Disclaimer: This is for entertainment and educational purposes only. This is not to be taken as investment advice. I am not an investment advisor, nor have I considered your personal situation as your fiduciary. In other words, any investment you make (or don't make) is completely your responsibility.
Part 3: Valuation
In case you missed it, here’s what we’ve covered so far:
Mungers four investment requirements
Can I understand this business?
What is the durable competitive advantage protecting them from competition?
Do they have an amazing management team?
At the bottom of this post &
Is there a Margin of Safety?
Today
We’re going to look at the fourth requirement of Mungers. Value.
We will:
Look at Southwest's past growth numbers
See what the analysts think LUV is worth today
Through a quick Discounted Cash Flow Analysis
I use my own growth rate numbers to find Southwest’s Fair Value
This one is a bit surprising…
Find out if Southwest Airlines has a Margin of safety
I’ll also define what that price is.
We’ll find out what price Super Investor Mohnish Pabrai paid to own the business
And how many shares he bought.
We’ll look at Southwest’s 5 year past to see where it’s traded
Price history &
P/E history
Last, but not least, we’ll find what out our Next Level Price for Southwest Airlines.
Note:If you don’t have time to read the full post, (it won’t take long) check out this quick Summary video:
It’s Valuation Time!
It’s time for the most important aspect of everything we do. We need to find out what price we should pay to own Southwest Airlines. Some people will say that you can’t put a price on LUV. Well, today we’re going to be doing just that (pause for laugh...). Because sure, the business can be great, the management can blow our minds, and we can really understand how they operate... and yet, we still can’t just pay any price to own the company. Instead we must stack the odds of a great return (Return on investment: ROI) in our favor, and to do that, we must make sure we are only buying the company when it is deeply discounted to its intrinsic value.
Side Note: Intrinsic value is what a business is actually worth, not what it’s currently selling for on the market. In other words, the stock price may not reflect the actual worth of the underlying business.
Normally, to do a valuation calculation we need to look at how well the business has performed in the past. In other words, we need to look at it’s past growth numbers over the last 10 years, 5 years, and 3 years. We are looking for them to be growing rather than shrinking. If they are shrinking, we need to pay close attention to the rate at which they are slowing down and enter this positions with much more caution going forward.
Here’s the growth numbers for Southwest:
Growth Rate | 10 years | 5 years | 1 year |
Revenue: | 11% | 9.70% | 7.70% |
Return on Invested Capital | 8.40% | 13.30% | 19.90% |
Earnings Per Share | 16.2% | 66% | 2.90% |
Free Cash Flow | 0% | 38% | -5.50% |
Book Value | 5% | 7.80% | 11.90% |
NextLevelInvesting.org | |||
Today we’re going to cheat a bit and go to Gurufocus and use their free DCF calculator. Here’s what the Default settings spit out for LUV:
DCF Calculation
Here’s what this tells me; The analysts are expecting an EPS growth rate of 20% for the short term, which seems a bit too high for me. It’s also important to note that the discount rate is automatically set to 12% on GuruFocus, while the Terminal Growth Rate is set to 4%.
Definition: Terminal Growth Rate is the rate at which the company will continue grow into perpetuity (when it’s no longer in its growth phase). In other words, this is the rate that’s used as it’s default growth rate into the deep future of this company. This is usually determined by averaging the historical inflation rate (2-3%) and the historical GDP growth rate (gross domestic product 4-5%).
Definition: Discount Rate is used to determine the minimum acceptable rate of return we'd be happy to achieve with our investments. If we pay our ‘Fair Value’ price for the business this is the return on our investment we will achieve if everything goes according to plan.
Note: Many professionals use something called the ‘Risk free rate’ (treasury bill) plus adding ‘risk’ to be invested in the market, and numerous other metrics we don’t need to worry about. The real question is ‘What Return on our Investment would we be happy with?’. Personally, I don’t accept anything less than 15%. That’s my absolute minimum. And I actually shoot for 24%...
Let’s see what our fair value would be at these rates, just for fun...
Default Growth Rates
You can see why some people may currently find Southwest airlines to be undervalued at today’s price (around $54 as of writing). But here’s the problem, I don’t think they can maintain a 20% growth rate for 10 years, maybe not even 5. Instead I’d like to use a more realistic number that’s in line with their past growth of 15%.
Note: I’m using ROIC on this one as I think it is one of the most important metrics when it comes to future return potential, and it seems to be the most steady.
With that being said, I’d also set our discount rate to our Minimum of 15%. Here’s what that looks like now. This is my own setup, you can change it however you see fit.
There you have it. In order for us to achieve a 15% return per year on our investment, we would have to pay $52.30. But we’re forgetting something… This is the Fair Value price of Southwest Airlines after all, and since when do we want to ever pay full price to own anything?
We don’t, this is why we must demand a large Margin of Safety (MOS) before we make any investment. This is where we get the protection against our own forecasting errors. As long as we pay our MOS price, we have a large cushion to prevent ourselves from a loss of capital over the long-term.
Side Note: This is exactly how we increase the asymmetry of our investment; we demand a large MOS. We always want to buy in at a large discount to Intrinsic/Fair Value. By doing so, we lower our downside risk, while improving our upside potential. But keep in mind, this only works If we’ve already looked into the Meaning, Moat, and Management, and they’ve all meet our standards. We demand a large MOS to ensure that we follow the first rule of investing : Don’t Lose Money. Plus, if we buy businesses with these large MOS, we’re likely to do very well in the long run.
This is very easily calculated, you simply cut that price in half, and there you have it, your 50% Margin of Safety. In other words, this would give us a Southwest Airlines MOS price of…
Southwest Airlines
There you have it. Our MOS price for Southwest Airline is $26.15. Pretty easy right? As you can see, at our current market price we are nowhere near our MOS. Let’s compare that to What one of my favorite Guru’s; Mohnish Pabrai, paid to buy into the company.
What Price did Pabrai Pay?
One of the biggest checks we can make against our investment ideas is to see if any Guru’s are already invested in the business we’ve decided to do the research on. In other words, instead of relying our research alone, we can ‘stand on the shoulders of giants’ and use them as another metric to make sure we’re on the right track. The best part is, you can find this information for free on Gurufocus. Simply search Mohnish Pabrai, and look at his current portfolio. Here’s what I found:
There you have it. If you do the research, you’ll find that Mohnish Pabrai originally bought 512,220 shares of Southwest Airlines for (the lowest price of) $35.54. What this tells us is that he expected a decent return at this price. We know that Pabrai has very high standards on any investment he’s making. Therefore we can be confident in paying a similar price to him (If we can pay less, that’s even better). As long as we don’t pay any more than what he paid, we’ll likely be getting a great price on Southwest Airlines. This price also gives us a 32% margin of Safety on our calculated Fair Value price. Here’s the next question we need to ask…
What Price Should we Pay?
Now that we know both our MOS price and the price a Certified Next Level Investor paid to own the business, we have to figure out what price we’d be happy the company at. Since we aspiring Next Level Investors live in the real world, we need to figure out a likely price that we’ll actually have the opportunity to buy Southwest Airlines for in the future.
Let’s take a look at where Southwest has been in the last 5 years:
Now that we know the price of Southwest has been as low as $8.71, it doesn’t seem as unreasonable to expect to see our Margin of Safety price available to us again in the future.
But what price would I be happy to pay today?
This is where we add another step to our valuation. We know what price we should pay ($26.15) we know the price a Guru Paid ($35.54) now we have to decide what price we’ll get the opportunity to buy this business for in the future.
Side Note: To do this I usually find myself at a website call Wolfram Alpha. I know, it’s a strange name, but they have compiled a ton of data. Next, what I look at is the Historical P/E range of the business. and see where the business was trading for in the past during difficult economic times. This gives me a good idea about what multiple I’ll likely be able to buy the business for in the future, during another crisis.
Here’s what the the price to earning ratio of Southwest Airlines has been for the last 10 years:
Based on the chart, it looks like the best opportunity that we’ll have is around a 10 P/E. Realistically we’ll have a much better chance if we set our buy opportunity to around a 12 P/E. If you look at the chart you can see that once it hits that 12 P/E level, it really doesn't stay there long. If we use today’s earnings, that puts us at a buy price slightly above that of Pabrai at $39.24.
Note: If we eliminate the area from April 2009, to June 2010, we get a much better average P/E of 20.48 (as it appears to be anomalous). In theory, as long as we buy below the average P/E (by as much as we can) and sell above that Average P/E, we should see a large appreciation in our stock price.
As long as Southwest Airlines continues to increase its earnings (or even stays the same) as long as we focus on our MOS, we will be sure to come out ahead.
The Power of Buying with a Margin of Safety.
Example:
LUV Earnings = $3.27 per share (EPS)
Buy in at P/E of 12
Buy price = $39.24 (P/E x EPS)
Sell at P/E of 25
(for arguments sake we’ll say that earnings stay the same…)
Sell Price = $81.75
Stock Appreciation = $42.51
Return On Investment (ROI) = 108.3%
I think this example demonstrates the simple power of buying at the right price, and selling above the average historical P/E. Awesome right? It truly does pay to be patient.
Keep in mind, this was with zero growth in the actual earnings of the business. If they continue to grow, then this will increase our ROI even more.
So what should we pay at today earnings of $3.27 a share? Drumroll please…
Don’t forget, this is a moving target. If earnings start to decrease and we go into a recession, we’ll likely be able to pick up Southwest Airlines at our MOS price mentioned above. This is the NLI price today, and will continue to move up or down based on the earnings of the company.
Conclusion
Turns out, Southwest Airlines is a Great company. I can easily understand how they do business (think Sky buses), they have a healthy moat protecting them from competition. They have a great management team in place who really has a good view of the long term potential for the company. The only place where we run into an issue is with the current price of the stock. This is where we have to pause and be patient.
As I’ve mentioned many times before: Price is the most important aspect of any investment we make. We need to make sure we are setting ourselves up for the highest probability for success. At today’s price we would likely do fine over the very long-term (10+ years), but we want to do better than just ‘fine’ on our investments. That’s why we must be patient and wait for the businesses we love to go on sale. It’s no different with Southwest. We have to stick to the plan, and then follow through when we get the opportunity.
What Now?
So for now, if you like this business as much as I do, put it on your watchlist. Read the quarterly reports and annual reports until the price corrects. Then, if all the positive factors are still in place, we buy when it goes on sale, hold, then sell when it’s over priced. Rinse and Repeat until very wealthy.
That’s all I have for you today.
We’ll talk again soon,
~Ryan Chudyk~
PS.
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