In the days following the publication of my article on Lifeway Foods (Nasdaq: LWAY ) last week, I received more feedback from Fool.com readers -- and much friendlier feedback, I might add -- than in response to anything I have written for the Fool since my politically incorrect article in support of outsourcing. (And, yes, the hate mail is still trickling in.)
Why so much feedback? Well, because the Lifeway story seems to have fed on itself. A stock gets highlighted because the company behind the ticker is good. The stock price goes up. So, did the stock price go up because the company was good, or is the company suddenly "good" because its stock is going up?
To me, the answer is clear: Lifeway was a good company before I wrote about it. Absent any news over the past week that has affected its business, Lifeway remains a good company today. But in my humble, Foolish opinion, the stock is now quite fully valued.
Before we delve into the company's valuation, however, a quick recap of why I wrote so glowingly about Lifeway is in order:
- Valuation: On the day of publication, Lifeway had an enterprise value-to-free cash flow (EV/FCF) ratio of 23.6, which was cheaper than the market as a whole.
- Growth: Lifeway has grown its earnings at an average annual rate of 19% over the past five years, with earnings growth accelerating to 25% in the last year for which a full 10-KSB has been filed (2002).
- Profitability: In 2002, earnings grew 25%, outpacing revenue growth of 14.3%.
- Financial stability: Roughly 17.5% of Lifeway's market cap was made up of the cash and cash equivalents in its coffers.
- Shareholder-friendly management: Lifeway's CEO pays herself less than $75,000 a year, and management is not diluting minority shareholders with stock options.
That was the situation with Lifeway early last week. But since then, the market has bid up its share price with a vengeance. To be clear, I thought the stock was a "buy" at $14 a stub. But Lifeway is now closing on $28! Let's take a look at the company's valuation as of today, and see if it is still worth our investing dollars.
Adventures in bean counting
Like co-Fool contributor Matt Richey, I prefer to evaluate a company's worth based on its EV-to-FCF ratio, an investing metric familiar to regular readers of Motley Fool Hidden Gems. I then check its prospects as an investment, based on how that EV/FCF ratio compares to its five-year projected rate of earnings growth.
At close of trading on Tuesday, Lifeway sported an EV of $104 million. Over the past 12 months, its free cash flow totaled roughly $2.2 million -- so the EV/FCF ratio is about 47.
Only one analyst covers Lifeway, and that analyst has not (to my knowledge) published a projection of Lifeway's earnings growth potential for the next five years. Still, over the past five years, earnings growth has averaged 19%. From 2001 to 2002, the company grew earnings 25%, so growth appears to be accelerating. It might therefore not be unreasonable to calculate its intrinsic value by using the 25% figure.
But I won't.
Lifeway has run up so far, so fast, that I think the only prudent thing to do at this time is to use the most conservative numbers -- based in fact -- available. Over the past five years, the company increased earnings "only" 19% per annum on average, so let us use that figure for the next five years, as well.
To calculate the company's EV/FCF/growth value, you simply take the EV/FCF number and divide it by the growth rate (as a whole number, not a percentage). So:
47 divided by 19 = 2.5
That is roughly 25% more than the value for the market as a whole. But Lifeway is a micro cap -- remember that the father of value investing, Benjamin Graham, has said that the market generally values small caps at a discount to their intrinsic value. This should be doubly true for micro caps.
Equivocation is the better part of valor
That said, as long as we are quoting Benjamin Graham, let's study his formula for valuing companies. In The Intelligent Investor, he used the formula: 8.5 + (growth rate x 2) to yield the market's reasonable valuation multiple for a company.
Plugging in Lifeway's numbers, that gives us 8.5 + (19 x 2) = 46.5. A 46.5 times multiple, applied to Lifeway's trailing 12 months core earnings of $0.57, yields a fair value of $26.50. Applied to the company's projected 2004 core earnings of $0.70, the fair value becomes $32.55.
The $32.55 figure suggests that Lifeway's stock still has room to grow. But the $26.50 figure suggests that the company is already fully valued. Indeed, if you follow Graham's value-investing rules faithfully, you should probably conclude that Lifeway is now overvalued, because it is not trading at a discount to its $26.50 intrinsic value.
Just due (diligence) it!
The moral of the story is this: Lifeway, the company, is a great company. But Lifeway, the ticker symbol, is fast becoming a "momentum stock." While I feel that its valuation today is defensible, the company really does sit right on the brink of overvaluation.
Being a value investor, I like to invest with a strong margin of safety. If I can buy a company at 60% of its intrinsic value, the chances are good that the market will eventually realize what the company is worth, appraise the company at close to its full intrinsic value, and I will realize a substantial profit. At the same time, if the market has already marked my stock "40% off!" its true value, the chances of a steep decline from that point are pretty slim. This is the reason we call the discount the "margin of safety."
The fact that you can ever buy a stock at 60% of its intrinsic value is proof that the market does not always price companies efficiently. The market can undervalue a stock such as Lifeway -- as it did prior to last week. But by the same token, the market can overreact and overcompensate for its earlier mistakes, bidding a stock up to more than its intrinsic value. I suspect that this is what happened to Lifeway yesterday, when the stock surged 28% on news of a stock split. (As we have stated over and over again here at the Fool, a stock split is a non-event. It simply does not affect a company's fundamentals.)
Of course, the stock split is not the only reason Lifeway has increased in price over the past week. The stock was undervalued to begin with. A positive earnings announcement is expected any day now. Both of those factor in. But the rapidity of the price rise suggests, to me at least, that some people out there are buying without first doing their due diligence, afraid of "missing the boat."
That is not investing, Fools. That is momentum trading -- buying a stock because it is going up. That is not what we practice, nor what we preach, here at the Fool.
Motley Fool contributorRich Smith owned shares in Lifeway Foods last week and continues to hold them. That said -- and as his wife will aver -- Rich is a card-carrying cheapskate and refuses to buy anything not on sale or without a coupon. Unless and until Lifeway stock goes on sale again, he will not be buying more. The Fool has a disclosure policy.