There's a big misconception in value investing that valuation is anchored to a discounted cash flow approach, using the present value of a company's future cash flows to determine its intrinsic value.
DCF serves a very useful purpose and should be a part of any value investor's toolkit. But an asset is only worth what the next buyer is willing to pay for it. If you bought a $500,000 home in 2007 and wanted to sell in 2009, your home wasn't worth $500,000 to a buyer. Stock market investing is no different.
At times, one of the most effective valuation tools for a publicly traded business is determining that company's value to a private buyer. Take Dell (DELL), for example. When I became interested in the company the shares were trading just under $10, I pegged fair value around $17 to $19 per share based on a conservative discounted cash flow approach. Yet Dell appears to be going private at a price of $13.65 a share as that's the price it's worth to a private buyer. Still, when it was trading at $10 the valuation was still cheap enough to lead to a healthy upside premium.
With a similar mindset, a friend of mine told me about apparel company True Religion (TRLG). True Religion is a leading player in the high-end denim market, with jeans retailing from $200 up to $500 for limited edition styles. Shares trade for $23, down from more than $40 a year ago. The market cap is $600 million and the balance sheet is stuffed with nearly $170 million in cash and no debt. For the three-year period of 2009 to 2011, free cash flow has averaged around $50 million per year. The company will announce fourth-quarter and full-year results after the market closes today. For the first nine months of 2012, True Religion generated about $15 million in free cash. Historically, the fourth quarter has been the company's strongest.
To a private equity buyer, True Religion is a layup. It's a $600 million company sitting on nearly $200 million in cash and no debt. In addition, the company's 3.4% annual dividend yield is equal to another $20 million a year that goes to shareholders that would stay with the company if it were privately owned. True Religion also has an iconic leader in Jeff Lubell, who I presume at a fair price would be glad to leave the scrutiny of public markets. Less than a year ago, True Religion was a billion-dollar company. It's not too difficult to see $800 million or more as a take-private price. Its prodigious cash flow generation would have financiers lining up to finance this deal.
A couple of years ago, another iconic brand name, J. Crew, was taken private in a $3 billion deal lead by private equity firm TPG. The deal valued J. Crew at 8x EBITDA and revenues for the full year were $1.5 billion. The 2011 EBITDA for True Religion came in at $90 million. Applying a similar multiple gets you a value of $720 million. Add in the $170 million in cash on the balance sheet gives you $900 million. The 2011 revenues for True Religion were $450 million. Applying the same multiple of 2x sales for J. Crew yields a value of $900 million.
At the end of day, the ultimate value will all come down to private equity appetite, which is clearly strong today.
