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Altria Group, Inc.
Valuation of Altria

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By admiraltroll
March 21, 2003

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Hi Guys,
I have been tracking Altria for some time and although I do not own any shares I would if I had cash for a bigger US account. Most of my cash is in Canadian tax sheltered accounts, which require me to have 70% invested through Canadian securities instruments.

However I do run a US "Cyber Fund" for my own learning purposes on TMF and MO was one of my first "purchases" there. Here's the link to the "fund" update and here's a link to the board.

I do a fairly simple discounted earnings valuation based on the TTM normalized earnings. Normalized for one-time items such as the sale of Miller Brewing. I then select a discount rate and use a 3-stage growth model, first 5 years, years 6 - 10 and then a terminal rate after year 10

I use a program called StockWorth to do the actual calculation although you can use a calculator or other online programs.

OK so on with the valuation. First I will explain what I did to arrive at an intrinsic value and then I will look at some alternate possibilities.

Normalized Earnings
All discounted earnings or DCF calculations have to start with a base. I use normalized earnings rather than FCF as the base. For a company like MO with a steady long-term record on earnings the cash flows usually tell the same story. In any case I would check out the FCF to Net Income during my fundamental analysis long before I got to the valuation of any current stock price or market capitalization.

For Altria I checked their website for Investor Relations which gives links to SEC Filings and the Annual Report. Like many other companies the 2001 SEC 10K referred me back to the Annual Report for Financial Statements. Here's the link.

If I'm doing a quick study to find out if I'm interested in further research then I would get the info from MSNmoney but I prefer to check the SEC Filings. Here's the MSN data.

If you look you can see that MSN normalizes earnings, although a thorough check through SEC Filings is preferred. So anyway I'd use $8.449b as my TTM normalized earnings.

Discount Rate
Some people just put in their required rate of return for the discount rate to come up with a maximum buy price for the stock. I use a build up method to assess the risk of owning a particular stock. The basis is the "risk free" rate of the safest alternative investment; usually long term 30 yr Treasury Bonds currently at 4.7%.

So if these really safe government bonds yield 4.7% then I will need a premium to tempt me to invest in inherently riskier stocks regardless of how safe I think a stock may be. My friend LeBeancountiere uses 9% as the lowest discount rate in his database for the bluest of blue chips with excellent earnings records. Note that all companies in his database generally have or have recently had a market cap in excess of $5b. If I don't apply this additional risk premium I would have to apply a much larger margin of safety to the end result for assessing a reasonable purchase price.

On top of this I would add specific company risk. These could be for size (the smaller the company the higher the risk), higher debt, inconsistent earnings, newer company or any other factor, which may increase the risk of owning this particular company. I use the discount rate to allow for companies with excessive ESO's, eg Siebel's historic share dilution due to ESO's is 5% so I increase their discount rate by 5% over and above other risk considerations. Should Siebel severely curtail ESO grants or not replace underwater ESO's I may have to revisit this figure. After all, the discount rate applies throughout the whole period of future earnings.

More from LeBean on Margin of Safety.

So I selected 13% for MO as it is a blue chip but with a significant risk in tobacco litigation. I assessed a 4% addition to the discount rate for this risk alone. Some may chose higher or lower than this.

Growth Rates
In general I use Zack's analyst low forecast for the first 5 years as do I, the only exception being if there is just one really low estimate and all the others are bunched around a higher number. Sometimes I don't believe the analyst's and assign a different growth rate. With some programs you can break the growth rates down into any number of years but StockWorth keeps it simple, 1st 5 years, years 6 to 10 and a terminal (continuing) growth rate after year 10 to year 100. Often there is a lot of discussion over the terminal rate as it has a huge affect on the Intrinsic Value, per % point second only to the choice of Discount Rate. I usually choose just 3% as an approximation of the long-term inflation rate. Some will say this is ridiculous and that up to 6% may be more appropriate for say Coca-Cola. However we then end up with an IV with more than 50% of it's component value from earnings after year 10 and not too many of us are that prescient as to know what will happen in the years after 2012!Here is the Zack's link for MO.

Note that the average consensus 5-year forecast is 9.67% and the low forecast is 8%. However only 5 analysts made a 5-year forecast so I decided to be a bit more conservative and use 7%. For years 6 - 10 we usually step the growth down as another conservative measure and then I used 3% after year 10. In considering growth rates we should remember that companies can have years of negative earnings growth (just look at techs today!) and so we should not take these sell-side analysts forecasts too literally - they like to exaggerate a bit! So I chose 7%, 5% and 3% for my growth rates

For shares outstanding I used 2,069,000

Intrinsic Value (IV) for MO
Normally I would draw up a table of IV's for different growth rates and different discount rates to test the sensitivity of the IV to different inputs.

So for MO I'll just select a few possibilities for you so you can see the effect of different inputs.

My original selection
Discount rate 13%, Growth rates 7/5/3 = $52

Analyst consensus growth rates
Discount rate 13%, Growth rates 9.7/7/3 = $61

Increase discount rate by 2%
Discount rate 15%, Growth rates 7/5/3 = $43

Increase terminal rate by 2%
Discount rate 13%, Growth rates 7/5/5 = $58

Flat 3% growth for 100 years
Discount rate 11%, growth rates 3/3/3 = $53
Discount rate 13%, growth rates 3/3/3 = $42
Discount rate 14%, growth rates 3/3/3 = $38

Zero growth for 100 years at 13% discount rate = $31

Some of you may have seen a valuation of MO that I did last year where I used a 12% discount rate. Since then I increased the discount rate by 1% to take more account of the litigation risk.

So I have $52 to which I'd apply a minimum margin of safety of 20% giving me a maximum buy price of $41.60. MO was $34.29 at today's close so it is trading 34% below my valuation. Of course I could be wrong but even if MO only grew forever at 3% it's still nearly 20% under the intrinsic value per share using a 13% discount rate

Oh and did I mention the near 8% dividend yield :-)

So there you go now you know why I think MO is undervalued. By how much? Well you take your pick!

Regards
Philip


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