2008 was a tough year for Moody’s Corporation, with free cash flow (FCF) levels falling to 2003 levels, or $450 million. In our previous analysis, we argued that Moody’s economic moat has shrunk over the last couple of years, as its credit ratings for structured finance products proved unreliable for predicting distress and default risk. So far though, Moody’s credit ratings for municipal and corporate debt have been reliable. The question for today—what price would Moody’s Corporation command from a private buyer in light of recent events?
In the past, we have introduced Seth Klarman’s three methods for valuing a business—by determining its liquidation value, the net present value (NPV) of its future cash flows, or its value relative to similar businesses trading in the public markets. Since Moody’s has a negative book value and has no comparable standalone competitors in the public markets (Standard & Poors is embedded within The McGraw Hill Companies), the NPV approach here is appropriate. And with the help of Morningstar’s FCF data, a NPV analysis is not a difficult exercise.
Since 2001, Moody’s has grown its FCF from $291.5 million to $450 million (FY 2008). As many know, in order to value future cash flows, an investor must make a reasonable estimate what they will be. In Moody’s case, estimates could vary widely, as its FCF in 2007 was $802 million. If we use past growth rates of FCF to estimate Moody’s future, we will get very different growth rates using the FCF data from 2002-2007 vs. those from 2001-2008. The former period shows a FCF growth of 20.4%, and the latter 6.4%.
For today’s analysis, I will use the latter—a 6.4% FCF growth rate—as it likely better approximates Moody’s business prospects over the next decade. Following upon a period of robust growth in its structured products ratings division—a division whose revenue has now fallen by half YOY—it is hard to imagine Wall Street’s structured products returning to their previous levels in the near future, much less to grow at their past rate.
Assuming then that Moody’s will grow its FCF from 2008’s $450 million at 6.4% per year for the next decade, and then assuming that it will continue to grow at 3% for the following decade, Moody’s should throw off $16.3 billion over the next two decades for its owners. If we discount those cash flows at 9% (an estimate of average stock market returns over the long-term), the NPV of those sixteen billions should be $6.578 billion. However, if today’s buyer offered $6.578 billion, he would be assuming a business with nearly a billion dollars in negative book value. Knocking $994 million off the expected purchase price would value Moody’s equity and future cash flows at $5.583 billion. With 235.2 million shares outstanding, the prospective buyer should be willing to pay $23.74 per share for Moody’s.
Of course, at $23.74, the buyer’s assumptions better be correct, because he’s paying fair value for the business and its earnings power. For investors like Warren Buffett, paying fair value typically does not offer a sufficient margin of safety; to warrant investment dollars, Buffett wants to buy dollars for fifty cents. Here a 50% margin of safety would suggest that the investor only purchase Moody’s below $11.87 per share. As of Tuesday’s close (4/7/09), Moody’s traded close to its intrinsic value, at $22.20 per share.
Disclosure: No position