Valuation: SKF

Yesterday the first of the large cap big guns, SKF, released its Q3 report. The company is a leading global supplier of products, solutions and services within rolling bearings, seals, mechatronics, services and lubrication systems. Because of its global sales and business to various industries it is also seen as a bell weather for the Swedish and global economy.

The report failed to meet expectations causing the share price to drop around 7% from 184kr. It has recovered slightly with the latest US budget news and lies now at 173kr. Expectations were probably too high with the share price up 20% this year before the report came out.

Disappointing quarterly reports can provide buying opportunities, yet the question we must ask is whether a cheaper price also means good or better value. I will attempt to answer his question buy going through some numbers.

Firstly with a P/E 19.7, P/B 3.5 and ROE 18.2% it certainly isn't a classic 'value stock' and is priced for growth. How much growth and at what price is the next question. To answer this I have calculated an 'owner earnings' for the past 5 years. These earnings can be viewed as the cash generated by the company which could be returned shareholders, sometimes also referred to as a 'potential dividend'.

As it is SKF pays an reasonable dividend of 3.2%, which is 62% of earnings, the rest is kept by the company. We can try to put a value on the company by determining a current value of these potential future cash flows.

Anyway, 'owner earnings' are calculated as follows 

Owner earnings = Net income + Depreciation & Amoritisation - Capital Expenditures

As SKF is an industrial related company, I took an average of the past 5 years to capture the recession of 2009 and get a cyclically adjusted cash flow of 3896 msek. At this point I extrapolated the growth of this cash flow 20 years into the future, a lot of assumptions of course built in there!

I was fairly generous (I believe so anyway!) and gave SKF an earnings growth of 7% for the next 5 years, then 5 % up to the final 5 years which was then reduced a modest 3%. Each of these projected yearly owner earnings were then discounted at 9% to a present value.

The sum of these cash flows were added to the book value of equity and divided by the number of shares to give a value per share of 174.8kr. Pretty much the current market price!

Admittedly I probably have been anchored by the market price and adjusted the inputs accordingly. However, we now have an understanding of what expectations are required to get a share price of 174kr. If you think they are fair or even overly cautious then SKF could be a buy at these levels.

Ideally a margin of safety should be included in the valuation, such as 25%, to cover for inevitable mistakes and give us room for error. Such a margin would suggest a buy price of 131kr.

They say patience is a virtue, especially for value investors, but with the current market strength and continuing bullish sentiment I will not be holding my breathe whilst waiting for another 25% decrease in SKF's share price! The hunt continues.