By: Steve Rubis
Often investors must dig deep within an industry to find undervalued stocks. Currently, the Residential Construction Industry seems to be fairly valued and lacking many bargains. In Friday’s post, two stocks were identified as possibly being undervalued: WCI Communities (WCI) and Avatar Holdings (AVTR). The analysis which follows will further illuminate the possible valuations of WCI and AVTR.
The analysis which follows will illustrate that Avatar Holdings seems to be a sound investment, where as WCI seems to be somewhat dicey. The chart below will give the reader a quick glance at how we determined the above conclusion:
Table 1: Valuation of WCI and AVTR
The analysis above suggests that Avatar Holdings is an undervalued stock trading for an attractive price. At current prices, AVTR trades at a 31% discount to fair value, which makes for a compelling argument. AVTR’s main markets are Florida and Arizona where they focus on communities of single family homes. Despite the negative climate for Residential Construction, AVTR seems to offer a significant margin of safety for interested investors. Readers will find an explanation of how Table 1 was developed throughout the rest of this article.
Investors must always pay close attention to what they pay for a stock. If one pays too much, the possibilities of holding a losing position increase. The most sophisticated investors, such as those engaged in private equity, constantly analyze companies in order to determine if they are worth more as a private entity. The “Take Out” method of valuation allows investors to develop an idea what a private equity investor might pay for a stock.
Table 2: Private Equity Value Illustration
Private Equity investors rely on EBITDA (earnings before interest, taxes, depreciation, and amortization) to drive their primary valuations. Above, a value is calculated both on a price to EBITDA and enterprise value to EBITDA basis. The reason this metric is attractive is because it gives investors a limit as to how much debt a company can hold.
The chart above shows two differing stories considering WCI has a negative value, where as AVTR provides a strong showing. AVTR is more attractive because it has less debt and therefore, if taken private, can assume more debt. The negative values for WCI suggests that it is speculatively financed and debt heavy.
Next, it is important to use “Relative Multiple Analysis” to see how these two stocks fair on a price to sales, price to earnings and price to book value basis.
Table 3: Valuation Based On Ratio Analysis
Relative Multiple Analysis allows investors to determine a stock’s value based on industry metrics. The table shows that while AVTR has lower revenues, it is able to better convert sales to profit and generates shareholder value. Investors should pay close attention to AVTR’s $16.59 in earnings as well as the $61.68 book value. Such a strong showing for these two components drives the $98 average fair value price. Based on industry averages, AVTR is considerably undervalued.
Value investors like to analyze the earnings component as well as a company’s assets. Investors can use Earnings Power Value to determine the value of the companies engine: profit generation. The table below calculates the Earnings Power Value for both WCI and AVTR based on its definition taken from Value Investing and Beyond by Bruce Greenwald, et al. Our calculation will proceed by adjusting each company’s EBIT (earnings before interest and taxes) values and then using the WACC (weighted average cost of capital) for discounting purposes.
Table 4: Earnings Power Value - Adjusting EBIT
Investors should note, that in adjusting EBIT, investors add value for the portion of SG&A, which contributes to a growth in sales. This is calculated by multiplying the SG&A expense by the growth rate.
Table 5: Earnings Power Value - WACC
Investors must take note of the Adjusted EBIT and Net Income comparisons in the chart above. AVTR’s Adjusted EBIT and Net Income substantiate one another, leading us to believe that our analysis is accurate. WCI’s poor showing causes to grow skeptical of its valuation, as well as question its capitalization structure.
In order to fully appreciate Earnings Power Value, one must analyze reproduction value as well. Reproduction value allows investors to evaluate a companies assets based on the belief that the company will not go bankrupt.
Table 6: Reproduction Value Method
Again, two methods of calculation are used in order to validate our findings. The Enterprise Value calculations are illustrated above, which are based on market cap, debt and cash. The table below illustrates the adjustments made to the balance sheet, which is necessary to develop a true reproduction value for a legitimate going concern.
Table 7: Reproduction Value - Balance Sheet Adjustments
The major adjustment in our reproduction value calculation pertains to Inventories. Each company has a high inventory value on the balance sheet. AS interest rates rise, credit markets constrict and less lending is available for home purchases. AVTR’s recent 10k cites a weakening home sales market as a drag on results. Therefore, it seems prudent to value each companies Inventories at 90% of book value.
When using Earnings Power Value and Reproduction value, an investor should compare these calculations rather than analyze them separately. Table 7, illustrates the necessity for comparison.
Table 8: Value Comparison and Validation
When analyzing Earnings Power and Reproduction values, the company in question should have a higher Earnings Power Value. In this case, AVTR, highlighted in green, exhibits the ideal state. The EPV is considerably higher than the reproduction value; this means that AVTR is worth at least reproduction value and possibly somewhere within the margin between the two values. On the other hand, WCI has a higher reproduction value, causing us to question the validity of our calculation.
*The author has no position in either stock at time of writing. The author was not compensated nor approached by the companies in question in this article. The author cannot be held responsible for monies gained or lost based on this article.
