EBay Shares Reasonably Priced - But Without Margin of Safety

On Complete Growth Investor, we calculate various measures of free cash flow on every stock we hold in our two real-money portfolios. On a company-by-company basis, we run true free cash flow [TFCF], structural free cash flow [SFCF], and/or maintenance structural free cash flow [MSFCF] on each stock we own or follow. Free cash flow is what creates and drives long-term shareholder value, much more so than earnings per share.

Each quarter, we're able to review company SEC filings and update our free cash flow spreadsheets, seeing which companies are improving, and which may not be.

Following its latest quarter, eBay (EBAY) is one that is improving.

First, if you need a refresher, true free cash flow is cash from operations minus capital expenditures minus tax benefits from stock options. Structural free cash flow (what Warren Buffett calls "owner's earnings") is net income from operations plus depreciation and amortization minus capital expenditures. These are two key ways to measure the health and growth of a business, as both show realities that mere earnings per share numbers often don't.

You can see in the table that in the first quarter of this year, eBay's true free cash flow gained 10.6% year-over-year, while structural free cash flow leapt 82% as net income jumped about 50%. Trailing-twelve month results are higher, too, and put the stock at 25x TFCF and nearly 31x SFCF, lower than the 35x trailing P/E.

Speaking of that: this year eBay's EPS is expected to grow 27%, followed by estimates of 18% growth in 2008. The stock trades at 19x that forward estimate. Management provides guidance of about 20% growth this year, so Wall Street is expecting more.

The numbers we're looking at argue that eBay looks fairly priced for the next 18 months assuming no real premium is given to the shares. But remember, of course, that the stock market will continue to look ahead: starting next year, investors will be trying to value eBay on 2009 results or later, just as they now value it on at least 2008 estimates.

Looking at other financials during our quarterly health check-up, the company's balance sheet remains strong with $3.2 billion in cash and investments and no long-term debt. But one area where we'd like to see some improvement is in dilution. eBay's diluted share count increased 2.3% last year to 1.425 billion shares, and in the first quarter of 2007 the diluted count increased another 0.8%, to 1.437 billion shares.

But what we'll be watching even more closely the rest of this year are expenses. Last year, sales grew 31.1% to $5.96 billion, but total operating expenses jumped 43.5% to $3.28 billion. Cost of sales was a major contributor to the problem, increasing 53.5% to $1.25 billion. This year began with more promise, as expenses began to decline in relation to sales, but we need to see follow-through.

Overall, eBay shares look reasonably priced. This argues that the stock may be able to appreciate at a percentage rate in the high teens each of the next few years, as long as FCF growth is in-line with that number or better. This year, it should be better. That said, the stock is not priced with a margin of safety, so any disappointments would not be met patiently.

Comments

[borisb:]

i like this valuation analysis. the 1 month bounce is rich $3+ 30.50s > 34s.
but the high point of $34-ish has been a base ceiling since November 2006.
i dont see why the stock doesnt breakout past $34 in line with growth.
Goldman Sacs recently said the intrinsic value in the shares is $50.
Ebay is strong in 3 of the 5 main internet areas.... e-commerce, payments,
and communication. the other 2 search and entertainment as dominated by
Google and Yahoo. Ebay has some good leadership in the 3 areas, although the
rise of Amazon is occuring rapidly in e-commerce. EBAY has been nearly $50 & $60 numerous times, so $31s-$34s should be buying low if there are no hidden issues.

2007 Jul 16 06:19 PM