Seeking Alpha
Profile| Send Message|
( followers)  

Introduction

In this article, I'm going to show how much US Bancorp stock (NYSE:USB) is worth according to a Warren Buffett "owner earnings" DCF style analysis.

I will be posting a link to the valuation model (in an excel file) that I used along with describing the assumptions that went in it. This file will contain all the cash flow data from USB going back to 1991. (The last year in which there is EDGAR data for the stock in the SEC website.)

Thesis

I built an excel file with a valuation model using Buffett's measure of "owner's earnings." Warren Buffett is known for being skeptical for conventional valuation models that rely on GAAP such as price-to-earnings ratio and the like. He defined one of his methods in the 1986 Letter to Shareholders:

These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges...less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include plus - but do not subtract.

In order to make it consistent with his conservative approach, I will be using safe assumptions in order to make sure a buy or sell rating in the stock is not based on predictions that are difficult to make. Please note that this article is not a suggestion that Buffett would value the stock exactly like suggested or that he would agree with this article. I'm simply using a model that is similar to how he described his valuation method, I like to think of these Buffett style valuations as DCF analysis with significant margins of safety (trying to find the fish in the barrel).

The assumptions that went into the model were:

-I defined owner earnings as Operating Cash flow minus "Investment in Subs/Purchases of bank promises-equipment" minus "other assets" plus asset sales (when there is any). Why add back asset sales? It represents a recovery from old capex and M&A so in a way, it's old operating cash flow coming back home.

-I assume USB will have another 10 years of above average owner earnings growth of 9% then normalize to 3% for the long run. The compounded rate of growth over the last 15 years is 11.92%. The compounded rate of operating cash flow growth is 23.77% for the entire period. 9% seems a reasonable number since it is below these historical figures

-USB required return is 11% (the rate at which the future cash flows are discounted back to the present). I'm assigning a higher discount rate than CAPM would suggest (which is 9.36%) due the hidden risks inside the banking business. The company does very little M&A so there is one less way that the company could destroy shareholder capital but still banking is highly dependent in management discipline as Buffett himself acknowledges. When a company is leveraged at 8-1 (like USB) it doesn't take much to burn shareholder capital. Even Jaime Dimon, whom Buffett consistently praises, oversaw a huge loss due to the London Whale debacle. For that reason I would assign a higher discount rate of the company.

-Long-term normalized growth is 3%. This is even lower of what US Nominal GDP is likely to be going forward. Earnings growth tends to be quite similar to Nominal GDP growth over long periods of time. Given how long Buffett has been in stocks like Wells Fargo (NYSE:WFC) it seems likely that Buffett considers US banking a "forever" stock holding.

-As margin of safety at the start of the valuation, I took USB owner's earnings and decreased by 20%. This 20% decrease takes into account cash liabilities that are unexpected like lawsuits settlements, government fines, random losses (like JPMorgan's (NYSE:JPM)), dumb M&A and other unexpected charges. This adds a margin of safety in estimating future cash flows and is consistent with Buffett's skepticism of people not subtracting enough from cash flow figures.

Plugging all these in the Excel file, projecting the owner cash flows and discounting it back to the present at the chosen discount rate yields a fair value price of $61.89. But this valuation assumes you are the "owner" of the company, as a minority shareholder you can't use the cash flows and determine the direction of the company. Subtracting a control premium (which usually is around 20-30% in most M&A deals), I arrive at a fair value figure of $46.41. With the stock trading at $37, I would call the stock undervalued right now.

Conclusion:

According to a safe set of assumptions and a Buffett like valuation model, USB stock is currently undervalued. I wouldn't be personally buying stock right now as I believe the US stock market is likely to correct significantly in the next 12 months. But this stock along with other Buffett style valuation "winners" like Coca-Cola (NYSE:KO) are definitely in my shopping list when a correction does arrive. It is also in my watch list to buy if it gets hit by a temporary loss situation like JPM's given that one time charges or losses matter very little for the long-term value of a business but frequently stock investors and traders overreact to the situation presenting a valuable dip to buy.

Source: Buffett-Style DCF Valuation Of U.S. Bancorp