Novice Investing - Fair Value of a Declining Business

Date: Thursday 07th 2008f August 2008 01:38:42 PM

Fair Value of a Declining Business - 04/03/2008

By: Hari Wibowo

Our first article regarding fair value, we discussed the fair value of a common stock. We compare a stock's annual profit with the dividend paid out by a ten year treasury. If a ten year treasury is giving us 4% yield year in year out, then the fair value of a common stock would be around 6% or more. This is because stocks do not always consistently give out the same yield due to the nature of the peak and trough of a business. Now, this is for a business that we 'predict' to have constant profit year in and year out.

If the fair value of a common stock that has a constant profit, how should we value a common stock with a declining profit? The concept is very similar with non-growing business. However, there is certain discretion for each investor. Some will want to project earnings up to five years down the road, other ten or fifteen years ahead. For our valuation purpose, we prefer to project up to five years forward. The main reason is fairly simple. The longer the projection runs, the more uncertainty and less accurate it is. Thus, projecting a ten year earnings ahead with reasonable accuracy is a futile attempt.

Let's take a simple example of Idearc Inc. (IAR), which is in a yellow page business and whose business has dwindled due to competition from internet advertising. If we assume that the yellow page business will shrink by 5% annually, what would Idearc's fair value be? You can view a comprehensive table below which use the following assumption: Revenue shrink by 5 % annually from 2007 Gross Profit Margin constant at 80.6 % Selling General & Administrative (SG&A) expense is flat Interest expense: 7.5% rate from debt outstanding Idearc can refinance any debt coming due before 2012 with the same 7.5% interest rate 50% of Idearc's net income will be used to pay down debt. No dividend distribution for 2007-2012. Income tax rate is identical to 2007 (35.6% rate) Constant shares outstanding of 146.7 Million shares

Year	2007	2008	2009	2010	2011	2012
Revenue	$ 3,189 M	$ 3,030 M	$ 2,878 M	$ 2,734 M	$ 2,597 M	$ 2,468 M
Gross Profit	$ 2,572 M	$ 2,442 M	$ 2,320 M	$ 2,203 M	$ 2,093 M	$ 1,989 M
SG & A	$ 1,141 M	$ 1,141 M	$ 1,141 M	$ 1,141 M	$ 1,141 M	$ 1,141 M
Interest Expense	$ 676 M	$ 660 M	$ 644 M	$ 631 M	$ 620 M	$ 612 M
Income Tax	$ 238 M	$ 228 M	$ 190 M	$ 153 M	$ 118 M	$ 84 M
Net Income	$ 429 M	$ 413 M	$ 345 M	$ 278 M	$ 214 M	$ 152 M
Shares Outstanding	146.7 Million	146.7 Million	146.7 Million	146.7 Million	146.7 Million	146.7 Million
Earning per Share	$ 2.92	$ 2.82	$ 2.35	$ 1.90	$ 1.46	$ 1.04

In this case, Idearc will earn $ 1.04 per share in 2012, which is a far cry from $ 2.92 it earned in 2007. However, please remember that we assume a 5% revenue decline here while Selling General & Administrative Expense remains constant. Anyway, so what is the fair value of Idearc's shares in here? We have to add an additional information here. Since, Idearc is using half of its net income to pay off its long term debt, by 2012, its long term debt has fallen to $ 8.160 Billion from $ 9.013 Billion in 2007. With $ 1.04 per share of net profit, we can use similar way to find the fair value of a common stock. Real price = 16 x Earning per Share, assuming 6.25% yield for Idearc's stock.

Real price = stock price - (cash+ short-term investment) + long-term debt.

16 x $ 1.04 = stock price - $ 6.24 + $ 55.6

Stock price = $ 16.64 + $ 6.24 - $ 55.6 = - $ 32.72 per share.

Therefore, Idearc's shares is worth negative if revenue is expected to decline 5% each year. This is due to its high debt load.

END

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Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding Idearc Inc. (IAR) or any other securities.

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