When we talk about industrial construction, there are a few names that pop up instantly. Yes, I am indeed talking about Caterpillar Inc. (CAT), Deere & Co. (DE) and Cummins Inc. (CMI). Concerning the Investment valuation on these companies, the margin of safety was more than 50%, which is above the requirement of Benjamin Graham of at least 40% below the true value of the stock. Let us find out which stock among these three equipment companies is the best candidate for a Buy. As it is well known in the heavy equipment industry, CAT is the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel electronic locomotives. Today, we will compare these three equipment companies and track the latest investment status for each.
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The investment valuation on CAT, DE and CMI will be based upon the Pricing Model, which is prepared in a very simple and easy way to value a company for business valuation purposes. This valuation adopts the investment style of Benjamin Graham, the father of value investing. My basis of valuation is the company's last five years of financial records - the balance sheet, income statement and cash flow statement. In my valuation, first I will calculate the discounted cash flow, then the enterprise value and the margin of safety. The relative method was considered as well. Now, let us walk step by step.
1. The Enterprise Value Approach
The enterprise value is the present value of the entire company. It measures the value of the productive assets that produced its product or services, as well as both the equity capital (market capitalization) and debt capital. Market capitalization is the total value of the company's equity shares. In essence, it is a company's theoretical takeover price because the buyer would have to buy all of the stock and pay off the existing debt, pocketing any remaining cash. This gives the buyer solid ground for making an offer.
Going forward, let us walk through the table below as a summary for the calculation of the enterprise value:
On the basis of each company's five-year historical data, we see that the market capitalization for CAT was erratic in movement. It has a 101% increase from 2008, while DE has increased by 102%. On the other hand, CMI has increased 280% on its market capitalization. Moreover, the takeover price to date, April 23, 2013, was $88.6, $23.6 and $19.6 billion at $132, $59 and $103 per share for CAT, DE and CMI, respectively. The market price to date was $82.71, $83.82 and $107.67 per share for CAT, DE and CMI respectively.
Furthermore, the total debt of CAT was greater than its cash and cash equivalent, while for DE and CMI, the total debt was less than their cash. Therefore, buying the entire business of CAT would entail paying 57% of the equity and 43% of its debt. To buy DE and CMI, you will be paying 100% of their equity and zero debt.
2. The Net Current Asset Value Approach
Benjamin Graham's Net Current Asset Value (NCAV) method is well known in the value investing community. Graham was looking for firms trading so cheaply that there was little danger of the prices falling further. The concept of this method is to identify stocks trading at a discount to the company's Net Current Asset Value per Share, specifically at two-thirds or 66% of net current asset value.
The formula for the net current asset value is: NCAV = Current Assets - Current Liabilities. It shows that the stock price of NOK, CSCO and ERIC was overvalued because the stocks were trading above the liquidation values of the companies.
The net current asset value approach of Benjamin Graham tells us that the stock prices of CAT, DE and CMI were overvalued because the stocks were trading above the liquidation values of the companies. Therefore, the stocks have not passed the stock test of Benjamin Graham.
3. The Benjamin Graham's Margin of Safety
The Margin of Safety is the difference between a company's value and its price. Value investing is based on the assumption that two values are attached to all companies - the market price and the company's business value or true value. Graham called it the intrinsic value. Value investing is buying with a sufficient margin of safety.
The question is, how large of a margin of safety is needed to be considered sufficient? Graham considers buying when the market price is considerably lower, a minimum of 40 percent, than the real or true value of the stock.
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Let us find out the average margin of safety for CAT, DE and CMI. Remember the historical data, which were gathered for each company as we take into consideration the prior period's performance.
It shows that the margins of safety have passed the requirement of Benjamin Graham and it tells us that the stocks of CAT, DE and CMI are good candidates for being a Buy. As you may notice, the enterprise value was less than the intrinsic value, which is the true value of the stock, meaning the stock is trading below the true value of the stock.
The formula for intrinsic value is:
Intrinsic Value = EPS * (9 + 2G)
The explanation of the calculation of intrinsic value is as follows:
EPS -- the company's last 12-month earnings per share;
G -- the company's long-term (five years) sustainable growth estimate;
9 -- the constant, which represents the appropriate P/E ratio for a no-growth company as proposed by Graham (Graham proposed an 8.5, but I changed it to 9);
2 -- the average yield of high-grade corporate bonds.
Furthermore, here is the summary of the results of the calculations for growth:
The sustainable growth rate (SGR) shows how fast a company can grow using internally generated assets without issuing additional debt or equity, while the return on equity shows how many dollars of earnings result from each dollar of equity.
The result of the calculation for the sustainable growth rate shows that CAT and DE achieved almost the same percentage of 45 and 44%, respectively, while CMI has achieved one-third of their results. CAT, DE and CMI have the same earnings per share. In addition, CAT gave a higher payout ratio of 43%, compared to 29 and 20% from DE and CMI, respectively. They have the same net margins of 7%, except for CMI, which has an 8% net margin on average. Looking at the overall picture for growth, CAT and DE have the same percentage of growth, while CMI has only one-third of their percentage of growth results.
Going a little deeper, I have calculated the solvency ratios and the liquidity ratios of the three equipment companies. Let us find out what they say about each company.
These ratios are part of the financial ratio analysis, which helps the investor determine the company's long-term survival prospects. Let us determine whether each company can service its long-term creditors. As a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. Therefore, the ratios indicate that CAT and DE have a greater probability that they will default on their debt obligations. CMI has the ability to meet its long-term obligations and is far from bankruptcy.
The Total Debt/Total Asset ratio indicates that almost half of CAT's assets are financed using debt, while DE shows that more than half or 58% of its assets are financed using debt. In addition, CMI shows only 7% of its assets are financed by debt with the remainder financed by equity.
Furthermore, the liquidity ratios show a company's ability to pay its short-term liabilities. It also measures the efficiency of the company in its operations and its ability to turn its products into cash. DE shows that the company is able to pay its short-term obligations when due dates arrive. CAT and CMI, however, will be having a little harder time meeting short-term debt when the due dates arrive, but that does not necessarily mean that the companies will go bankrupt. The rule of thumb is, below 1.00 means that a company is not financially healthy.
4. Relative Valuation Method
The Relative Valuation Method for valuing a stock is to compare market values of the stock to the fundamentals (earnings, book value, growth multiples, cash flow, and other metrics) of the stock.
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The Price to Earnings/Earnings Per Share (P/E*EPS) will determine whether the stock is undervalued or overvalued by multiplying the P/E ratio by the company's relative EPS and then comparing it to the enterprise value per share. In the Relative Valuation Method, the stock price of CAT was overvalued because the market price was greater than the P/E*EPS ratio, while, for DE and CMI, it shows that the stock prices were undervalued because the market prices were less than the P/E*EPS ratios.
On the other hand, the EV/EPS valuation is used to separate price and earnings in the enterprise value. Dividing the enterprise value by projected earnings results in the price (P/E) and the difference represents the earnings.
On the other hand, the EBITDA/EV is the percentage of the cash generated income of the company against the enterprise value. The EV/EBITDA tells us that it will take 9, 4 and 7 years to cover the cost of purchasing the entire businesses of CAT, DE and CMI, respectively. In other words, it tells us that it will take 9, 4 and 7 times the cash earnings to cover the costs of buying the entire businesses of CAT, DE and CMI, respectively.
Overall, it indicates that the stock price of CAT was overvalued, while DE and CMI have undervalued stock prices. However, while the growth of CMI is not that impressive compared with that of CAT and DE, the test of solvency shows that CMI is far from bankruptcy and has the ability to meet its long-term financial obligations. Therefore, I recommend a BUY on the stock of Cummins Inc.