Some Simple Valuation November 19, 2002
PICL
Jim Mueller, Financial Partner
So, last time we looked at how to read the charts that services such as finance.yahoo.com provide when we get stock information from them. We ended with the question, “now what?”
We’re going to take one of those numbers, the P/E ratio, and use it to try to predict how much a stock will be worth 5 years from now. Then we will use that information and some assumptions as to what the company will do (based on what it has done in the past using some of those other numbers) to find out what a current fair value for that company would be now. The purpose is to determine if now is a good time to purchase the stock of that company.
For this exercise, we will use The Cheesecake Factory, Inc. (CAKE)
Overview:
(copied from “ companyinformation/busidesc&Ticker=CAKE”, which was reached from finance.yahoo.com’s Profile of CAKE, link for “Expanded Business Description” in the Business Summary)
The Cheesecake Factory Incorporated operates 50 upscale, full-service, casual dining restaurants under The Cheesecake Factory mark in Arizona, California, Colorado, Florida, Georgia, Illinois, Indiana, Maryland, Massachusetts, Missouri, Nevada, New Jersey, New York, Ohio, Pennsylvania, Rhode Island, Texas, Washington and Washington, DC. The Company also operates two upscale casual dining restaurants under the Grand Lux Cafe mark in Los Angeles, California and Las Vegas, Nevada; one self-service, limited menu "express" foodservice operation under The Cheesecake Factory Express mark inside the DisneyQuest family entertainment center in Orlando, Florida; and a bakery production facility. The Company also licenses three bakery cafes under The Cheesecake Factory Bakery Cafe mark to another foodservice operator. The term "restaurants" includes both The Cheesecake Factory and Grand Lux Cafe concepts, and excludes the one "express" location and the three licensed bakery cafes. Total restaurant sales represented 92.7%, 92.9% and 92.2% of its total revenues for fiscal 2001, 2000 and 1999, respectively.
The Company's menu consists of approximately 19 pages and features approximately 200 items including appetizers, pizza, seafood, steaks, chicken, burgers, specialty items, pastas, salads, sandwiches and omelets. Examples of menu offerings include Tex-Mex Eggrolls, Roadside Sliders, Crusted Chicken Romano, Shrimp Scampi, Cajun Jambalaya Pasta, Santa Fe Salad, Orange Chicken and Caribbean Steak. Dessert sales represented approximately 15% of total restaurant sales for fiscal 2001, 2000 and 1999. The sale of alcoholic beverages represented approximately 13% of total restaurant sales for fiscal 2001, 2000 and 1999.
In May 1999, the Company opened its first Grand Lux Cafe at the Venetian Resort-Hotel-Casino in Las Vegas, Nevada. Grand Lux Cafe is an upscale, casual dining concept that offers unique global cuisine in an elegant but relaxed atmosphere. The menu at Grand Lux Cafe offers approximately 150 menu items including appetizers, pasta, seafood, steaks, chicken, burgers, salads, specialty items and desserts. Examples of specialty menu offerings include Slow Roasted Lamb Shank, Chicken Venetian, Seared Rare Ahi Tuna Tostadas, Tuscan Bread Salad and Miso Glazed Salmon. A full-service bar and bakery are also included in the concept. Its location in the Venetian Resort-Hotel-Casino is open 24 hours a day and also serves a breakfast menu. Based upon the initial success of the concept in Las Vegas, the Company opened a second Grand Lux Cafe at the Beverly Center in Los Angeles in November 2001, and plans to open an additional Grand Lux Cafe in Chicago during fiscal 2002, in order to more fully evaluate the concept's future expansion potential.
The Company's operations originated in 1972 as a producer and distributor of high quality cheesecakes and other baked desserts. The creation, production and marketing of quality cheesecakes and other baked desserts remain a cornerstone of its brand identity. At its bakery production facility in Calabasas Hills, California, the Company produces approximately 50 varieties of cheesecake based on its proprietary recipes. Some of its popular cheesecakes include the Original Cheesecake, White Chocolate Raspberry Truffle, Chocolate Peanut Butter Cookie-Dough, Kahlua Cocoa Coffee, Dutch Apple Caramel Streusel, Fresh Strawberry and Triple Chocolate Brownie Truffle. Other popular baked desserts include chocolate fudge cake, carrot cake, blackout cake and apple dumplings. In the aggregate, its bakery production facility currently produces approximately 300 product SKUs (store-keeping units).
Numbers:
EPS (ttm)0.92
MktCap1.68 $B
Shares49.6 M
Float38.7 M
% short8.2 this month
8.2 last month
Price (as of 11/15)33.94
P/E33.94 / 0.92 = 36.89 (range of 25.2 – 44.3 over the last 10 years, avg of 32.7)
Revenue (in $M):
20012000199919981997
539.13438.28347.48265.22208.59
% Grow23.026.131.027.1--
CAGR* for 4 years: 27
Income (in $M):
20012000199919981997
39.3132.1021.7314.039.94
% Grow22.547.754.941.1--
CAGR* for 4 years: 41
Debt: none
Use of numbers:
What we are after is a current fair value, based on what we assume a future value will be. One way to obtain this is to do the following.
1. Pick two growth rates to be applied to each of the next five years.
2. Determine what EPS would be 5 years from now for each growth rate.
3. Pick three P/E ratios to be applied to the stock five years from now.
4. Determine what the future stock price would be for each growth rate with each P/E.
5. Determine what the current stock price should be, assuming a reasonable rate of return
per year.
The basic equation to do this is with the following growth formula.
“future value” = (1 + “% growth”) ^ “number of years” * “current value” (eqn 1)
Step 1:
Since revenues have grown by a bit more than 25% per year for the last 4 years, while income has grown at an even higher rate, we will choose 25% (the conservative choice between revenue and income) as one of our growth rates.
For the second growth rate, let us assume that the company has to slow down a bit over the next five years, so let us choose 20% as the other growth rate.
Step 2:
With those two different growth rates, what would the EPS be in 5 years, assuming that growth rate applied evenly to each of those five years (eqn 1) ?
20%: (1.20 ^ 5) * 0.92 = 2.29
25%: (1.25 ^ 5) * 0.92 = 2.91
Step 3:
For a high P/E, let us choose the average over the last 10 years of 33.
For a middle P/E, let us choose the low end of the last 10 year range, 25.
Of the 59 restaurant companies who reported earnings and were listed on the Dow Jones Restaurant Index, only 13 had a P/E of more than 20, including CAKE. For a conservative P/E, let us choose one more representative of the industry, 18.
Step 4:
Future price = future P/E * future earnings
P/E20%25%
1841.2150.54
2557.2370.19
3375.5592.65
Step 5:
What we are after is a “discounted value”. This is the current price to which a growth rate is applied to reach the future value we determined in Step 4. (The “discounted value” is the same as the “current fair value” mentioned at the beginning.) In other words, what must the stock price be now in order to reach the future price, assuming a particular growth rate (discount rate)?
To calculate this, we use something called the “discount rate”. This is the growth rate applied to the discounted value to reach that future value. The larger the discount rate is, the lower the discounted value will turn out to be (see Calculations, below). This makes sense, since a larger growth rate (discount rate) applied to a smaller starting point allows us to reach the same target as a smaller growth rate (discount rate) applied to a larger starting point.
Guidelines for choosing a discount rate:
1. If you really feel you understand the ins and outs of a company and have analyzed most of the risks, use a lower rate.
2. If the company is rock solid, use a lower rate.
3. If you feel the company is inherently riskier, use a higher rate.
4. If your understanding of the company is less thorough, use a higher rate.
5. Generally, set the rate higher than the average return of the stock market as a whole (11% annually). You can achieve this rate just by investing in an index fund. You want some additional return for your effort in investigating and tracking the company.
6. The level to use is subjective, based on your analysis of the company, its risks and prospects.
Calculations:
The equation is a rearrangement of eqn 1, with a couple of terms renamed. The term “current value” in eqn 1 is “discounted value” in eqn 2 and “growth rate” in eqn 1 is “discount rate” in eqn 2. “future value” is the result calculated in Step 4, above.
“discounted value” = “future value” / (1 + “discount rate”) ^ “number of years” (eqn 2)
12% discount rate15% discount rate18% discount rate
P/E20%25%P/E20%25%P/E20%25%
1823.3828.681820.4925.131818.0122.09
2532.4739.832528.4534.902525.0230.68
3342.8752.573337.5646.063333.0240.50
Which discount rate to choose?
Reasons for choosing 12% and not something higher:
1. No debt at all.
2. Growing number of restaurants without using debt to finance them.
3. Long track record of high growth.
4. An appealing product (a “luxury” item at a reasonable price) which should lead to steady growth in the future.
What it might mean:
Assuming a 5-year future P/E of 18 and a growth rate of 20 – 25% annually, this gives us a current fair value of 23.38 – 28.68 per share. At the current 33.94, it is probably overvalued.
Assuming a 5-year future P/E of 25 and a growth rate of 20 – 25% annually, this gives us a current fair value of 32.47 – 39.83 per share. At the current 33.94, it is probably fairly valued.
Assuming a 5-year future P/E of 33 and a growth rate of 20 – 25% annually, this gives us a current fair value of 42.87 – 52.57 per share. At the current 33.94, it is probably significantly undervalued.
Would we buy?
Now for “margin of safety”. The best companies to buy are those which you think are good companies, but are currently undervalued, based on future prospects. The difference between the current fair value and the actual stock price (if the latter is less than the former) is called the “margin of safety”. This is a buffer which protects you if your decision to buy was bad for some reason. A bigger margin of safety is better, but you could wait a while before a company’s stock price drops that low or you could end up pricing yourself out of the market.
With only 50 restaurants open in 18 states (and DC), I think it has several years of good growth ahead. Management wants to have 200 or more restaurants open in the U.S.. At 25% growth, it will take about 6 years to reach that goal. Given that the market has for the last 10 years given it a premium P/E rate and that it has grown so successfully in the past, a P/E of 25 to 33 might not be unreasonable. Therefore the current price is either right on or undervalued. If it is undervalued, then we have a margin of safety of ~20% (33.94 vs 42.87). As long as management continues to finance growth out of the company’s own resources (i.e. does not go into debt), then I think it is worth buying at the current price.
Footnotes:
* CAGR: Compounded Annualized Growth Rate. This is calculated from a rearrangement of eqn 1.
“future value” = (1 + “% growth”) ^ “number of years” * “current value” (eqn 1)
Solve for “% growth”
“future value” / “current value” = (1 + “% growth”) ^ “number of years”
(“future value” / “current value”) ^ (1 / “number of years”) = 1 + “% growth”
“% growth” = (“future value” / “current value”) ^ (1 / “number of years”) – 1 (eqn 3)
Use the 2001 value as “future value” and the 1997 value as “current value” with “number of years” equal to 4.