Much simple way of calculating intrinsic value using FCF

James A. Ohlson(http://www.cfapubs.org/doi/pdf/10.2469/cp.v1998.n2.6) has derived quite a simple way of determining whether a company is over or under value by just using a few simple parameters on using Free Cash Flow(FCF)

1) Current FCF, the author used FCF = NOPAT - Change in Invested Capital, but I will use an easier format which is cashflow from operation - capital expenditure

2) Anticipate growth in FCF, use growth of sales to infer the growth rate of FCF, but I can also use the past 5 years FCF history to determine the growth rate of FCF.

3) Use modified dividend growth model and applied it to FCF, which is = Current FCF * (1 + Growth)/ (r- Growth)

4) Infer r by reverse engineering, which derive r = Growth + Current FCF/value of the firm(cash yield), where value of the firm = market cap of equity + net debt

5) Decide whether the stock is overvalue or undervalue by looking at r. If r is high, means it is undervalue, vice versa.

This illustrates that investor's expected return has two components: growth and cash yield. What a company does not generate in growth it must generate in current FCF, what it does not provide in current FCF it must provide in growth

I will use an example here to illustrate the formula, Franklin Resources(NYSE:BEN),

1) Current FCF of BEN = 2,566million

2) Growth in sales for the past 5 years = 14.8%

4) Value of firm (enterprise value) = 22,828 mil

5) r = growth + cash yield = 14.8% + 2.566/2,2828 = 26%

Relatively high r, so Franklin Resources is undervalue at this moment

Western Union (NYSE:WU; Price= $15.51; Long call with target price=$19.64; P/E=10.9; P/B=7.76) – 16 Oct 2014, With vested interest since Feb 2015.

Business Model: To send money efficiently and cheaply around the world with 510K locations. C2C represents 82% of revenue, geographical diversification of revenue split across Europe(22%), North America(19%), Middle East and Africa(16% with 6% growth YoY),Asia Pacific(12%), Latin & Central America(8%) and WesternUnion.com (4%, C2C E-commerce, with 31% growth YoY in digital expansion). C2B contributed 10% of revenue and Business Solution represents 7% of revenue.

Investment Thesis: 1) Price is low due to worry of compliance cost(4.5% of its revenue), but cost will be normalized in the future(FY14 guidance=3.5% to 4.0% of revenue), other competitors might not be able to compete due to non-compliance issue(country specific) like adhere to money laundering(for e.g. Barclays exited money transfer business in Jul 2013), therefore strong economic moat will most likely enhanced in future due to regulatory moat as shown by past average 5 years ROC = 643.5% 2) shareholder friendly; generate around $1.1b of operating cashflow, with 61% used to do stock repurchase and dividend payback 3) Strong distribution network, with more than 510K locations worldwide, emerging market would still need brick and mortar store to receive physical money with flexibility of doing price adjustment if there is a competition, 4) e-commerce segment is growing, as well as Business Solution segment(average 10% per quarter), 5) potential growth in India, China, Mexico and the Philippines with workers needed to send money back home. Remember spending money using credit card (value for purchased items are relatively lower) and transferring money(notional maybe large) are two different things. Need lower transaction cost, network effect(brick and mortar), compliance and reputation(163 years of history) to be in money transfer business.

Profitability & Financial Ratio:

	2009	2010	2011	2012	2013	TTM	2009-2013 CAGR
Revenue(USD mil)	5084	5193	5491	5665	5542	5587	1.74%
Gross Margin(%)	43.45	42.64	43.51	43.61	41.63	41.13	-0.85%
Operating Margin(%)	25.23	25.04	25.22	23.48	19.98	19.4	-4.56%
Net Margin(%)	16.7	17.52	21.22	18.11	14.41	14.04	-2.91%
Asset Turnover	0.79	0.68	0.65	0.61	0.57	0.56	-6.32%
Equity Multiplier	20.77	13.60	10.13	10.06	9.16	9.23	-15.11%
EPS(diluted)	1.21	1.36	1.85	1.7	1.43	1.44	3.40%
Free Cashflow per share	1.64	1.32	1.6	1.51	1.51	1.52	-1.64%
Number of shares(mil)	701	668.9	634.2	607.4	559.7	539.9	-4.40%
Dividend yield(%)	0.53	1.30	1.63	2.77	2.93	3.00	40.77%
EV/EBIT	11.15	10.21	8.8	7.55	10.44	6.32
ROC(%,Greenblatt definition)	646.85	648.75	701.98	674.78	545.52	526.96
Price to Free Cash Flow	8.93	14.07	11.41	9.01	11.35	10.31

Peer analysis: Xoom is operating on an online model only, trading at x128.7 P/E; Moneygram traded at 5.78 EV to EBIT but with lower net margin of 7.29% and only 300K locations. Euronet has less than 150K locations.

TTM	Western Union	Moneygram	Xoom	Euronet
Revenue(USD$mil)	5587	1516	140	1485
EV/EBIT	6.32	5.78	75.84	19.51
ROC(%)	526.96	4.85	14.25	112.36
Net Margin(%)	14.04	7.29	2.9	6.36
Asset Turnover	0.56	0.31	0.49	0.91

Valuation: Traded at 6.32x EV/EBIT(10 years EV to EBIT range: 5.3 to 19.9); 10.31x P/FCF(10 years P/FCF range =6.69 to 28.69). Using earnings power valuation with no growth assumptionà27% upside from current price

EBIT Margin average for the past 5 years	0.230811
Average Sales for past 5 years(mil)	5404
Average EBIT(mil)	1247.304	Required Return of Equity	9.00%
- Current interest(mil)	174	Forecast equity value(mil)	10603.38
- Current tax(mil)	119	Amount of outstanding share(mil)	539.9
Add: 3 years R&D	0
Earning Power(mil)	954.3039	Fair value of share(US$)	19.64

Risk: Low revenue growth; earnings hurt from strong USD in short term; competition from Peer to Peer transfer and Mobile Payment; economy downturn causes worker to lose job and then sending less money back home. However operating margin maybe able to improve to 25% once the compliance completed, thus offsetting the low revenue growth, with added bonus from digital expansion in C2C channel.

Summary: Buying a high ROC (due to regulatory moat and no high capex needed) company with a cheap price(temporarily low due to compliance cost) will offer decent return in a long run.(credit to Joel Greenblatt). Notable guru holdings: David Abrams(used to work with Seth Klarman, 26.31%), Charles Bobrinskoy(Ariel Focus,4.8%), John Rogers(Ariel Appreciation, 4.51%)

AP Oil

AP Oil(Code: 5AU, Price:S$0.20, Target Price:S$0.43, P/B= 0.8, P/E=6.3, market cap=S$32.9m)

Background: Incorporated in 1975(listed in 2001 and upgraded to mainboard in 2003), engaged in manufacturing of petroleum lubricating oil, including wholesale of oil and fuel, dealing in paraffin wax, lubricating oil grease. Manufacturing segment manufactures range of lubricating oil and fluids and specialty chemicals for industrial, automotive and marine applications, and providing blending services(61% of revenue). The manufactured goods were sold under the Company’s brand names. The trading segment trades in base oil and additives and specialty chemicals(19.5% of revenue). The franchising segment includes trades in raw materials for products under the Company’s brand names(19.7% of revenue).

Economic moat:

1. Customized solution for industrial lubrication needs(metal working oil, stamping and forming oil, heat transfer oil, gear oil, hydraulic fluid, compressor oil, transformer oil etc) – Differentiated focus
2. Strong R&D capability and focus on quality
3. Brand name is established; relatively high switching cost(customer won’t risk damaging the machine if switch to another brand)
4. Exported to over 20 countries; Singapore generated 64% of revenue(Bulk of the figure included marine lube delivered to foreign vessels at Singapore port and specialty chemical that sold to SG multinational companies and subsequently re-exported to other countries). Vietnam, Myammar and Bangladesh accounted for 25.6% of revenue.-->Emerging Market Exposure

Profitability Analysis:

	2013	2012	2011	2010	2009
Net Profit Margin	8.09%	5.26%	6.39%	4.21%	8.51%
Asset Turnover	1.33	2.08	1.63	2.09	1.73
Return on Asset	10.76%	10.92%	10.43%	8.78%	14.72%
Equity Multiplier	1.18	1.19	1.25	1.21	1.26
Return on Equity	12.73%	12.96%	12.98%	10.65%	18.51%
Piotroski F score	7	8	7	6	8
Profitability
Positive Net Income	1	1	1	1	1
Positive Operating Cashflow	1	1	1	1	1
Increasing ROA	0	1	1	0	1
Operating CashFlow > Net Income	1	1	1	0	1
Liquidity, Debt and source of fund
Increasing current ratio	1	1	0	1	1
Decreasing ratio of long term debt to total assets	1	1	1	1	1
No increase in outstanding share	1	1	1	1	1
Efficiency
Increasing Gross Margin	1	0	1	0	1
Increasing Asset Turnover	0	1	0	1	0

Valuation: 1) Using residual income method: If ROE earning more than Required Return, then it should be atleast selling at the Book Value + Residual Income

2) Using FCFF: Assuming sales growth =2.3%, EBIT margin= 8.65%, WACC = 10%, long term FCF growth rate =2.47%,  intrinsic value= S$0.43 per share

FREE CASH FLOW (FCF)		2014	2015	2016	2017	2018
Profit after tax		3.496	3.612	3.749	3.872	3.904
Add back depreciation		1.055	1.055	1.055	1.055	1.055
Change in net working capital
Increase in operating current assets		-0.918	-0.338	-0.346	-0.354	-0.362
Add increase in operating current liabilities	-0.947	0.129	0.132	0.135	0.138
Subtract capital expenditures		-1.143	-1.145	-1.148	-1.150	-1.152
Subtract increase in other assets		0.000	0.000	0.000	0.000	0.000
Add back after-tax interest		0.026	0.025	0.007	0.005	0.097
FCF		1.568	3.337	3.449	3.563	3.680
Valuation
WACC	10.00%
Long-term free cash flow growth rate	2.47%
Year		2014	2015	2016	2017	2018
FCF		1.568	3.337	3.449	3.563	3.680
Terminal						50.107
Total		1.568	3.337	3.449	3.563	53.787
Discounted value	44.685
Add back initial cash	26.211
Firm value	70.896
Subtract total debt value	0.248
Implied equity value	70.648
Number of shares outstanding	164.53
Implied value per share	0.43

Thesis for investing: Low P/B<1, Low P/E <10, No long term debt, ROE > 12% for the past few years. Solid F-score history(>=6) for the past few years. Cash per share = S$0.159

Risk: 3 major customers contributed 58.8% of revenue of 2012, 2 major customers contributed 40.63% of revenue of 2013; Low liquidity, same as the SG small caps, daily transaction lots around 50 lots, Optimum size of asset allocation 20-30K SGD, need to hold for long term(3 years+)

Family ownership: Ho Chee Hon, Deputy CEO, son of CEO, increase holdings from 1.83 mils shares to 3.16 mil shares with S$0.21 per share on 11th March 2014. Total percentage of share holding by CEO Ho Leng Woon, his wife and his son = 49.9%