# Maintenance CapEx

Companies make money by selling stuff they make. To make stuff, they need to invest capital.

This invested capital (IC) often takes the form of PPE for traditional widget manufacturers. From a business standpoint, one can take a broader view of IC, and recategorize any expenditure that is borne in a particular period, but “pays off” over longer time periods as capital. Thus, R&D or subscriber acquisition costs (in sticky businesses) may be thought of as CapEx.

This might involve reinterpreting the CapEx that appears on the cash flow statement.

CapEx (CX from now on) has two components: maintenance capex (MCX), which a business has to reinvest just in order to stay in place, and growth capex (GCX), which is the part of CX that increases sales.

`CX = MCX + GCX`

MCX is a “cost”. GCX is an investment.

If you own a rental business for example, replacing a broken heater is MCX.

Buying a new rental property is GCX.

Warren Buffet’s owner’s earnings (OE) or Greenwald’s adjusted earnings try to account for this “cost” of doing business.

`OE = NOPAT - MCX`

## Calculation

Calculating MCX is both art and science. It is not a number that is directly broken out in financial statements. However, we can develop some intuition on how to think about it broadly, and estimate it.

For a mature company with stable sales (no growth or decline), there is no GCX. Thus, all CX is MCX. For such stable businesses, MCX is approximately equal to the depreciation.

`MCX = depreciation`

Another popular method uses the following algorithm:

• estimate the sales to capital ratio, SCR
• compute the change in sales dS = S(t) – S(t-1)
• GCX = dS/SCR
• MCX = CX – GCX

### Additional Notes

• average SCR over several years; compare with industry averages
• some CX may not produce sales growth immediately (ex. building a new theme park). This may involve projection, if the past doesn’t rhyme with the present.
• if stable or meaningful SCRs cannot be extracted, then be wary of the number you produce.

## References

1. CS Investing: Calculating Capex
2. Old School Value
3. Seeking Wisdom
4. Gurufocus
Advertisements

# Valuation Updates

Here are some updates on companies I valued earlier this year

First Solar: I came up with a fair value of ~\$31/share in January, and suggested huge uncertainty around that estimate. I even embarked on a put campaign when it dipped to my target buy price near \$25, before it roared back to nearly \$50.

Under Armour: I estimated UA to be worth about \$17.50. Since then, it has simply hovered in the \$15-\$20 range. I’ve been trying to build a position in UA by writing puts. In August 2017, I bought 40% of my target allocation for \$16.15. The recent swoon in prices has me eyeing a second slug.

VF Corp: I thought VFC was worth about \$65, when it was selling in the low \$50s. Since then, it has bounced back to \$63 and change. I have no position in the stock currently, although I did make a decent return writing puts.

Hanesbrand: I came up with a conservative \$20-25 range for HBI, when it was trading at the lower end of that range. Currently, it is trading at the higher end of that range.

Compounding Insurers: In April, I updated by valuation of BRK (\$200), MKL (\$1080) and Fairfax (\$580). Since FFH was cheap for a large part of the year, I doubled my position. Just today, the price breached \$500 on the back of a stellar Fairfax Asia deal.

ALJ Regional Holdings: A depressed fair value estimate for the company is about \$3.40. But buying ALJJ is a bet on the jockey. It could be worth more than \$5 shortly. I have been buying ALJJ since June.

Others: I thought Charles Schwab was an excellent company worth somewhere between \$30 and \$40, and that GameStop was a struggling retailer that might still be worth about \$25-30. Finally, I estimated the value of Disney to be \$120.

# Cash Secured Puts: An Algorithm

Here’s a rough flowchart of my current CSP strategy.

I am still actively tweaking my process; so the following only represents a snapshot of my current thinking.

## Search

The first step is to search a good candidate. Usually, I have about 20-30 stocks on my radar. These are stocks I am interested in owning. Some of these are companies I already own, but want to own more of.

In any case, I have a reasonable guess of the intrinsic value, IV, for this set of companies. Some of them may be trading below IV (price p < IV). If they trade at a sufficient discount, I will consider buying them outright. Usually, I like to buy stocks for at least a 20-25% discount to IV. This represents my margin of safety (MOS).

But what do I do, if the discount is not large enough? Say,

`IV - MOS < p < IV.`

I use this condition as an initial filter.

At any given time, depending on the overall market, 3-5 stocks may pass this filter. Two stocks, I am looking at, that pass this filter currently are MSM (IV ~ \$85-90), and WFC (IV ~ \$55-60). If MSM or WFC traded around \$60-65 or \$40-\$45, respectively, I’d buy the stocks outright.

The second important filter is liquidity. When I am buying stocks, I usually don’t care about liquidity, because my holding periods are usually long. I don’t trade positions frequently. This freedom allows me to buy small-cap and foreign stocks.

With the CSP strategy, however, I need a fair bit of liquidity, since (option) holding periods (more on this later) are usually of the order of one month, and bid-ask spreads on illiquid names can be brutal.

This restricts the universe to somewhat large cap names, say market cap greater than \$5B. This number is a guide, not a strict threshold. I like to see open interest for upcoming ATM options to be greater than a few hundred. Usually, both these facts are correlated.

WFC has a market cap over \$250B. MSM is much smaller, ~\$4B. The open interest for the \$50 WFC put expiring on Oct 20 is about 5000. The comparable number for MSM is about 10. So WFC passes the second filter; MSM doesn’t.

The third filter is stock price. I like the stock price to be around \$50 or below. This seems quite arbitrary, but is a self-imposed constraint because of position sizing and tactical considerations.

Right now, I like to restrict new positions that I ease into using CSPs to a maximum of 5% of my portfolio. At my current portfolio size, this means a total outlay of between \$20-25K. Unlike many options traders, my goal – my ideal outcome – is to buy with a sufficient margin of safety. CSPs are a way to reduce the effective buy price below that level.

The main reason for the \$50 stock price filter is that I might embark on long CSP campaigns. Sometimes, this means committing additional capital to the position if it moves deeper in the money.

I like to have 4 slugs in my revolver (\$20K outlay/4 options ~ \$5K/100 shares ~ \$50 price threshold). This gives me added flexibility to adapt, adjust, and exploit volatility.

The final filter is price of the option. I target a minimum return of 20% IRR. If I commit a certain amount of cash to a new CSP, I seek annualized returns on that capital of 20% or more. I will discuss this filter in more detail in a separate post, because there is a fair amount of nuance.

If a stock has fallen in the recent past, its implied volatility is often high (say >30%). These are ideal candidates to chase, since the fall in stock price may have brought them close to value territory, making the pursuit all the more fruitful.

To recap, I search for the following characteristics:

• attractive stock, but not cheap enough,  0.75 * IV < p < IV
• liquid options market (generally large cap >\$5B)
• p <= \$50, approximately
• initial hurdle IRR > 20% (high implied volatility helpful – but check upcoming events)

## Start Campaign

Okay, once we’ve figured out we want to pursue this strategy on an attractive candidate, we write or sell ATM puts on 1/4 or 1/2 of the intended position, with a duration of about a month. Why?

We sell at ATM options, because they have the thickest time value premiums. Ideally, we want to maximize these as we are going in. Later, we may be have to be content with ITM puts, which are less juicy, but we aim high to begin with!

How to size the initial position? This depends on how large the margin of safety is at the current price. If it is reasonably large, then I’d go with half. If it is not large enough, then I go with a quarter. This usually ties up \$5-10K in the first round.

Finally, I usually try to sell options about one month out. You can get higher IRRs by using weekly options if they are available. This involves more frequent trading (potentially higher commissions), and careful upkeep. A frequency of one month is short enough to capture a fair chunk of the fastest decay in time value, and long enough to suit my temperament and schedule.

To summarize, we start a CSP campaign by,

• writing ATM or slightly OTM puts,
• on 1/4 – 1/2 the intended final position (depending on MOS),
• with a duration of about a month.

Then we collect the premium and wait.

## Quick Validation

Several things can happen. One outcome is that the underlying stock shoots up, and moves far away from the strike price of the puts we wrote. If that happens, it may be worthwhile to close the position prematurely. Suppose,

```G = initial premium collected = maximum gain
T = initial duration of the put (in days)
t = current time to expiry
g = gain on the position at current time (g < G)```

Currently, I use a rough rule of thumb.

If the gain on the position exceeds 75% of the maximum possible gain, within the first half of the intended holding period, then I close position. Mathematically, this condition can be expressed as.

`t < T/2 and g >= 0.75 G`

The reason for not continuing to hold on to the position is that it frees up capital.

Thus, if the stock spikes, and then falls down again, you may be able to exploit the volatility by collecting twice on the same stock. In reality, things can work out even better. When the price of the security rises, its implied volatility falls. That, and the moneyness of the position make it cheap to buy it back. If the stock falls back, generally implied volatility increases, and you can juice out more time value from an ATM option.

## Expiration

At expiry, you encounter one of three possibilities. Let’s dispose of the easy ones first.

If the stock prices exceeds the strike (p > S), you let the position expire. Depending on the price, you may consider reestablishing a new position at a later time.

If the stock prices hovers around the strike (p ~ S), or slightly below, you can roll out the position. This means you close the current put, and write a new put one month out. This lets you collect additional premium, or lower the effective buy price.

If the stock price has gone substantially below the original strike, things get interesting. This is where experience may be invaluable. I haven’t been doing CSPs systematically for long, but think that I have already gotten better at a few things.

In any case, you have several options; you could,

1. take delivery – if you have reduced your effective buy price to a point where it is sufficiently below the intrinsic value, then it might be a good idea to take possession. Remember the overarching goal of the strategy is to buy good companies at a cheap price.
2. roll out  – If you aren’t still happy with the effective buy price and have no new capital to commit, you can roll out the position. Note that the premium for ITM or deep ITM options may not be terribly attractive. Increasing the duration beyond one month might help add a little meat on the bone, but it will hurt your overall IRR. That said, it is a fine default strategy.
3.  add position: if you have dry powder left (this is why I like four slugs in my revolver), you have more flexibility. There are multiple flavors, you could (i) keep the strike the same, (ii) lower it, or (iii) lower it and add extra duration. The first option (keep strike same) usually gives you the fattest premiums – it works best, when you think the stock has gotten really cheap and you want to lock in this cheapness. You fully expect the stock to rebound before the next expiry. The second or third options (lower strike/add duration) are worth considering, when you think the stock is headed even lower. You may take an IRR hit extending your position this way, but you are playing the long game. This way you reduce your effective buy price, and set yourself up to write future options that are less ITM (and collect fatter time premiums).
4. use a wheel strategy: this involves some combination of the alternatives laid out above, and requires additional dry powder. You take delivery of the ITM options, write slightly OTM covered calls on these options, and use your dry powder to simultaneously write ATM or slighly OTM puts.

In future posts, I will highlight specific examples using this template.

# MSC Industrial Direct

MSC Industrial Direct (MSM) is an 75-year old industrial distributor with a focus on metalworking and maintenance, repair, and operations (MRO)-related products and services.

It is primarily a US based company (>95% revenue), where it has 5 large distribution centers and 80 branch offices.

Since its IPO in 1995, it has grown top and bottom lines at 12%. Here is its fundamental performance since 2007.

Here is the performance of its stock price, annotated with some plausible narrative:

In 2017, it fell from a high of \$105 to its current price in the \$65-\$70 range.

Alan Mecham had this to say about industrial distributors (emphasis mine):

… an industrial distributor, like MSM, has very low cap ex requirements but large working capital needs. What I have an affinity for are companies with staying power that I feel I understand well.

I like the hourglass model, where a distributor stands in the middle of fragmented markets. That model allows a well-managed distributor to enjoy strong bargaining power in both buying and selling while occupying a niche that’s valuable to customers and difficult for competitors to dislodge. I also like when there’s a high-touch service component that’s valued, which further fosters sticky customers.

So here we have a \$4B market cap company with \$2.9B in TTM sales, and \$382M in EBIT, whose price has fallen ~40% from recent highs. It is probably worth a look.

The rest of the post follows a Q&A format. I raise questions that seem relevant, and try to address or counter them, as best as I can.

EBIT and sales have grown at 13% for 20 years. Is this extraordinary growth sustainable?

The MRO business in the US is fragmented. Not just the suppliers and the customers, but also the distributors.

The top 50 distributors account for less than 30% of the market. MSM is in the top 10. Currently, there are 145K companies like MSM in the US; most of them operate at a much smaller scale.

Management estimates that the total addressable market for MSM is \$160B. With revenues of \$2.9B, MSM has a market share of under 2%. There is plenty of room for consolidation. MSM could acquire or displace smaller companies. It is also small enough to get acquired itself.

If MSM continues to grow at 13% for another 20 years, its revenue would be ~33B. Over the time period, it is possible that the TAM would have increased further, making this scenario (brisk and steady growth) completely within the realm of possibility.

Industrial distributors like MSM have high gross margins near 45-50%. Are these sustainable?

MSM has boasted gross margins in the neighborhood of 45% since inception. That said, product cost is a tiny sliver of the total operating expenditure, which is instead dominated by the procurement and inventory operating costs. Thus, focusing on gross margins might be somewhat misleading.

If this is a big market with juicy margins, won’t Amazon Supply step in to defragment the market and eat their lunch?

Bezos is famous for saying, “your margin is my opportunity”, and even during these time of “peak Amazon”, I wouldn’t willingly compete against Bezos or Amazon.

But AMZN is not infallible. That I am willing to bet on.

Amazon’s entry into a large market with juicy margins, doesn’t mean incumbents are toast. Amazon tried to compete with Priceline in the online travel business before giving up. The Fire smartphone was a debacle – it couldn’t hold its own against the iPhone or Samsung. In these markets, it was Amazon that had to retreat.

In other domains, including groceries I suspect, AMZN will be a player – perhaps, even an important one – but it won’t suck the oxygen out of the room. 15 years ago people worried that Walmart would displace all the local and regional grocers, yet stores like Publix and Wegmans have continued to thrive.

You don’t want to fight Amazon (or yesteryear Walmart) only on price. When outmatched, like David against Goliath, the key is to play the game by different rules. For example, I happily go to my neighborhood Publix, even though there is a Walmart offering better prices at the same distance, because of three reasons: (i) The staff is familiar, and I feel my presence is acknowledged (low churn unlike Walmart), (ii) shopping is more pleasurable; the lighting, the produce; if I don’t find something I need there is someone close by happy to help, and (iii) I absolutely love their store branded (Greenwise) cereal.

There are some lessons here for industrial distributors like MSM, which runs a well-oiled call-center that fields customer queries. They might not be able to compete with AMZN in logistics, but so long as they play in a field where customer relationships are important, they will be resistant to AMZN attacks. Even if AMZN somehow makes deep inroads, MRO is not necessarily a winner-take-all business.

Also, who knows, at a \$4B market cap, AMZN might even see MSM as an acquisition target. Of course, the Jacobson family who owns most of the voting power would have to bless any such merger.

ROIC has decreased from 20% in 2012 to 13% TTM. Operating margins have declined from 15-17% to 13%. EBIT has stagnated. Earnings have declined. Is the best behind?

MSM operates in a cyclical industry. Currently demand and pricing are soft, and yet MSM spews off cash throughout the cycle.

CEO Erik Gerstner once remarked:

Economic slowdowns are the times when MSC makes its greatest strides. These are the times when the local and regional distributors that make up 70% of our market suffer disproportionately. History tells us what will happen to local distributors if this downturn prolongs. Reducing their inventory leaves customer service vulnerable. Clamping down on receivables disrupts long-standing customer relationships. Laying off people creates hiring opportunities to acquire industry talent not typically available.

We are just starting to see the very early signs of these things occur in the marketplace. The pace will accelerate the longer these conditions hold. We are pleased with our share gain performance to date and would anticipate it to continue or even accelerate the longer these conditions last, and that will lead to disproportionate top-line growth when the environment does improve.

At some point, the cycle will turn. Perhaps, the infrastructure bill will be the first domino to fall. It might be something else. Whatever it is, it will cause the earnings numbers to explode. If tax-reform happens around that time (currently MSM pays 35% in taxes), any savings will flow to the bottomline, and lace the upside.

The company’s debt has increased significantly over the past few years. Isn’t that a cause for worry?

Debt is still only 1/3 of the total capital, and less than 2x EBIT. So debt-levels are very manageable. From a tax perspective taking on some more debt might be the smart thing to do.

By and large, management allocates capital well. Recently, they borrowed \$365 million at 1.29% after tax to retire shares which yielded nearly 2.5% in dividends each year [S/O have declined by 10% over the past 10 years]. This would be smart, even if shares were fairly valued. However, if MSM is undervalued, this is even smarter.

So what is it worth?

It is always difficult to value a cyclical company at the bottom of the cycle. Especially, one that gains strength during a down cycle.

Based on history, assuming long enough holding periods, one would expect returns to mimic ROE: mid teens, say 15%.

A DCF with reasonable inputs yields \$65-\$75 as fair price for the equity. At its current price, it is in the lower range of my estimate.

However, my DCF anchors too much on the recent past and suppressed earnings, even when it tries not to. It doesn’t factor in the likely levered upswing, when the cycle turns. Both Credit Suisse and Morningstar have target prices in the low \$90s. Those analysts probably know how to account for cyclicality better than me.

Over the past 5 years, MSM has traded between \$55 and \$105. The EV/EBITDA and P/E have ranged between 8.3-15, and 15-27, respectively. The current EV/EBITDA and P/E at 9.7 and 16.8, are at the lower end of the historic range. Unless you believe that the recent stagnation is a secular trend, and not a cyclical low, it would be prudent to bet on some reversion to the recent mean.

# Colfax: Getting Warmer?

I wrote about CFX in October 2016 (“Some Cold Facts about Colfax“). At the time, the stock had bounced back from a low of about \$20 earlier that year to about \$30. In the wake of Trump’s election, it continued to rise above \$40, before dropping to the mid-upper \$30’s again.

Some company-level developments:

• Top-line growth returning?: Revenue decline stalled. FY2017 sales are expected to tick up marginally to \$3.7B from \$3.65B in 2016. For a company exposed to cycles, this might be an important datapoint.
• Effect of leaner operations?: EBIT is expected to grow more than 10% to ~\$360M from ~\$320M. This growth is significantly greater than sales growth, which suggests better cost-management.
• EBIT margins have increased from 6.5% (FY2016) to about 7.5% (TTM). This is still much lower than the targeted mid-teen operating margins.
• ROIC even without goodwill and intangibles is still around 10%.

To summarize, fundamentals have improved modestly (10% EBIT growth). But the stock price has jumped much more (30%+), since last reckoning.

## Valuation

To hold the stock at \$37-38, where it is trading today, one has to believe that a serious transformation and acceleration is underway. That is, the forward-looking view from the windshield is much better than the rear-view mirror. Some level of faith in the management is important, because no matter what I do with a conservative DCF (which still relies on extrapolation of the recent past), I cannot justify a price much above \$32-\$35.

So let’s do something simple, but dangerous. Let’s try to visualize how CFX might look like in 5 years from now. Suppose sales grow at 4-5% to yield a revenue of \$4.6B in 2022. Suppose management manages to hit mid-teen margins: EBIT = 0.15 * 4.6B = \$690M. Factor in a reasonable interest expense (10% EBIT = ~\$70M), and tax rate (35%), we get after-tax operating earnings to equity of about \$400M. Dividing by shares (124M), we get an EPS ~ \$3.20. Since CFX is expected to grow 1-2% faster than GDP, and become more profitable, it might deserve a premium valuation of 18x. This gives us a target share price in 2022 of 18*3.20 = \$57.

Of course, I can guarantee things won’t go smoothly from where we are now to \$57. There will be plenty of bumps. An acquisition or two can certainly be expected. They will be unexpected tailwinds. Nevertheless, this \$57 gives us something to anchor to, if things play out well.

Given today’s price of \$37, this implies a CAGR of about 9%, which would be respectable in today’s environment. However, don’t forget that lots of things have to go right for CFX for that to happen.

## Strategy

I am a little conflicted on CFX.

I like the management. Incentives of the insiders are aligned with long-term shareholders. They have been trying to do the right things in a trying environment.

Over a long enough holding period, I expect intrinsic value to compound at a decent clip. Things are turning around. Even if they don’t transform immediately, CFX is no melting ice-cube. Time is on its side.

Optically, the performance doesn’t look great. But look at its sister, Danaher. It has never looked cheap to me. But you would have done very well buying that stock just about anywhere, and going to sleep for a long long time.

Okay, so why am I conflicted?

The current operating performance is shit. Operating margins and ROIC are meh. And that is a charitable reading. My cost basis is higher than the current stock price, and given how much stuff I’ve been forced to sell this year, I wouldn’t mind racking up some offsetting losses to ease the tax bill.

So what I’ve ended up doing is something that reflects my indecision. Since March of this year, I have been writing covered calls for \$40 and \$42.50, and rolling them over. The price action has been very cooperative, and I have collected over \$4/share in premiums.

# CSP Example: WFC

Note: I wrote this memo for private consumption about a month ago. With the decline in WFC, I have re-established a short-put position.

I just got off a 118 day cash-secured put campaign on Wells Fargo. I pegged WFC’s worth at about \$60 or more, and it has been trading in the \$51-56 range since April.

It isn’t rich enough for me to write covered calls on, or cheap enough for me to add to the position directly (I require a margin of safety of 20%).

On April 10, I wrote 1 \$54 put 25 days out (5/5 expiry), when the stock was trading at \$54.42. After earnings, which came out right away, the stock dropped to \$51.53, when I wrote another put \$52 put, expiring 5/12. I booked premiums of \$128 and \$158, after commissions.

On 5/5, the stock traded above \$54, and the first put expired worthless. On 5/12, the second put also expired OTM, with the stock trading around \$53.

I immediately wrote 2 more \$53 puts (\$128), and rolled them over twice. Once on 5/25 (\$174) and 6/8 (\$126). On July 14, the stock ended above \$53, and I let the position expire.

Overall, I collected \$714 in premiums after commissions (on \$10,600 cash outlay) over 118 days, for an annualized return of 33.5%.

This campaign reduced by effective buy price to \$49.50, even though I ended up not buying any shares.

If WFC falls to \$53 or below, I will probably embark on a new CSP campaign.

# The Moat around Magic Kingdom

This summer we took a family vacation to Magic Kingdom in Orlando. My experience, (especially the \$150 entry pass) re-emphasized the enormous pricing power of Disney.

While there were many other excellent theme parks in the vicinity, suggestions of substitutes went unproposed to my 4- and 8-year old daughters, due to perceived cruelty.

Next summer, we are also going on a Disney cruise with a bunch of extended family. The cruise costs nearly 2.5x as much as its competition.

I always knew that Disney had a strong moat. However, the observation of how powerless someone as cheap and brand-agnostic as me is, in avoiding paying up premium dollars, forced me to look at Disney the business after we got back from the trip. The recent swoon (after earnings) forced me to pen down my thoughts.

## Background

Disney has four business segments. In the order of revenue generated in FY 2016,

• Media Networks (ABC, ESPN, cable channels) – 43%
• Parks and Resorts – 30%
• Studio Entertainment (film, TV, home video) – 17%
• Consumer Products (books, video games, licensing) – 10%

We can think of Disney as two units, Media Networks + Studio Entertainment, which contributes 60% revenues and 65% EBIT, and Parks + Products, which constitutes 40% revenues and 35% EBIT.

DIS is insanely profitable.

It boasts of consistent gross and net margins of approximately 45% and 15%, respectively. The return on equity has been around 15% since forever, and has occasionally breached 20%. The company is generally well managed; its long term debt/capital is about 25-30%. Over the past 10 years, the number of shares outstanding has been shaved by 20%.

## Risk Factors and Opportunities

### Subscriber Loss at ESPN and pay TV channels

ESPN earns ~\$8/month per subscriber in bundled cable plans. People are moving away from bundled cable packages. This will hurt ESPN (and other channels) in the short and medium term.

• Longer term (10 yrs), new sports contracts will reflect this deterioration, and will probably be priced accordingly.
• Management will figure out a way to best monetize these assets. The situation may be more serious for other pay TV providers, which lack a franchise or differentiation.
• The recent “DTC” move while painful in the short run, was inevitable. In the long run, it will probably look smart.

### Heightened CapEx at Parks will Subside

Currently, CapEx/Sales at Parks and Resorts is high (25%). If and when it normalizes to the 15% level,  cash will start gushing out of the pike. Credit Suisse estimates that cash-flow will grow from \$800m in 2016 to about \$2.7B, when that happens.

## Valuation

ROE

The long-term ROE is in the vicinity of 15%. If you hold DIS for long enough, your returns should be pulled or pushed towards this number, unless the story changes dramatically.

Multiple

For FY 2017, EPS is estimated to come in at about \$6. At \$103, DIS is trading at a PE of about 17. Given the quality of the company, it probably deserves to trade at a premium to the market. If we say it deserves a multiple of 20 (arbitrarily for now, will contextualize later), then it is probably worth around \$120.

Terminal Model

Let’s use a simplified “terminal” model. Revenues have been growing at 5% or more since a long time. Operating and net income have been growing at 10% CAGR in the past, but let us suppose that this will taper down to 5% (same as revenue growth).

The return on capital has been around 12%, historically, while the cost of capital has been 8-9%. Given Disney’s moat, let us assume that is one of those rare moaty companies which can earn above its cost of capital, and continue to grow, thereby creating value. Note that this implies a reinvestment rate of 5%/12% = 40%.

It is estimated that DIS will earn an EBIT of about (\$15.7B) \$9.80/share in 2018 (fiscal years end in October).  Thus, the value of its operating business is,

`Operating Value = NOPAT(t+1) (1 - growth/ROC)/(COC - growth)`

= \$9.80 * (1-0.35) *  (1 – 0.05/.12)/(.08 – 0.05) = \$124/share. If we subtract the present value of the long term debt (~\$13/share) from this, we get an estimate around \$110/share for the equity.

Past Relative Valuation

Over the past 5 years, the PE ratio has varied between 15 and 25. Based on current earnings this implies a \$90-\$150 band. The EV/EBITDA has varied between 8.6 and 14 implying a slightly narrower \$88-\$140 valuation band. It must be remembered that over the past 5 years the stock has basically doubled.