a quick earnings power valuation of Southwest. 

Looking at Southwest’s top line from 2019-2022 shows figures of $22.4B, $9B, $15.8B, and 23.8B respectively. Obviously revenue was impacted during 2020 due to Covid, and still did not fully recover in 2021. Removing these outlier years, we can estimate Southwest’s go forward revenue at $23B.

Southwest’s operating margins vary, especially during outlier years 2020 and 2021. A reasonable estimate of operating margins seems to be 15%. Applying this margin to the estimated revenue produces an approximate operating earnings of $3.45B.

The income tax rate the LUV pays also varies quite a bit. For this analysis I will use a 25% tax rate. This tax rate turns our operating earnings into $2.6B of after tax earnings.

Next, I capitalize the estimated after tax earnings to produce an enterprise value. First I look at Southwest’s historical P/E ratio, which ranges between 10-16, with a few outlier years. While Southwest is known to be a quality airline, the airline industry is not known for having the qualities of a high quality business. Therefore I think Southwest should have a discount rate a tad higher than quality large cap companies. For my analysis I will use a 7% discount rate, which produces a $37B enterprise value.

In order to convert the enterprise value into an equity valuation, the long term debt is subtracted from the EV, and the cash balance is added back. LUV has about $9.5B in debt, and about $10.5B in cash. This produces an estimated fair value market capitalization of $38B. 

Dividing the fair value market cap by the 593M shares outstanding, we arrive at a fair value stock price of $64. As I mentioned earlier, Southwest currently trades for around $37. This appears to be quite the discount to fair value. Just for some context, LUV traded above $60 a share pre-pandemic and for a brief time in 2021. 

It appears the recent scandal has made Southwest’s shares look pretty attractive. One problem with this valuation is that it is potentially based on cyclical peak earnings. If a recession happens in 2023, Southwest’s revenue may take a beating. However, travel seems to be on a secular uptrend, so perhaps LUV would bounce back quickly. Either way, I think the company is worth doing a deeper dive on.  

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KLA Valuation

KLA Corp. (KLAC) is an American company that manufactures process control and yield management equipment for the semiconductor industry. It appears the large semiconductor equipment companies have high profit margins, great returns on capital, and barriers to entry. Currently, there seems to be a cyclical downturn in semiconductors in general, so many of the stocks are down quite a bit from their recent highs. Given this background, I want to do a rough valuation on KLA to see whether it is fairly valued or undervalued.

Since I believe KLA has a moat, I will use the growth return valuation method from Bruce Greenwald’s valuation book. With this valuation method, first a sustainable shareholder yield is estimated, then estimated growth rates are added to get expected return from buying the stock. 

The first step is to figure out a reasonable steady state revenue. In 2022, KLAC did a record $9,212M in revenue. Since the semiconductor capital equipment industry can be cyclical, I will smooth out KLACs revenue by using a 5 year average. The 5 year average comes out to be $6,108M, which I’ll use for the preceding analysis. 

After revenue comes operating margins. KLA has averaged 35% operating margins over the past 5 years. Using these margins, KLA should be able to produce $2,138M in operating earnings based on my estimated go-forward $6,108M revenue figure.

The next step is to get an after tax earnings figure. KLA typically pays an effective tax rate of around 17%. This tax rate applied to the $2,138M in operating earnings produces an after tax earnings of $1,774M.

Now that we have the estimated after tax earnings, we almost have a sustainable shareholder yield. KLAC has 152M shares outstanding, which produces an estimated EPS of $11.67. Looking at past shareholder returns, KLA tends to return most cash back to shareholders. I will estimate that KLAC can sustainably return 70% of their cash flow as dividends and stock buybacks. Applying the 70% to the $11.67 in EPS, we arrive at a distributable earnings of $8.17. With a current share price around $375, KLAC estimated shareholder yield is about 2.2%.

Once we have the estimated shareholder yield, Greenwald adds the estimated returns due to revenue/earnings growth to get the total expected yield of the stock. Revenue growth comes in two forms: organic and through reinvestment. 

Thinking about the organic growth rate of the semiconductor equipment industry over the next 10 years, there are many tailwinds with increased semiconductor demand in automotive, cloud compute, Internet of Things, etc. Despite these tailwinds, the semiconductor industry is cyclical, so I want to be a bit conservative with a long term growth estimate. If GDP is usually around 3%, a long term revenue growth rate of 5-7% could be reasonable for the semiconductor equipment industry.

Reinvestment growth occurs when a company reinvests its leftover cash in things such as expanding production, performing research for new product lines, or performing major acquisitions. However if a company is returning a large portion of its cash back to shareholders, then the business is most likely in a mature state. Since KLAC is returning most of its profits back to shareholders, my view is that they are not reinvesting in their business at a large scale. Therefore I will only utilize the organic growth figure when estimating the return in KLAs stock.

Finally we have all the pieces to estimate the long-term returns of KLAC at its current stock price. The estimated shareholder return gives us 2.2%, then we add the growth return of 5-7% producing a total return of 7.2-9.2%. Given these ranges, KLAC seems fairly valued. However, if we re-compute the returns using their current 52 week low of $250 a share, the shareholder yield would be 3.3%, bumping the total return to 8.3-10.3%. 

After doing this analysis, I think a decent return could be achieved from buying KLA at the current prices, however as a value investor I would prefer to see it get a bit cheaper. If the stock sells off back around $250 I may consider it. Another point is that my organic growth estimates are quite hand-wavy, so it could be possible that higher returns are realized if revenue growth surpasses my expectations.     

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Intel Valuation

Intel (INTC) has been an out of favor stock for over a year now. The company’s share price had a recent peak in April 2021 at $68 and is now trading around $27. This is quite the move for a large cap stock, let alone one of the largest semiconductor companies in the world. Intel designs and manufactures CPUs and other integrated circuits for PCs, data center, AI, and autonomous vehicles.

One of the main reasons Intel has sold off is due to their inability to manufacture the cutting edge transistors. This has led to their competitor AMD to gain market share since they utilize Taiwan Semiconductor to manufacture their chips. Additionally, demand for semiconductors have recently softened, which has led to most semiconductor stocks to face drawdowns. Given all this negative sentiment around Intel, I decided to perform a rough valuation to see if it is a candidate for my portfolio.

The valuation approach I will use is a simplified “earnings power” valuation from Bruce Greendwald’s valuation book. The first step is to figure out a reasonable steady state revenue. In 2021, INTC did $79B in revenue, which is an all time high. However this year Intel has lowered their guidance, estimating revenue coming in around $65B. Using this year’s guidance, plus the last four years of revenue, Intel’s average revenue comes to $73B, which I will use for this analysis.

Next is operating margins. Over the past 10 years, Intel operating margins have hovered between 33% and 25%. For this analysis I’ll use 30% as a steady state operating margin. This produces $21.9B in operating earnings based on my $73B revenue figure.

Greenwald’s earnings power valuation uses an after tax earnings. Philips typically pays an effective tax rate of around 20%. This tax rate applied to the $21.9B in operating earnings produces an after tax earnings of $17.52B.

The next step is to capitalize the after tax earnings with a reasonable cost of capital to arrive at the estimated enterprise value. Looking at historical P/E ratios, INTC has varied between 18 and it’s current value of 6. Seeing that Intel is a large cap stock with strong earnings, but still rough around the edges, I think a 7% cost of capital is reasonable.

By dividing the cost of capital by the post-tax earnings, we get the enterprise value of the company. Capitalizing the $17.52B in earnings by 7% produces an enterprise value of $250.3B. INTCs current enterprise value is around $120B. From these rough calculations, it appears there is a margin of safety in Intel’s shares. 

Since Intel looks promising, I’ll go ahead and calculate the estimated fair value of its shares. To go from enterprise value to equity value, first the cash balance of $28.4B is added back. Next, the short and long term debts are subtracted, which are currently $4.6B and $33.5B respectively. This produces an estimated equity value of $240.6B, and dividing by 4.09M shares outstanding produces a share price of $58.80. 

Since Intel definitely looks cheap on paper, I want to continue to do more due diligence. One thing that is concerning is Intel’s inability to produce the cutting edge transistors, thus losing market share. I would like to study the issue more and see if Intel has a chance of regaining superiority in CPUs. Additionally, I’ve heard Intel is slated to spend a large amount of money on capital expenditures. I would be interested to know what all that money is going towards, and whether it will produce much growth for the company. Intel definitely has some challenges ahead, but the stock price does seem compelling as long as the fundamentals do not deteriorate significantly in the future.

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Philips Valuation

In this post, I want to do a rough valuation of Koninklijke Philips (the ADR ticker is PHG). Philips provides healthcare imaging solutions, medical records solutions, respirators and other medical devices, as well as personal care devices such as electric toothbrushes and shavers. The company’s stock price hit a high around $61 in April 2021, and then proceeded to slide down ever since to the current price of around $18. It seems that a reason for this decline is due to a recall of respirators. I usually like to buy out of favor stocks due to some scandal or other temporary ailment, so PHG seemed right up my alley.

I recently read Bruce Greenwald’s Valuation book, and have been applying his different valuation approaches to the companies I am interested in. Here I will do a simplified “earnings power” valuation from the book. The first step is to figure out a reasonable revenue estimate going forward. In 2021, PHG did $19.5B in revenue, which is quite a bit down from the 2020 print of $23.8B. Looking at the past several years of revenue, Philips has not grown much, so a reasonable revenue estimate I’m using is $22B a year.

Next is operating margins. Over the past 10 years, Philips has had operating margins as low as 2.3% and as high as 9.5%. Usually margins are around 8% but there are a few bad years. For this analysis I’ll use 7% as a steady state operating margin. This produces $1,540M in operating earnings based on my $22B revenue figure.

Greenwald’s earnings power valuation uses an after tax earnings. Philips typically pays an effective tax rate of around 30%. This tax rate applied to the $1,540M in operating earnings produces an after tax earnings of $1,080M.

The next step is to capitalize the after tax earnings with a reasonable cost of capital to arrive at the estimated enterprise value. Looking at PHGs bond yields shows an average interest rate of around 6%. Another data point I use is to look at historical P/E ratios. Here, some of the average annual P/E ratios are very high, mainly due to low earnings that year and I guess the stock price did not decline much. Even with removing these outliers, the historical P/E has varied between 17 and 35, with an average around 20. Since the 6% cost of debt is higher than the historical earnings yield, I’ll stick with the more conservative rate of 6% (even though I feel like this value seems low). 

By dividing the cost of capital by the post-tax earnings, we get the enterprise value of the company. Capitalizing the $1,080M in earnings by 6% produces an enterprise value of $18B. PHGs current enterprise value is $23B…so clearly the stock is still overpriced. Unfortunately, even though Philips has had a large drawdown, I am not seeing any margin of safety based on reasonable assumptions on what the business can produce. Therefore, Philips is a pass, but at least it provided a good valuation exercise.

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