John Deere: Valuation of Share Price by DCF and Analysis of Metrics
For this article only, I will be providing the formulas for the metrics I will be using so you can follow and interpret the results of the formulas. For my next valuations, only results and interpretations will be shown, to be able to compare companies quicker and without the same formulas being thrown over and over again.
Introducing the 3 methods used to value the stock:
The cash flow for John Deere has been a roller-coaster ride, so I considered $0.42 billion for year 2012, $0.91 billion for 2013 and negative cash flows for 2014 and 2015 (-$0.23 and -$0.70 billion, respectively), and $1.75 for 2017. The average cash flows for the last 5 years were $0.39 billion, with the new cash flows, the average cash flow per year increases marginally to $0.44 billion.
Terminal value was $48 billion ($27 billion at NPV), a long-term sustained growth rate of 3.5% was assumed, and the discount rate was Deere´s WACC of 7.3%.
The result: $100.73 per share.
The formula on my last article contained a P/E number instead of the variable, which could confuse some readers, the formula Benjamin Graham used is:
Stock Value= EPS * ((P/E + (2*growth))
Deere´s result was $74.62 per share.
EBITDA X 7
I mentioned this one in my last article, and will no longer reference the explanation.
Deere´s result: $86.79 per share.
Time for Deeper Analysis
There are very valuable metrics that will be used to determine if this stock will be a good investment and analyze where the company excels and where there could be trouble, but give us no numerical value for the stock.
These metrics will be used in later articles for comparison purposes between companies of the same industry:
- Price/Sales Ratio
This ratio determines how much investors are paying for every dollar of a company´s sales.
The result: Investors are paying $0.92 per every $1 of Deere´s sales. Looks good, but the high debt has to be considered.
This was used in my first valuation article on CAT, but has been taken out for accuracy´s sake.
This ratio is similar to Price/Sales, but it is way more helpful to tell the difference between "cheap" sales and less healthy, debt-burdened sales. The lower the ratio, the cheaper the company is.
When we add the company´s long-term debt to the company´s market share and subtract the cash, we arrive at the company´s Enterprise Value.
Deere´s EV is $49.54 billion, higher than the Market Value of Company Assets, which is $40.5 billion (as estimated in the DCF Valuation).
The EV is often used as an additional measure to gauge the cost of buying a company.
The result: EV/Sales for Deere: $1.55
This means investors are paying $1.55 per every $1 of Deere´s sales. You can clearly see the difference in interpretation a more complete formula makes.
3. ROE (Return on Equity)
ROE= Net Income/Total Equity
Pretty straightforward, but can be "tricked" by lowering the total Equity a company has, and considering how small Deere´s equity is, ROE will be pretty high.
The result: ROE for Deere (4 year average): 30.1%
4. ROIC (Return on Invested Capital)
ROIC= NOPAT/ Invested Capital
Invested Capital is understood as: Total Equity+ Total Liabilities - Current Liabilities - Excess Cash.
Excess Cash is = Total Cash -MAX (0, Current Liabilities-Current Assets)
ROIC is better than ROE because it also includes debt, but excludes all current liabilities and excess cash, making it harder for companies to tweak.
The result:Deere´s ROIC: 9.1%
This is the Cash Return on Invested Capital, and it tells us how much free cash flow a company can generate based on each $1 it invests into operations.
The formula for calculating CROIC= FCF/ Invested Capital
Every time a company generates cash, it can either pay dividends to shareholders or reinvest it to keep the company growing.
CROIC tells us if the company is doing a good job at reinvesting cash for growth, or if management is hoarding cash when it should be returning it to shareholders to let them reinvest it somewhere else.
The formula is simple: Free Cash Flow/(Shareholder´s Equity + Total Liabilities-Current Liabilities)
Since Deere´s 2011 FCF was negative, CROIC is going to be negative. On the plus side, it went up 85% from -2.3% to -0.35%. It may be bad, but not terrible enough to outright short in my opinion.
Result: Deere´s CROIC is -0.35%
This is one of my favorite metrics, check out this article by author Jae Jun to see the impact this simple metric can have on your portfolio.
6. ROA (Return on Assets)
Deere´s 2011 ROA was 5.9%, the last 3 year average is 5.1%, pretty stable and decent given its huge size.
7. Return on Net Assets (RONA)
RONA = Net Income / (Fixed Assets + Working Capital)
Increases in RONA indicate higher levels of profitability, but unlike ROA, RONA takes the company´s liabilities into account.
Result: Deere´s RONA is 119.6%
In Deere´s case, this one is tricky, since they have negative Working Capital; the RONA is a lot higher than if they had a healthier, positive Working Capital.
8. Earnings Yield
This is 2011´s EPS dividend by the current market price of the shares. It is basically the inverse of the P/E ratio. The result is 9.65%.
For liquidity, I compare 2 metrics: the Current Ratio, which is equal to: Current Assets / Current Liabilities. Anything lower than 1 is a red flag, and indicates the Cash, Receivables, Inventories and other current assets that could be converted to cash in less than one year is not enough to cover Accounts Payable and any other current liability which has to be paid in less than one year.
Result: Deere´s Current Ratio is 0.77
The second one is the Acid-Test, which is the same formula as above, but removes inventories, as they could take longer to convert to cash.
Result: Deere´s Acid-Test Ratio is 0.52. Red flag here, heavily in short-term debt compared to cash & receivables.
10. Capital Structure
To evaluate Deere´s structure, 2 methods were used.
The first one is Total Debt/Assets; this of course includes current liabilities and long-term debt.
Result: Deere has 86% debt and 14% capital. It leans very heavily on the borrowing side.
The second one only takes into account only the Long-Term Debt, divided by Assets.
Result: Deere´s Long-Term Debt to assets is 35.2% of the Balance Sheet.
11. Economic Profit
The formula for this metric is very elegant, summarizing and straightforward.
Economic Profit= (WACC-ROIC) * Invested Capital
It is a residual performance metric and one of the best because it summarizes in a single number if management created or destroyed capital invested a considering its cost, during the exercise.
It also does something EPS does not: it incorporates the Balance Sheet, recognizing explicitly that money is not free, and if growth was purchased with capital, the Economic Profit assigns a charge (the company´s WACC) for the capital used to purchase this growth.
Economic profit is all profit in excess of this cost.
Result: Deere´s Economic Profit for 2011 was $0.512 billion.
The average share value with the 3 methods used to value John Deere´s stock gave a price tag of $87.38, giving it a potential upside of 19.3% from its current price.
Standard & Poor's has a $111 12-month target on with a Buy recommendation. Seems a bit high to me considering its liquidity red flags and high debt load, but they got their own analysis.
Of the 22 analysts following the stock, the 2012 EPS estimates range from a low 7.76 to a high of 8.50, the average was 8.25, which was the one used for this analysis.
DE is currently trading in the middle of its range, which has been between $60 and $95 for almost 2 years.
If you want to go long, I would suggest buying 1/3rd of your full position when we get closer to $70, and if the price drops another $3, buy another third, and so on.
Worst-case scenario is you miss the upside. Best-case scenario, you get a good company at an average cost of around $67 if DE drops low enough.
For conservative investors, selling $60 Jan´13 puts would give you a $3.07 premium, and yield a 5.11% return, low but might be enough to beat S&P 500 and safe enough to get DE shares at $56.93.
More aggressive investors may want to look at selling the $80 strike Jan´13 puts for $11.80 credit.
If DE is at a higher price than $80 and the put you sold expires worthless, this strategy would yield a 14.75% return; if it´s higher, you would get assigned 100 DE shares per every put sold at a better price than today: $68.20.
I´m open to suggestions for valuations on any stock. Next up are: NAV (to directly compare (NAV) to DE and CAT. Then it will be CRM, LNKD, CMG, FFIV and ISRG.
A table summary:
|Share Value w/DCF Valuation||$100.73|
|EBITDA (in billions)||$ 4.982|
|Company Value w/EBITDAx7||34.8754|
|Share Value with EBITDA x 7||$ 86.79|
|Graham Formula Share Value||$ 74.62|
|EPS for next year||8.25|
|FCF to Sales||$ (0.00)|
|ROE (last 4 years avg.)||30.1%|
|ROA (last 3 year avg.)||5.1%|
|RONA (Return on Net Assets)||119.6%|
|Liquidity: Current Ratio||0.77|
|Liquidity: Acid-Test Ratio||0.52|
|Capital Structure: Long-Term Debt/Assets||35.2%|
|Capital Structure: Total Debt/Assets||86.0%|
|Economic Spread (ROIC-WACC)||1.8%|
|Economic Profit (in billions)||$ 0.512|
|Average Value with the 3 Methods||$ 87.38|
|Potential Upside (Downside)||19.3%|
Disclosure: I am long TEF.
Additional disclosure: Also short SPY call spreads.