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Valuing Cigar Butts & Value Traps


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How do you determine the margin of safety for a security such as ELNK or USMO which have declining CFs?  These firm sell for less than 3x FCF but in three years USMO's value would have declined by about (based upon a 6% decline in FCF per year) 20% and ELNK by 33% (based upon a 13% decline in FCF per year).  If I use a 12% discount rate a starting point (from 1/8.5 Graham PE with no growth) and add 6% and 13% respectively I get FMV P/FCFs of 5.6x and 3x respectively.  That would put USMO @ 41% of FMV and ELNK @ 83% of FMV.  Any comments or other ways to look at these investments.  TIA

 

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Well, before I even look at valuations in a declining cash flow. I first look if that company is conscious that the end is inevitable and that it is ready to let it die for the profit of shareholders. That is even before looking at PV and making projections.

 

For example ELNK has about 170M of FCF but only redistributed 47M to shareholders. Why are they stacking so much cash? It seems to me they will want to buy another business to survive. It's not my type of investment, I would much rather if the company would distribute 90% of it's FCF. Then you have a nice margin of safety as the earnings go straight to your pocket. The company must also show capable capabilities of downsizing it's operations as it's revenues go down, you don't want the cash flow to reverse just because the fixed charges cannot be reduced at the same pace as earnings, it would kill your investment.

 

BeerBaron

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In Ben Graham's day, there were many good companies that were beaten down to the point that they were net\nets.  Good opportunities in this area today are fleeting and require much study of management's intentions to find a handfull that are likely to return the surplus to shareholders.  Greenbacked.com has the best site for evaluating these mostly microcap and some smallcap opportunities.  :)

 

The value traps are the ones that keep pouring money into crappy businesses or have a history of buying crappy businesses, especially when the CEO is entrenched.  These in general don't return much if any value to shareholders.

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