In an attempt to explain the current energy weightings in the funds I manage, I’m going to delve into some of the details behind the valuation work I do on companies.
In the wake of oil prices crumbling, many investors are so gripped with fear that they’ve thrown logical thought away in a panic, selling anything that is declining. To borrow from Rudyard Kipling – if you can keep your head when all about you are losing theirs, there is a fortune to be made, my son.
First, some basic principles.
Discounted cash flow
The ideal method for valuing any company is discounted cash flow (DCF). This method takes the sum of all future cash flows generated by a company after all required expenses (i.e., free cash flow), and discounts those free cash flows to today.
Discounting means turning future cash into current dollars. This is done because $1 today is obviously preferable to $1 one year from now. However, $1.20 in one year is, in most cases, better than $1 today. This is accomplished by using a discount rate. Let’s say you apply a 10% discount rate and the sum of future free cash flow equals $10/share. Buying that stock today at $10 would ensure a 10% return per year forever (assuming your predictions for free cash flow came to pass).
In reality, DCFs are fraught with issues, but the main concern is that the method requires a prediction, and we all know that forecasting the future is extremely challenging.
Gauging market expectations
Despite their inherent limitations, DCFs can be useful for gauging market expectations for the future. This is done by using a reverse DCF. With a traditional DCF, as mentioned, you are trying to calculate what a stock is worth today. In a reverse DCF you already know the stock price and use the DCF to solve for future free cash flows. This brings high school algebra back with a vengeance!
Let’s get technical – McCoy Global Inc.*
To help make this (somewhat) clearer, I have chosen a recent purchase, McCoy Global Inc., to illustrate. McCoy Global Inc. makes drilling equipment for the oil and gas industry.
We bought McCoy at $3.30/share in Trimark North American Endeavour Class on December 12, 2014. At that time, the company had $1.20/share in net cash. Let’s say you owned 100% of McCoy, you could give yourself that cash immediately to offset some of your purchase price. In effect, your actual cost of buying the company’s shares was $2.10. Next, take McCoy’s current free cash flow of $5.7 million. To earn a 10% return from $2.10, McCoy’s free cash flow would have to decline 2% per year for a decade and stay there, forever. That may not sound like much, but that means free cash flow is permanently 17% lower. But in this energy environment that might seem possible.
To see how dramatic this decline really is, let’s translate that free cash flow number into the income statement. Historically, McCoy has been a great growth company, with 29% annualized revenue growth for the last 10 years (Source: Invesco Canada). However, the company is now larger than it was a decade ago.. Factoring in these two issues, I think McCoy can grow 6% per year for the next decade. If McCoy is able to do this, in order to have 17% lower free cash flow, it would need to have 3.7% operating margins†, forever.
Compare this with the company’s long-term historical operating margin of 13.8% and McCoy’s profitability could drop 73% and you’d still get a 10% return owning McCoy at $3.30.
Alternatively, that revenue estimate may be too aggressive. So let’s go at this another way.
Assume McCoy can eventually get to 13.8% margins, even in a lower revenue environment (it did 15% in 2004 with $52 million in sales). At 13.8% margins, McCoy’s revenue 10 years from now would be $48 million or 56% below 2014 levels. I’m not sure McCoy’s revenues will decline that much in the next two years (its biggest historical decline was 34%), but I’m virtually certain revenues won’t drop 56% and stay there permanently.
But even if they did, you’d still get a 10% return on the investment.
The point is not to predict what McCoy’s revenue or margins will be in the future, but to illustrate what the stock market is implying about McCoy amid the current fear of all things energy related. I don’t know exactly what the future holds for McCoy, but I feel strongly that it will be better than the market anticipates. This limits the risks of owning McCoy.
What about the upside?
As the saying goes, “If you avoid losing money, the upside takes care of itself.” But let’s look at what could happen to McCoy if it turns out that this isn’t the end of petroleum after all. I won’t get into how I arrived at my upside scenarios – this blog post is long enough already! (My thanks to anyone still reading.) But, suffice to say, I believe McCoy could be worth around $10/share.
What I want to illustrate with this is the importance of time for a long-term value investor such as myself. If I buy McCoy at $3.30, how long can I wait and still get a great return – say 15%? In this case, for me, it’s just over eight years. If McCoy hits my upside scenario in early 2022, I’m going to be quite happy with how the investment has played out for our unitholders – myself included.
What am I trying to say here?
This kind of analysis can be done on almost any energy company – with similar results.
I want to emphasize two main points:
- I believe that having a long time horizon and the patience to wait it out can be tremendously profitable
- I believe that valuations in the energy sector look great right now
Thanks for reading and please feel free to leave any questions or comments below. I’m always happy to respond to our readers.
* The above company was selected for illustrative purposes only and is not intended to convey specific investment advice.
† Operating margin is a measurement of what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.
Source for all data, unless otherwise specified is FactSet Research Inc. as at February 15, 2015.
Trimark North American Endeavour Class, Series A provided the following performance returns as at January 31, 2015: 1 year, 7.53%; 3 years, 20.21%; 5 years, 9.45%; 10 years, 4.83%.