PER

Much like earnings results, when a company delivers 20% revenue growth, how does one determine whether that is a good or bad? It really depends on what expectations are priced into the stock that allows an investor to determine whether or not the company has delivered. But understanding the expectations priced into a stock in not an easy task, that is, unless you use The Applied Finance Group’s (AFG) Value Expectations (VE) interface.

AFG’s Value Expectations interface provides clients a platform to better understand economic profitability, and at the same time understand the performance a company must deliver to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low. Take, for example, the typical company during the tech bubble: the expectations that were priced into the average tech stock far exceeded what it could realistically deliver. For this reason, AFG identified the technology sector as overvalued, as well as potential torpedos such as Cisco, whose expectations were unrealistically high.

After determining if a company is a valid investment opportunity, users have the flexibility to adjust expectations based on their own research, build out pro-forma financial scenarios, and arrive at an NPV target price.

In addition, the VE interface has all the key theoretically components of a well-thought-out valuation model, which takes into consideration the appropriate risk, with a market derived discount rate (MDDR) that is adjusted for size and leverage. Competition and perpetuity issues are also taken into account, using company specific Competitive Advantage Periods (CAP).

By gaining a better understanding of the embedded expectations built in to security prices, relative to what a company has delivered historically, can provide insight into the Sales Growth, EBITDA Margin, and Asset Turnover a company must deliver in the future to justify its current trading price. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.

Our recent analysis of Dell’s acquisition of Perot Systems is a good example of how we have recently used the VE interface to determine the value of one company (PER), to get an understanding of what the acquiring company is paying for.

Our analysis revealed that Dell would acquire Perot Systems for $30 a share, a 68% premium over where PER closed last Friday. The sales growth required to justify the $30 a share price Dell has agreed to pay was quite lofty relative to PER’s historical performance. Using realistic, if not generous, expectations for EBITDA Margins of 11% and asset turns of 1.4, we concluded that PER will need to deliver an astounding 26% sales growth each year over the next 4 years to justify a $30 share price! This compares to the 13% average annual sales growth PER has delivered over the past 5 years, the 6.4% sales growth it delivered in 2008, and the expected but rather certain decline of 9% in sales in 2009. Overpaying for such growth destroys rather than creates shareholder value. Therefore, the real losers in this situation are the company’s existing shareholders who paid for the excessive acquisition premium by losing $1.4 Billion of market value Monday.

This is just one example of how Value Expectations can be a powerful tool to help investors understand the embedded expectations in security prices, with the added flexibility of building your own set of expectations for a company.   As you enter your own set of expectations (proforma), this will recalculate your inputs and translate them into an intrinsic value.

Below is a view from within the Value Expectations interface :

As you will note, we have solved for expectations on the $30 a share price Dell paid to acquire PER.

In this particular interface, users have the ability to stress test each input.  This is very handy for busy Portfolio Managers an analyst to them determine which stocks they need to reevaluate if it's a current holding.  If it's a new stock they are considering, they can quickly determine if it's worth their time to further investigate or to build a complete set of  proforma financials, using AFG's Proforma Builder.

Once a scenario is generated, there are many charts and options to present the data.  The Visual we selected below, does a nice job at comparing PER's lofty expectations with its historical performance. 

Value Expectations Interface allows investors to:

• Understand the performance expectations embedded into today’s stock prices.

• Build out Different Pro forma Financial Scenarios

• Determine NPV target price based on the users assumptions.

• Quickly determine if a company is over/under valued

• Benchmark valuation attractiveness against peer groups

• Efficiently Identify investment opportunities or potential torpedo’s

• Help clients outperform!

Components within the Value Expectations Interface:

Target

• The NPV target price.

• Based off forecasted cash flows and Economic Margin (EM) levels.

Upside

• The percent premium or discount to the market price.

• The “Percent to Target” or percentage up/down side

CAP – Competitive Advantage Period

• Defines the terminal value period

• A number of years over which EMs decays to zero.

• Force companies to be a “break even business” over time

• A four-factor regression analysis based on a company’s profitability, variability, EM trend, & size.

Cost of Capital

• Market Derived Discount Rate (MDDR).

• Adjusted for Size and Leverage on company specific basis.

• Expressed as a nominal rate

Tools

• Calculate- After new data has been entered in the Sales Growth, EBITDA%, Asset Turns, Price, CAP or COC select Calculate in this menu or click on the calculator to have the model reflect the changes and calculate a new target price.

• Solve- Select either Sales Growth or EBITDA% to see what percentage is required to keep the stock priced at the current price assuming that all other variables (sales growth, EBIDA% and asset turns) remain constant. The same results can be achieved by clicking the solve buttons next to Sales Growth and EBITDA%.

• Pro-forma Stages- Choose a pro forma stage from one to five to view Sales Growth, EBITDA Margins, Asset Turns and EPS for the number of years selected.

• Publish- Publish saved Value Expectations™ models to make them available to other members of your investment team

• Reset- Changes data in the Value Expectations™ model to the default values; clicking on the reset button in the header will also do this.

Charts

• Utilize value driver charts to benchmark and track your forecasts

• Benchmark forecasts vs. peers Data

• Multiple VE modules allow various starting points for your forecasts

• 1 Year Median

• 3 Year Median

• 5 Year Median

• Analyst (Default Forecast)

Value Drivers

• Sales Growth - Annual % increase or decrease in sales.

• EBITDA -Operating Income + DD&A

• Asset Turns - Total Sales/Total Assets

Smooth

• Use to straight-line up/downward trends.

EPS

• In the Analyst mode, this represents the consensus street estimate for forecast years 1 and 2

• Calculated as operating earnings, free of the impacts of financial manipulation

Stages

• Forecast 5 years out explicitly. Collapse the model down to forecast average or Long Term (LT) figures.

Price – Last night’s closing price

CAP and COC in greater detail:

CAP – The CAP field represents the Competitive Advantage Period calculated by AFG. The CAP value represents an exponential decay expressed in number of years. The decay range is between 7 and 39, with the average company having a 17-year CAP period. For each company, AFG performs a four-factor regression on historic Economic Margin (EM) levels to determine how attractive the company’s line of business is to competition. The four factors consist of profitability, variability, trend, and invested capital. For example, a company with very high historical Economic Margins (EMs) indicates that the company is highly profitable. Highly profitable firms attract competition; thus, the model will decay the levels of Economic Margin (EM) much faster than a company with lower Economic Margins (EMs)—or vice versa. A company with very volatile historical Economic Margin (EM) levels will have a shorter CAP period than a company with more consistent historical levels of Economic Margin (EM). If a company’s historical levels of Economic Margin (EM) are on an upward trend, the CAP period will be extended; or conversely, on the way down (slippery slope) the CAP period will be shortened. In terms of invested capital, the model assumes that is more difficult to erode profits from a larger more established company; thus, extending the CAP period for larger companies, and shortening it for smaller companies.

COC – The COC field represents the Cost of Capital calculated by AFG. AFG calculates COC by taking a subset of companies (2200 industrial, 150 utility, or 300 financial) meeting certain qualitative criteria. For each individual company in those subsets we solve for the discount rate that makes them fairly valued today. We then rank order those discount rates and select the median discount rate to represent a typical firm’s COC in the marketplace. Each company is then adjusted from the market-derived discount rate for its size and leverage characteristics. Thus, the largest most levered firms have the smallest COC; and the smallest most highly levered firms have the highest COC. For a complete review of AFG’s COC please see the Advanced Learning section of our home page.

Dell (NASDAQ:DELL) announced that it would acquire Perot Systems (NYSE:PER) for $30 a share, a 68% premium over where PER closed on Friday. What input did Dell’s Board of Directors offer on this deal? While the equity dollar amount of the deal is only “$3.5 Billion”, relative to Dell’s $12 Billion cash coffer and market capitalization of $32.5 Billion, it is still a bet of more than 10% of the company’s value.

While paying a 68% premium for a company is not by definition silly, it is usually not very smart – in this case it will likely lead to significant wealth destruction. The market seems to agree.

Dell lost approximately 4% of its market value (net of market returns) yesterday when the deal was announced, representing approximately $1.4 Billion dollars. That loss basically represents the entire premium Dell anted up for PER! In other words, the market is saying the benefit given to PER owners has to come completely from the hide of existing DELL owners. The market clearly does not perceive this as a “win win” type of acquisition. Instead this seems to be a typical “winner’s curse” deal where management overpays to ensure it “wins”.

Is the market always right? Of course not, but unfortunately management teams listening to Investment Bankers trying to drive deals tend to be right less often. How can one tell when the market is likely to be wrong, and thus reap potentially lucrative rewards? The answer is easy: when one can affirmatively say that the price paid for an acquisition reflects reasonable future corporate performance expectations. With that in mind, let us deconstruct the PER deal.

While growing earnings and sales is nice, it is woefully insufficient to ensure shareholder value creation. Understanding value requires a fundamental grasp of: Profits, Investment, Growth, Risk, and Competition. We will utilize AFG’s Value Expectations™ framework and focus on the profit, investment and growth side of the value equation to decompose this deal.

The 3 charts below highlight PER’s value drivers – Sales Growth, EBITDA Margin, and Asset Turnover. In order to frame whether the transaction makes sense or not, we will back into an answer that describes the sales growth Dell must achieve from PER in order to make this deal work out for existing Dell Shareholders. We will first begin by determining a reasonable estimate of PER’s sustainable EBITDA margin and then estimate how much capital PER needs to sustain its sales model. Lastly we will impute the sales growth required to justify the $30 a share price Dell has agreed to pay.

Beginning with PER’s historic profit margins, what can Dell expect from the unit going forward? Looking at the EBITDA Margins in the chart below from 2000 through 2008, PER delivered EBITDA margins ranging from a low of 2.8% to a high of 11.8%. For our analysis, we will use what seems to be a reasonable figure of 11% to represent PER’s normalized long-term EBITDA Margin. In fact, given the volatility of PER’s margin historically, many can argue that 11% is a generous assessment. That said, let us use 11% nonetheless. Next, review the chart depicting PER’s Asset Turn Over ratio, which tracks how much a company must invest in its balance sheet to support a dollar of sales. For PER the figure recently was about 1.4x, or for every $1.40 of sales the company generates, it must invest $1.00 in assets to support those sales. Though PER has been much more efficient historically, its trend has been towards requiring more and more capital to support a dollar of sales. By using the most recent figure, we will assume it will minimally arrest that slide.

So what sales growth PER needs to generate to justify a $30 share price? An astounding 26% each year over the next 4 years! This compares the to the 13% annual growth PER has delivered over the past 5 years, the 6.4% it delivered in 2008, and an expected but rather certain decline of 10% in 2009.

Source (The Applied Finance Group)

Bottom line, Dell’s management team believes it will double PER’s growth rates over the next four years relative to what PER achieved during the past economic boom, while maintaining historically aggressive profit margins. While it is not impossible, it seems very unlikely. In fact, Dell executives did not give any targets for revenue, saying more details would come after the deal closes. They did touch upon expected opportunities for cost savings, saying the two companies spend a combined $4 Billion in the areas they plan to integrate, and its sees cost savings of about 6-8% in 2 years. If Dell hits those synergies, which justifiably the market rarely pays for, the new Perot would likely have profit margins approaching that of Accenture, arguably the best in class provider of these services. Again, while such an outcome is possible, it is much like betting on the expectation of hitting an inside straight – generally not a very good strategy.

Ultimately, that is the essence of an investment decision – How likely is a company to deliver on the expectations embedded in its share price. During the Tech Boom of 2000, the answer was “not very likely” as stock prices reflected absurdly optimistic future expectations. In March of this year, the answer was “very likely” as so much pessimism reigned, that stock prices reflected absurdly negative future expectations. (See this report for our analysis of the Tech Boom and 2008/2009 Panic).

Dell justifies the deal on the basis of “strategic fit”, as this acquisition should enable Dell to expand into higher margin IT services (increasing its revenues from Services from the current $5.5 billion to $8 billion) and to secure a more stable and recurring revenue stream as computer hardware becomes more and more commoditized. However, any strategically sound growth strategy must have a sound price tag. Overpaying for assets may allow the current management team to claim future revenue and profit growth, and depending on their compensation plans achieve nice bonus payouts. But overpaying for such growth destroys rather than creates shareholder value. Therefore, the real losers are the company’s existing shareholders who paid for the excessive acquisition premium by losing $1.4 Billion of market value yesterday.

Dell’s Board should do what every PC user does when its machine acts up – reboot. In this same tech spirit, Dell’s Board should reboot this deal until it creates value for existing shareholders.

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