Yesterday we noted Seth Klarman’s three methods for valuing businesses and observed that a net present value (NPV) analysis of future cash flows is most appropriate for a business with demonstrated earnings power.
With the help of Morningstar’s free cash flow data and the NPV function of Microsoft Excel, a NPV analysis is not a difficult exercise.
Since 2000, Ebay has grown its free cash flow from 50.4 million to 2.32 billion (2008). And from 2001-2008, Ebay grew its free cash flow at a 42% rate. These are simply phenomenal numbers—the result of starting from scratch and growing into a sector leader. More recently, the growth of Ebay’s free cash flow has slowed. In 2007, it grew about 23.2%, and in 2008, it grew about 5.6%.
As many know, in a NPV analysis of future cash flows, one must make a reasonable estimate of those future flows. Particularly in the case of Ebay, it is reasonable to expect those flows to be greater than today’s, given the company’s record of growing cash flows at a high rate. However, if one overestimates Ebay’s future growth, the NPV analysis will overvalue those flows. Thus, for those looking to buy a business’ future cash flows at a discount, it is very important to estimate future growth conservatively.
For today’s analysis, I will conservatively project that Ebay will grow its free cash flow at 10% over the next ten years, and then grow it at 5% for the following ten years. Given Ebay’s history of acquisitions, I expect 10% to be a reasonably conservative estimate for the next decade. 5% growth in my lights represents a business treading water—not gaining or losing market share—since 5% is a reasonable estimate of what the population growth plus the inflation rate will be for that decade.
Using these estimates, the net present value of the next two decades of Ebay’s cash flows, discounted at 15%, should be 27.6 billion. Add the 27.6 billion to Ebay’s book value, and you get a total value for Ebay of 38.68 billion.
In other words, Ebay should throw off 119.94 billion in cash over the next two decades. However, we don’t want to pay that much solely to have it trickle back to us over twenty years; instead, we want a decent return on our capital outlay—say 15%. Thus, we should be willing to pay 38.68 billion today for 119.94 billion in cash outflows over the next two decades. Per share of Ebay, that amounts to a price of $29.47.
However, for any investment, one should only deploy cash when one has a substantial margin of safety. Estimates prove mistaken; management gets lazy; competitors spring up. Given Ebay’s size and moat, a 25% margin of safety should be sufficient.
All told then, we should be willing to pay $22.10 per share for Ebay, expecting a 15% return on investment, with a 25% margin of safety. As of Friday, Feb. 6th, Ebay traded at $13.63 per share.
Coming up next—Valuation (even more conservatively), continued.
Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.