With this article we want to bring out an idea on how to determine a fair value for Baker Hughes Incorporated's stock (BHI) by using methods of fundamental analysis and stock selection.
Baker Hughes Incorporated supplies oilfield services, products, technology and systems to the oil and natural gas industry worldwide.
A few weeks ago, BHI passed our test based on the following screening criteria (defensive investor):
a) Excluding small companies.
b) Stocks with current assets at least twice their current liabilities.
c) Working capital (current assets - current liabilities)> long term debt.
d) Some earnings for the common stock in each of the past 10 years.
e) Dividend payments record.
f) Earnings growth. 33% cumulative earnings growth over 10 years.
g) Current price is no more than 15 times average earnings over the past 3 years.
h) Price to book value ratio of no more than 1.5.
We will calculate the fair value of BHI in 2007 on the ground of final data for the 5 periods ended in 2008-09-10-11-12 by assuming that 2007 is the current year (practically we are going to work on already known data). Then we will move the fair value forward in time until the end of 2012. We will compare BHI's fair value for 2012 with a price that in 2012 a knowledgeable acquirer, Superior Energy Services Inc, is willing to spend buying a stock of another company, Complete Production Services Inc or CPX (the Appraisal Method).
CPX used to operate in the same industry of BHI.
We will move BHI's fair value (computed in 2007) forward in time until the end of 2012 by means of the trends of the cumulative total returns BHI, S&P 500 Index and S&P 500 Oil and Gas Equipment and Services Index curves.
Why using the curves of cumulative total returns? Because when we apply the discounted cash flow model we assume, among other things, that the expected future cash flows will grow forever at a rate that analysts see in the growth rate of the economy of the country or the rate of an industry (in particular when we have to compute the terminal value). As the S&P 500 is used also to understand how an entire economy or an industry is moving, it seems fair to us to use the performance speeds of the cumulative total return curve to move the fair value of BHI forwards.
Furthermore the reasoning is based on the fact that there are investors who assign higher values to stocks that produce higher cumulative total returns. Consequently the curves of values and cumulative total returns have similar trends for a stock over time (from Is This Drilling Peer Group Too Expensive?).
Let's start to compute the BHI's intrinsic stock value with the Discounted Cash Flow (DCF) Model by assuming that 2007 is the current year and working on data that we of course already know.
Since we got negative values of FCFE, we cannot use them because we would reach to determine a negative value for the stock that would not have any economic significance. Also because we cannot use the negative value of the fifth year to determine the terminal value. We then decided to calculate an average of the five cash flows and use the result of the arithmetic mean as the expected amount of FCFE for the next 5 years. We pretend that we have forecasted FCFEs for the next five years (hit an Exact forecast).
Assuming that we are in 2007 we have to estimate BHI's cost of equity according to the CAPM.
Cost of Equity, Re, = Rf + Beta (Rm-Rf), where Rm-Rf = Market Risk Premium (MRP)
How can we calculate the market risk premium?
We can observe a long enough time series of equity market returns and risk-free, Rf, debenture yields to calculate the average difference. With reference to the experience of Anglo-Saxon countries a sufficiently significant statistical survey should be based on a five year range of monthly returns of securities and markets.
Charles Brandes (Value Investing Today) considers long-term (20-year) AAA bonds as a criteria to search for value stocks.
So we could also use yield on US 20yr AAA Corporate Bonds as Rf but here for our purpose we will use either US Treasury bills (or T-Bills) or the US treasury bond. We decided to use US T-Bills. Here you can find Annual Returns on Stock, T.Bonds and T.Bills: 1928 - Current.
Let's calculate the MRP for 5 years from 2003 to 2007.
We prefer to consider the data that comes out of the geometric mean because the geometric mean as opposed to the arithmetic mean ensures that any anomalous peaks in the distribution will not influence our analysis.
MRP (5yrs from 2003 to 2007): 5.34% (Difference between Stocks - T.Bills in terms of Annual Returns). That is the historical average return of BHI is higher than that of the T-Bills for 5.34%.
Now we need BHI's Beta for year 2007. We first need a nominated benchmark index - We will pick the S&P 500. Then we need historical stock prices for both BHI and S&P 500. You can get daily closing prices for BHI and the S&P 500 index between 1st January 2007 and 31st December 2007 for example from the Yahoo finance website. Then we simply calculate the fractional daily returns, as described in the picture below.
Now that cell range E5:E254 contains the stock returns and the cell range F5:F254 contains the index returns, we can calculate Beta. There are two ways of calculating beta with Open Office: the first uses the variance and covariance functions, while the second uses the slope function. The corresponding formulae are given below:
So Beta is equal to 0.99 (a rounded value).
As of December 31, 2007 BHI's Re = 1.59% (return on T.Bills for 2008) + 0.99 (BHI's Beta) x 5.34% (MRP) = 6.88% (cost of BHI's equity as computed in 2007).
A company generally finances the business with risk capital and with a loan so it would be more correct to consider an opportunity cost that takes into account that the company also uses borrowed capital. So we should calculate the free cash flow to the entire firm (and not just only to equity) for each of five years and the weighted average cost of capital (WACC). And then we should use it as a rate to discount the five FCFFs back to 2007 (remember that we are assuming that 2007 is the current year). But these are further calculations that we leave to the more fussy reader to make since the purpose of this article is simply to propose an investment approach idea on how to assess the intrinsic value of a stock.
Now we can estimate a terminal value of cash flows (assuming that we are at the end of 2007) according to the Gordon Growth Model.
Let's assume (in 2007) that BHI cash flows will grow in perpetuity (starting year 2013) by 4% per year.
Terminal Value of BHI = $452.4M (FCFE forecasted for year 2012) x 1.04/ (6.88% - 4 %) = $470.50M / 2.88% = $16,336.67M.
Now we can calculate BHI's Enterprise Value = ($452.4M/1.0688) + ($452.4M/(1.0688)²) + ($452.4M/(1.0688)³) + ($452.4M/(1.0688)^4) + ($452.4M/(1.0688)^5) + ($16,336.67M/(1.0688)^5) = $13,574.26M.
BHI's net debts as of December 31, 2007 = $15.4M (short- term debt) + $1,069.4M (long- term debt) - $1,054.4M (cash & cash equivalents) = $30.4 M (data from BHI's Form 10-k, 31/12/2007, ITEM 8.).
So the fair Value of BHI is $13,574.26M - $30.4M = $13,543.86M.
As of December 31, 2007 BHI has # 320M shares outstanding. $13,543.86M/320M = $42.32 per BHI share (we always prefer to consider the diluted number of shares instead of the number of common shares when we assess for an intrinsic stock value per share).
As you can see from the image below, BHI's stock was selling at a far higher value of $42.32 per share between the end of 2007 and the beginning of 2008.
Source: Yahoo Finance.
Surely those who have bought BHI shares somewhere between October 2008 and 2009 and then re-sold them in spring and/or summer of 2011 have made a remarkable deal, as you can see in the graphic below. Especially those who did this kind of transaction and would have set a margin of safety of, let's say, 30% and bought the stock at $29.63 per share.
Source: Yahoo Finance.
But the question we now ask is this: can this fair value of $42.32 still be considered as such for BHI stock?
It is certainly very interesting to evaluate the reliability of a method to evaluate stocks to see how much money one could have earned, as long as they had come to the same value based solely on forecasts. But we believe that it is much more interesting to know if information can still be used to make a good deal in the near future.
Let's consider the Comparison of Five-Year Cumulative Total Return Baker Hughes Incorporated - S&P 500 Index and S&P 500 Oil and Gas Equipment and Services Index (from BHI's Form 10-K, for FY 2012, page 18).
BHI's CAGR is -11.68%
S&P 500 Index' CAGR is 1.65%
S&P 500 Oil and Gas Equipment and services Index' CAGR is -4.24%
That's when we determined the intrinsic value of BHI using the DCF model; we have done our calculations on the basis that 2% is the long-term growth rate of the U.S. economy into eternity.
But if we read the CAGR we have calculated above, we certainly cannot say that the first five years (from 2007 to 2012) have laid the foundation to perpetual growth of approximately 2% of' the U.S. economy and of the industrial sector relevance of BHI in particular.
If we adapt the fair value of BHI to the three CAGRs we get the following three values for 2012:
$22.74 according to BHI's CAGR
$45.93 according to S&P 500 Index' CAGR
$34.08 according to S&P 500 Oil and Gas Equip. & Serv. Index' CAGR
Therefore, we should move inside a range of $22.74 and $45.93 with an internal value of $34.08 in order to determine the intrinsic value of BHI at the end of 2012.
We were looking on the internet to see if we could find some news about recent M&A in the same industry (Oil Well Services and Equipment) as the one where BHI operates.
We came across one but we are sure that with a little bit more persistence more news can be sought out about this topic. And of course the more observations on M&A you can collect from the network, the more representative our reference sample will get and the better our estimation will be. The idea here is to build a sample of stocks which purchase prices fall into the range that we have just computed before and then determine an average value of concentration.
Oil-field services company Superior Energy Services Inc. has agreed to buy Complete Production Services Inc. in a cash-and-stock deal that values its peer at $2.7 billion, a move that comes at a time when energy prices have slumped amid fears of another recession
As of September 30, 2011, CPX shares outstanding was 77.64 million, then $2.7 billion / 0.07764 = $34.78 per CPX share (valued by SPN, according to the news). You can find an overview of what the business of CPX was here.
The acquisition price of $34.78 could represent an indication of a purchase price for BHI shares that is discounted of about 20% (respect the current price [March 4, 2013]) and it is a bit more than the value of $34.08 that we have computed according to S&P 500 Oil and Gas Equip. & Serv. Index CAGR.
We are convinced that with a little more perseverance in the research for mergers and acquisitions, it may have collected a lot of really useful information in order to assess an intrinsic value. This will enable us to estimate an intrinsic value of a stock without resorting very time-consuming methods that are uncertain by nature since they are based on estimates and growth conjectures.