In part 1 of this analysis, I reviewed the qualitative elements of Ambev’s (ABV) business to determine if it had (and it does) a durable competitive advantage.
Ambev vs. Uncle Sam
We’ll be assessing the valuation from three different angles. The first is only a comparative value look and doesn’t result in a firm price target. It pits the current earnings yield against the long-term treasury bond. Ambev’s 2010 earnings per share were $1.57 (current exchange rate). Dividing EPS by the current market price of $31.30 equates to an earnings yield of 5%, which beats the 30-year bond yield of 4.25%. In addition, based on analysts’ five-year earnings projections, Ambev’s yield could grow 12% annually making it a winner over treasury bonds.
Another way to look at valuation, and the one most likely employed by a majority of investors, simply takes the current EPS of $1.57 and multiplies it by analysts’ five-year growth projection of 12%, which equals earnings per share in the fifth year of $2.77. Multiply this by Ambev’s current P/E of 20, which also happens to be the 5-year average, and we get a price target of $55.40. Adding in a .72 dividend growing at 10% annually (on the conservative side), the total take is $59.91 for a CAGR of 13.9%.
Since Buffett seeks investments where he can virtually guarantee himself a CAGR of 15%, he would likely wait for nice correction before taking a position.
The Incredible Expanding Coupon
The final way Buffett values a stock is by viewing it as an equity/bond with an expanding coupon. Looking at Ambev in this fashion, the initial investment of $31.30 a share would be seen as a bond yielding 5% (just like the first example above), but rather than grow at the EPS growth rate, the “coupon” would increase at the rate management is growing the equity base. This is where return on equity comes in.
Ambev’s shareholders equity value, or book value, is $5.05. Dividing EPS of $1.57 by book value equates to a return on equity of 31%. Since Ambev pays a dividend, all earnings are not retained for reinvestment and we must account for that. A payout ratio of around 46% means that 54% of earnings are retained. An ROE of .31 x .54 = .167 (16.7%) and this is the rate at which we can expect the equity base to grow. It follows that five years later we can expect a book value of $10.93. Multiply 10.93 by the ROE of .31 and you get projected earnings per share of $3.39. Multiple $3.39 by the current P/E of 20 and you obtain a five year price target of $67.80. Add dividends of 4.51 for a total of 72.31. This would mean a CAGR of 18% and represents Ambev’s true potential for building shareholder wealth.
My five-year price target for Ambev is 55 – 72 representing a CAGR of 14% to 18% respectively. I consider Ambev a buy at current levels and a strong buy on any move into the high 20’s.
Disclosure: I am long ABV.