Stock Valuation – Ebay

Below we shall evaluate a fair stock price for Ebay.

Free Cash Flow per Share:

  • EBAY’s FCF over the past 4 quarters was $2,456,160,000
  • EBAY has shares outstanding of $1,280,000,000
  • Thus the Free Cash Flow Per Share is $1.92

Annual Growth Rate:

  • From 2004 through 2007 Ebay has been growing at an average annual growth rate of 32%
  • Through 2008, free cash flow has been declining slowly from quarter to quarter, but remains remarkably strong in light of the current economic woes
  • The slowdown in overall consumer credit will certainly hurt ebay
  • However, it needs to be pointed out that EBAY is not a seller of products, ebay is a business that facilitates auctions between buyers and sellers; as individuals consolidate their finances they will sell more items on ebay; thus I expect this consolidation effect to counterbalance or at least dampen the effect of the decline of overall consumer demand.
  • EBAY is also well positioned internationally and derives a significant portion of its income abroad, balancing our the negative effects of dollar weakness to the shareholders
  • EBAY has a remarkably high ratio of shareholder’s equity to debt of 10:3, where all liabilities are short term liabilities such as accounts payable and $0.00 in long term debt, virtually shielding it from the current financial crisis
  • To be safe we shall assume that EBAY’s FCF will remain stagnant over the next 5 years and rise at a perpetual rate of 1% thereafter

Confidence margin:

  • Due to high volatility over the past 4 years, we shall apply a confidence margin of 50% to this profit expectation

Price:

  • Applying the valuation formula to the assumptions stated above, EBAY’s fair stock price computes to $108.73
  • It is, without a doubt, very reasonable to be bullish for EBAY at its current price of $14.45

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Stock Valuation – Precision Drilling Trust (PDS)

Below please find an valuation of shares of the common stock of Precision Drilling Trust (PDS)

Free Cash Flow per share:

  • PDS’s FCF over the past 4 quarters was $171,670,000
  • PDS has shares outstanding of $125,760,000
  • Thus the Free Cash Flow Per Share is $1.37

Annual Growth Rate

  • PDS’s FCF fell from $324 million to $297 million from 2004 through 2007. Temporarily there was a significant spike in the year 2006 which was certainly due to the continuous rise in oil prices. However, due to this high volatility it is not possible to make any predictions based on the past 4 years.
  • Precision drilling certainly thrives in a high oil price environment. The higher the price the more explorations and thus more demand for drilling equipment.
  • But the oil price has been falling sharply over the past 5 months. Even though the money supply has begun to grow significantly again, the effects on the oil price will not be visible immediately. It may take another 1-2 years before oil bottoms out.
  • In order to make our calculation as conservative as reasonably possible we shall thus assume that the annual cash flow for PDS will continue to fall over the next 5 years, at an annual rate of 10%
  • Thereafter we shall assume a perpetual growth rate of 1%

Confidence margin:

We shall apply an confidence margin of only 30% in order to account for the fact that we did not make very elaborate research on the overall strengths/weaknesses and opportunities/risks that the company faces and hence are not very sure if the expected returns will be achieved. In addition to this, the past data indicates a high level of cash flow volatility.

Risk Free Rate:

Price:

Based on the data above, the fair price for PDS is $13.13, about double of the current price which is $6.66. And this is assuming falling oil prices and a continuously falling cash flow over the next 5 years at an extremely conservative confidence margin. If oil prices bottom out or even begin rising again over the next 5 years the stock has the potential to explode.

In any case, based on the above it is reasonable to be very bullish on Precision Drilling at the current price.

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Mac Donalds Stock Evaluation Example

This is how the concepts of stock evaluation can be applied to the example of the company Mc Donalds (MCD):

Free Cash Flow per share:

Annual Growth Rate

Confidence Margin

We shall apply a confidence margin of 50% in order to account for the fact that we did not make very elaborate research on the overall strengths/weaknesses and opportunities/risks that the company faces and hence are not very sure if the expected returns will be achieved. The more research one does, and the more certain one is regarding the returns, the higher this number can be.

Risk Free Rate:

Thus the formula is as follows:

Price(MCD)

= ($3.23 x 0.5 x 1.07 / 1.0265) + ($3.23 x 0.5 x 1.072 / 1.02652) + ($3.23 x 0.5 x 1.073 / 1.02653) + ($3.23 x 0.5 x 1.074 / 1.02654) + ($3.23 x 0.5 x 1.075 / 1.02655) + ($3.23 x 0.5 x 1.076 / (0.0265-0.01) / 1.02656)

= $1.68343887 + $1.754777975 + $1.829140217 + $1.906653709 + $1.987451991 + $125.5560159

= $134.72

This analysis suggests that Mac Donalds shares are currently available at a price below the fair price. If my estimations turn out to be true, or the company performs even better than estimated, I would most likely be realizing a gain from this investment.

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Stock Evaluation

Shares of common stock are claims to entrepreneurial profits generated by the factors of production employed in a business. How much one should pay for a share depends on the value preference one assigns to it. While consumer goods render various services the valuation of which highly depends upon one’s value preferences, a share in factors of production, only renders one benefit to its owner: It yields specific amounts of money over a specific amount of time at a certain risk, where risk means the uncertainty over the amounts of money to be received.

Thus these three factors need to be incorporated when assessing the price one would be willing to pay for a share.

Within a certain territory, a so called risk free investment is a credit transaction with the government. The interest rate that the government pays shall be considered the risk free rate. It is expedient to apply the interest rate on 10 Year Treasury Notes.

Every investment in factors of production has to be measured against this risk free rate. If one can expect a guaranteed $1100 in 1 year  by loaning $1000 to the government, then $1100 in a year returned by a business will certainly be worth less than $1000. Thus this money received has to be discounted by a confidence margin between 0(very uncertain) and 1 (100% certain). As a standard, all calculations are looked at in annual terms, but it is not mandatory.

The price estimation for money received in the future is called present value. A present value for money received in a certain number of years is calculated as follows:

Present Value = (Payment Amount X Confidence Margin) / (1+ Risk Free Annual Rate)(Number of Years)

Since it is very hard to foresee more than what will happen over the next 5 years, the expected money received over those 5 years shall be factored into the valuation, but all future expected money shall be estimated at a very low growth rate. Thus we shall resort to a perpetuity calculation. A perpetuity is an arrangement where one receives a certain amount of money every year at a fixed growth rate for all time. The fair price of an annual perpetual payment is estimated as follows:

Perpetuity Price = Annual Payment / (Risk Free Annual Rate – Fixed Annual Growth Rate)

The profit generated thus far by a business is reported for all publicly traded companies. But the reports might be misleading. What they report under the label “Profit” is a very manipulated figure that is the result of numerous accounting techniques. The closest approximation of what one can expect to be the actual money available to the business is the free cash flow. The free cash flow can be approximated by subtracting capital expenditures from the operating cash flow (Free Cash Flow = Cash Flow from Operations – Capital Expenditures). All these numbers are available on financial websites. Example: NEM

Based on the growth of the free cash flow over the past 5 years plus the overall expectations of whether or not consumers will still have a demand for the company’s goods over the next 5 years, one needs to come up with an estimated annual growth rate for the free cash flow over the next 5 years. After that we shall assume that the free cash flow returned in the 5th year will grow at a perpetual annual rate of 1% for all time.

Thus the formula to approximate a price one should  be willing to pay for a share of common stock is the following (where FCF = Free Cash Flow per share over the past 4 quarters):

Price = Present Value (FCF * Annual Growth Rate, 1 year) + Present Value (FCF * Annual Growth Rate2, 2 years) + Present Value (FCF * Annual Growth Rate3, 3 years) + Present Value (FCF * Annual Growth Rate4, 4 years) + Present Value (FCF * Annual Growth Rate5, 5 years) + Present Value of 1% Growth Perpetuity Starting in 6 years

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