A Mispriced Value Opportunity

 | Dec 20, 2012 | 11:30 AM EST  | Comments
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ndaq

Vision is the art of seeing what is invisible to others. --Jonathan Swift

To outperform the overall market over the long term, an investor must seek, find and take action on opportunities before the rest of the market participants. Finding these mispriced equities is a key driver of superior performance. One of the best examples I can provide that occurred this year was the mispricing of eBay (EBAY) earlier in 2012, when the stock was selling at around $30 a share. Most investors did not realize that just the value of its fast growing PayPal service was worth what the stock was selling for and an investor was getting the rest of the company's businesses and revenues basically for free. As PayPal continued to post stellar results, investors started to understand the stock's true value and they have since lifted the stock above $50 a share. This represents a more than 60% gain for those who saw this opportunity first.

I am constantly looking for these misunderstood stocks, as they are the ones that are going to provide outsized gains in my portfolio. I recently added Nasdaq OMX Group (NDAQ) to my core portfolio, as I believe the shares are mispriced. Most investors associate NDAQ with providing low-margin transactional services like clearing. These types of stocks have underperformed the market over the last few years due to declining volume, competition from more electronic exchanges and regulatory changes, among other headwinds. These equities are going for 9x to 11x forward earnings currently. But 70% of NDAQ's revenues come from services like providing market data and allowing trading firms to set up servers near its matching engines to provide lightning-fast execution. It is also buying the investor relations, multimedia and public relations units from Thomson Reuters (TRI) for just under $400 million. This will bring NDAQ's non-transactional service revenue up to about 75% of total sales.

Before I go into my fair value calculation for NDAQ, I would like to provide quick details on how cheap NDAQ is at just $25 a share:

  • The stock sells for just 9x forward earnings, a discount to its five-year average (11.3).
  • NDAQ is priced at just 81% of book value and below 7x operating cash flow, both of which are at the bottom of the stock's five-year valuation range.
  • The company has a solid balance sheet and the stock has a low beta (.84). It also pays a dividend of 2.1%.

Fair Value Calculation: Since 75% of the company's revenues will come from providing market data and other higher-margin services, it should be priced at a valuation comparable to peers in that space. Thomson Reuters, another information provider, is selling at roughly 14x forward earnings. The remaining business should be valued in line with other exchange services. Let's take 10x forward earnings for that quarter of the business. This will give us a blended forward price-to-earnings ratio of approximately 13. Consensus earnings estimates currently called for $2.75 a share in 2013. This gives us a rough price target of $35 a share on NDAQ, some 40% above the current stock price.

Note: IntercontinentalExchange (ICE) is in talks to acquire fellow exchange NYSE Euronext (NYX) at $33.12 a share. This offer would value NYX at approximately 15x forward earnings. This might raise the value that is put on exchange stocks from the 10x forward earnings I put on that portion NDAQ's business in my fair value calculation.

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