Ask Packer - No Seriously, Ask Him Anything (AHA)!

[Packer16]

EBITDA is applicable to firm in a life stages.  FCF is most relevant in the mature phase.  In most cases if you find a cheap MVIC/FCF company it is also cheap on an MVIC/EBITDA basis.  I really use this metric to look at companies in a similar industry (content for example) and find the cheapest and try to understand if the discount is warranted. 

 

I do look at normalized metrics in cyclical industries.  The nice thing about EBITDA is that it is not as volatile as FCF.  You just need to be careful in understanding the use of EBITDA in comparisons.

 

Packer

[kab60]

Did you look at Cellcom Israel? Thought you might find it interesting. Not sure what the debt trades at.

[Packer16]

I haven't looked at Cellcom recently.  I will take a look.  Thanks.

 

Packer

[Phaceliacapital]

Packer, I have a quick question regarding business valuation.

 

When valuing a construction company (contractor business), do you consider performance bonds as liabilities and thus do you add these to calculate the company's EV?

 

Thanks!

[constructive]

Packer, I have a quick question regarding business valuation.

 

When valuing a construction company (contractor business), do you consider performance bonds as liabilities and thus do you add these to calculate the company's EV?

 

Thanks!

 

I wouldn't. Work in progress is a business risk, but not a liability. They are a liability for the insurance company who writes the policy.

[Phaceliacapital]

So in your response the construction company only pays its "insurance premium" but is not liable for the actual amount of the performance bond should something happen?

 

Does it always work like this?

[constructive]

So in your response the construction company only pays its "insurance premium" but is not liable for the actual amount of the performance bond should something happen?

 

Does it always work like this?

 

The contractor has to execute the construction contract. If they don't execute the contract, the performance bond pays out directly to their client. Then the insurance company attempts to collect from the contractor, but typically it only gets to this point because the contractor has already gone bankrupt.

 

The actual risk is much less than the performance bond amount. Contractors are typically paid and deliver work incrementally over time. If a contractor breaks the contract, the owner would only be able to make a claim for damages, not the entire amount of the performance bond.

[Packer16]

Constructive had a great response.  When we look at construction companies, we view a lot of the non-operating items like deposits and construction bonds as working capital and thus not added or subtracted from the EV as we would do with non-operating assets like investments in securities.

 

Packer

[Mephistopheles]

So in your response the construction company only pays its "insurance premium" but is not liable for the actual amount of the performance bond should something happen?

 

Does it always work like this?

 

The contractor has to execute the construction contract. If they don't execute the contract, the performance bond pays out directly to their client. Then the insurance company attempts to collect from the contractor, but typically it only gets to this point because the contractor has already gone bankrupt.

 

The actual risk is much less than the performance bond amount. Contractors are typically paid and deliver work incrementally over time. If a contractor breaks the contract, the owner would only be able to make a claim for damages, not the entire amount of the performance bond.

 

Now I know why your handle is constructive, ba dum psh!

[Phaceliacapital]

Thanks, very informative!

[theantilibrary]

Hi Packer,

 

I read your recent interview with Beyond Proxy (congrats BTW!). You referred to David Abrams' comments on "compound mispricings", (depressed derivatives [most likely calls or LEAPS] of depressed stocks, if I understood correctly) ... I was just wondering where you found those comments of his? I have barely been able to find any public commentary from David Abrams, anything you can share would be very much appreciated.

 

Thank you!

[Packer16]

It is from the Security Analysis (6th edition) I believe where he wrote commentary on a section of Security Analysis.

 

Packer

[theantilibrary]

Thanks Packer!

[Pelagic]

Hi Packer,

 

I read your recent interview with Beyond Proxy (congrats BTW!). You referred to David Abrams' comments on "compound mispricings", (depressed derivatives [most likely calls or LEAPS] of depressed stocks, if I understood correctly) ... I was just wondering where you found those comments of his? I have barely been able to find any public commentary from David Abrams, anything you can share would be very much appreciated.

 

Thank you!

 

Great question, I was interested in this comment myself and thank you Packer for clarifying where it came from. Having just re-read Abrams' introduction I still find it a little light on detail though. What confuses me is this, if a stock is undervalued, are it's derivatives also implicitly undervalued? This would seem to be the case since the price of the underlying is used to price the option you're faced with a garbage in, garbage out situation, where undervalued security implies an undervalued option as well, although high volatility can erode this edge by increasing the option's price. However, Abrams' seems to be saying there are situations where the options are somehow mispriced beyond the fact they're based on a mispriced security. The setup I see being most opportune for a value investor is an undervalued stock with relatively low volatility, since the options are priced on a distribution that is a function of volatility, the actual chance of a move outside the normal range is likely to be greater than the options market is implying.

 

Interested if you could shed a little more light on this Packer, or anyone else, thanks!

 

 

[Packer16]

I think the mispricing of stocks and derivatives can be related but are not necessarily dependent.  You may see for example a fairly priced or highly priced call option (implied volatility higher than historical volatility) on a stock if enough participants recognize the stock as being undervalued and anticipate a catalyst occurring before the option expire.  Options are tricky because you need to get the pricing and timing right to profit.  What a double mispricing tells me is sentiment is pretty bad or the derivative could be misunderstood like Korean preferreds.  There can be technical reasons for cheap options like a large demand for short sales which can drive up borrowing costs, this happened to FFH calls in the 2000s.  Cheap put options can happen when there is large demand for the other side of the bet like Nikki puts in the early 1990s or subprime CDS before the financial crisis.

 

Packer

[theantilibrary]

I feel a little stupid asking what I'm afraid is probably a very basic question, but how does one accurately assess whether an option is mispriced in relation to the underlying security? This idea of a "compound mispricing" is very attractive, but I have to admit that I have almost no experience with options/derivates and therefore I don't know how to assess whether a given option is mispriced relative to the underlying security. Packer's examples in the prior post such as instances of high demand for short sales or cheap puts when people are super optimistic (the Nikkei example) make sense for getting a general idea of when certain derivatives may be undervalued, but is there a more rigorous way to determine the extent of over or underpricing? I'm not familiar with the calculations that might be involved.

 

To create an example, if I think that GM common stock is undervalued, how would I go about determining whether certain call options are possibly undervalued even more in relation to the common? (And yes I'm aware of the A, B, and C warrants... I was just using GM call options as an example because I currently think the common looks quite inexpensive). Looking at prices earlier today I saw that the Jan 2016 42 strike calls were trading at the same price as the 40 strike calls with the same expiration date, so clearly the 40s were undervalued compared to the 42s, but how would I know whether paying $0.15 for either is relatively cheap in comparison with the common? (This is just an example, I have no particular thoughts on this option in particular). Does anyone have a good method of calculating relative under/overvaluation of options in relation to their underlying securities?

 

 

[Packer16]

There are two ways to judge the value of an option.  First, you can compare its implied volatility to the historical volatility.  If the implied is less and there is no obvious reason for this decline in volatility going forward is one way.  The other is to calculate an intrinsic value of an option assuming a fair value stock price and compare upside potential.  See attached spreadsheet.  Using this method you can compare relative upside versus the common as a "cheapness" metric.  You track this metric over time to see if relative upside is high or low.

 

Packer

TARP_Warrants_0211.xlsx

[theantilibrary]

Thanks Packer, very much appreciated.

[Fowci]

There are two ways to judge the value of an option.  First, you can compare its implied volatility to the historical volatility.  If the implied is less and there is no obvious reason for this decline in volatility going forward is one way.  The other is to calculate an intrinsic value of an option assuming a fair value stock price and compare upside potential.  See attached spreadsheet.  Using this method you can compare relative upside versus the common as a "cheapness" metric.  You track this metric over time to see if relative upside is high or low.

 

Packer

 

This is a great spreadsheet. But as far as I can tell, you are using call option formulae to value warrants? This overstates the value of warrants because it doesn't account for dilution (that if it's ITM, those who exercise give money to the company and receive shares and so everyone is diluted).  Depending on number of warrants this can be negligible (more warrants = more important) but I thought I'd raise it because I spent a week toiling in excel to come up with a working formula to price warrants.

[Packer16]

You are correct.  If the dilution is less than 10 percent the effects are small.  I can post a warrant with dilution model next that I have at work.

 

Packer

[Fowci]

You are correct.  If the dilution is less than 10 percent the effects are small.  I can post a warrant with dilution model next that I have at work.

 

Packer

 

No problem - just letting you know in case you weren't aware of the issue. I built an ugly spreadsheet with iterative calculations to price warrants and I was banging my head against a wall for a few days.

[Hielko]

I wonder how you would do that since the current stock price should also incorporate the possible dilutive effect of the warrants. So you would have to value the warrants without knowing the "true" current stock price, or you would have to value the stock without knowing the value of the warrants. Seems like a tough problem.

 

[Packer16]

It is easier if you have an estimated equity value that is distributed across the securities (warrants and common stock).  A closed form solution has been derived assuming a current stock price.  The formula is iterative as value of the warrant is dependent upon a stock price and probable dilution, based upon expected dilution at expiration.

 

Packer

[Fowci]

I wonder how you would do that since the current stock price should also incorporate the possible dilutive effect of the warrants. So you would have to value the warrants without knowing the "true" current stock price, or you would have to value the stock without knowing the value of the warrants. Seems like a tough problem.

 

You need to enable iterative calculations in excel (under options/formulas).

 

The two papers I found most useful were:

 

http://www.fintools.com/wp-content/uploads/2012/02/WarrantsValuations.pdf

(Specifically, the "Galai-Schneller Model with dividend yield" on page 2. This is how I built the BSM modified model)

 

http://www.pwc.com/en_US/us/audit-assurance-services/valuation/publications/assets/pwc-valuing-warrants-dilution-downround-protection-dwight-grant.pdf

(I found the section "Plain Vanilla Warrants and Dilution" good for intuition and some details about why you should use volatility of the company, not the stock price once warrants are issued).

 

This is also useful as a walkthrough (at the end) of how the iterative process works.

http://faculty.darden.virginia.edu/conroyb/derivatives/warrants.pdf

 

CEFs the are trading at a discount sometimes buy back shares and issue warrants at the same time so they don't disappear. You're often trading against retail investors when this happens, so can have a bit of an advantage if you know how the warrants should be priced.

[Packer16]

I personally never had this happen to me.  One factor you can look for a large stake by a strategic investor or they are on the board.  This can protect your interest.  NTLS has this dynamic.  The largest holder is also CoB.

 

Packer