Businessman Investor

Touching base with the rational business psyche of stock market investors

Sunday, August 21, 2011

FEU’s Cash Hoard. And They Said School is Boring...

This is Part 3 of a Series. Go to Part 2: So Where Have All Those Free Cash Flow Gone?

Majestic Campus. FEU is one of those few quality businesses that routinely produce and hoard free cash for the wealth enrichment of its owners.
I can’t blame anyone who thinks school is boring. Be it on what one may have experienced back in high school or college (e.g. boring classes and teachers/professors), or in stocks (i.e. boring, illiquid issues that hardly move in the market). But let’s take on the shoes of a prospecting investor interested in the fundamental cash-generating dynamics of a school as a business.

Disclosure: I'm currently a shareholder of Far Eastern University—yes, it is listed in the Philippine Stock Exchange (PSE: FEU).

Grasping the core business model of a school seems easy. Schools teach and prepare students for the real world, and in return collect tuition fees for this education service. As many are aware, they collect these fees upfront; before a student can walk into a classroom to learn, he must first pay the registrar a visit and write the accounting department a check. Not mentioning its other sidelines (such as leasing certain properties owned and deploying excess cash into other non-core business investments), that's how a school primarily makes its money.

As an owner, I'm always interested on how efficiently FEU is making use of its capital and how well it's bringing returns to shareholders (i.e. profitability), so I'm going to take a look at its compounding power and see how fairly it's been doing. Just by looking at its ROE (see under Analysis tab), I can say that this is a business able to deploy capital at high rates of return; with ROE's of 24.07%, 20.71%, 19.23%, and 19.02% for the years 2008 to 2011, FEU is able to demonstrate its capacity to compound capital at double digits (approximating somewhere 20%, mind you, this isn't really a norm in PSE-listed firms and I was stumped discovering this myself as I would least expect it in boring schools). The quality of its ROE is immediately backed-up by its Return on Assets (its ROA are still maintained at double digit levels ranging between 16 to 20%) and Debt-to-Equity Ratio (very minimal leverage, 0.22 at the most).

FEU Logo. I'm no Tamaraw by schooling, but I'm just loving the business that is FEU.
And just so to cut through the distortions of accruals and be bias on cash let's look at the correlation between Net Income vs Free Cash Flow:

Year: Net Income vs Free Cash Flow
2007: 603.53M vs 603.75M
2008: 592.91M vs 607.56M
2009: 567.00M vs 496.41M
2010: 585.18M vs 389.75M
2011: 642.430M vs 476.70M

Compelling... the parallel relationship between these two measures affirms the liquid nature of FEU's profits; such a cash cow! Despite being a school, FEU has a large treasury invested in various investment instruments such as Available-for-Sale Investments (usually stocks or bonds intended for resale), Held-to-Maturity instruments (usually long-term bonds), and investments in subsidiaries, associates, and other related parties (see under Cash Hoard tab). It amassed and sits on a whopping Php2.55B Cash Hoard (compared to Php3.56B Equity).

Note: Your derived Free Cash Flow can always be verified by comparing the change in Cash Hoard vs [Free Cash Flow - Dividends Paid - Share Buybacks + Additions to Capital (i.e. IPO's or secondary offerings)]

Estimating an Intrinsic Value using Cash Hoard as a Component

I maybe moving a little ahead of myself here, but FEU is just looking attractive, and I want to demonstrate how Cash Hoard can be used as a conservative component in estimating an intrinsic value of a company (or just to further justify that stock price premium). In finance, an asset is only worth all its future cash flows discounted back to its present value. This maybe a bit technical already, but the idea is that a peso today is worth more than a peso tomorrow (i.e. time value of money) since you can deploy that peso today in a profit-making venture and make it earn more; it's more valuable to receive it today than to receive the same amount, say, five years later, because of that opportunity of making it work and multiply now. That's the rationale behind discounting future cash flows back to their present values.

There seems to have been so much focus on future cash flows if you read the vast literature on intrinsic value estimation using the discounted cash flow (DCF) model. Most seems to have forgotten that when you buy a business, there's also that present free cash flow component which I refer to as Cash Hoard; this is where all previous free cash flows have accumulated. It only makes sense to include this when coming up with an Intrinsic Value estimate:

FEU East Asia College Building. Despite the flashy campus and all, the real value deal in FEU is in the Cash Hoard it's sitting on and the Cash Flows it continuously generates; not to mention its capacity to compound money and produce high returns on equity (ROE).
Intrinsic Value = Cash Hoard + Discounted Future Free Cash Flows

If you're gonna ask me what discount rate to use in discounting free cash flows, I'd say just base it on what rate of return you, as an investor, want (i.e. required rate of return). There's a plethora of writings on what appropriate rate to use (some would use the risk-free rate of government bonds), but then, in the end of the day, it is still what rate of return you would require. I'd personally want my money to compound at high rates with 15% as my minimum, so I'm going to use this rate.

While FEU's FCF varied year-on-year, I'm going to assume that it's going to perpetually produce Php450M in cash annually (I know, the garbage-in, garbage-out dilemma, but perhaps conservative enough since we're assuming that FCF has zero growth). Hence, the discounted future FCF's should be worth around Php3.00B (450M/15%). Its current Cash Hoard in year-end 2011 stands at Php2.55B. FEU should therefore be worth at Php5.55B (Php3.00B Discounted FCF + Php2.55B Cash Hoard) or Php565.84 a share (Php5.55B/9,808,448 shares outstanding). Too low? True, but at least it's a bit higher than the Php3.56B in "crude" equity.

Just a thought: the perpetual assumption already in itself immediately grounds and declares that buying based on intrinsic value estimates (esp. those done with DCF models) works best (if not should only work) when buying with the intent of holding indefinitely. That is so because in the computation, you have already assumed perpetual cash flows you will be receiving. That just immediately ties you, rationally and in theory, to the company forever if you do really want to earn that 15% per annum. Indeed, stocks are long-term.


  1. Wow! Didn't know they were sitting on such a pile of cash ! Is this school partly owned by Lucio Tan ? What's the intrinsic value of FEU assuming a decent reasonable growth ?

  2. Hey D'Intelligent Investor! Thanks for the comment! =D I still have to check if Lucio Tan's involved.. A "decent reasonable growth" rate... ah, that's a bit tricky. But for the sake of illustration, let's say we're gonna project a 5% growth in earnings for the next 5 years(which is pretty reasonable and conservative, I think)--starting with Php450M on year 1--and for the 6th year onwards, perpetual flat earnings (using the projected earnings in the 5th year i.e. Php547M), and use 15% as our discount rate, intrinsic value should be around Php5.78B or Php588.82 per share.

    Then again, I'm not really an advocate of using growth rates since that's where most of the overestimation pitfalls come from. If we keep on adjusting our intrinsic value estimate (by playing around with the growth rate) to justify a certain stock's premium price, that's somewhat fooling ourselves, don't you think? After all, the goal is not to justify the current market price level; rather, what we want to do is estimate a safe, conservative purchase price that has a lot of margin of safety in it against the potency of permanent capital loss. I remember a line from one of Alice Schroeder's speech (and you've probably already seen this video, hehehe ): "The purpose of the margin of safety is to render forecast unnecessary."

  3. Hello,

    In my opinion, although FEU did hoard that much cash, they don't seem to have any plans to substantially improve their future revenues which i think is necessary for stock price appreciation.:)


  4. @Renzie Doem: Hey there =) I sorta agree with that. Nonetheless, I'm more comfortable with consistent, not so substantial, boring revenue growth (check out the creeping, slowly but surely positive change in its revenue under the Income Statement tab) than seemingly substantial but not so sustainable revenue improvements. The easy, comforting truth about school institutions (such as the FEU) is that: you know they'll be around for decades to come, and that they shall keep on producing graduates. I mean, compared to a hyped (doomed to be depleted) mining stock, here, there's almost zero catastrophe risk.

  5. hahah agreed ako talaga diyan with Alice Schroeder. What is your personal figure when it comes to purchasing a stock based on intrinsic value. I mean since you conservatively assume flat or almost no growth at all, would purchasing a stock 50 % its intrinsic value fit your criteria ? or is it 30 %, 75 % ? Or would you go as high as 2x its value ? Because personally I'd have to say it would depend on the stock, but what is your sort of general rule that you set for yourself ? Let's just say limit. Would 2x be more than enough ?

    Natawa ako dahil stampede ngayon sa PSE. The technicians are in panic mode because whatever they do to chart the stocks wala talagang certainty. Kaya chartin nyo iyan kong kaya nyo. hhehehe. Akala ko pwedi nang itapon ang fudnamentals ay hindi pala. hehehehee. But us value investors can sleep soundly because we know the intrinsic worth of the stocks we have purchased :-)

  6. @D' Intelligent Investor: I'm starting to have a bias towards paying AT MOST the right price PROVIDED the assumptions used are so conservative that in themselves, they already warrant a hefty MARGIN OF SAFETY (i.e. zero, flat earnings). Instead of buying a stock at a deep discount from an intrinsic value estimate derived from very aggressive, too optimistic assumptions, I’d rather buy one at a reasonable price derived from very conservative, easily achievable assumptions.

    My view is: the prcinciple of Margin of Safety, rather than just being one of the steps of the appraisal process (i.e. a quantitative discount application to a derived intrinsic value estimate), is innately tied in the whole investing thought process—and that starts with banking on very conservative assumptions.

    You may want to check out this other post of mine to have a better understanding of what I mean:

    Down-to-earth return expectations make more sense and more meaningful to me now than deep value discounts thanks to that Schroeder video, lol!



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