How Does Float Affect Valuation? On Float Part 5

The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day. The hope being that our knowledge will compound over time so we’ll have huge advantages over other investors in the future.

The aim of today’s post is to continue this process by talking about a topic few investors know about. And even fewer understand.

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Most people overlook float when evaluating companies because they either don’t know what it is. Don’t know the power it can have within a business. Or don’t know how to evaluate it.

This won’t be an issue here.

Press On Research subscribers already know this as I talk a lot about float in many of the issues I’ve written. But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.

Today’s post is a continuation of the earlier posts:

Today we’re going to talk about how float affects valuation. The issue brought up way back in part 1 of this series linked above. But before we get to this let’s go back to On Float Part 4 to continue this talk about valuation with those companies.

Insurance Company Float and Valuation

Below is the unedited float analysis I did on an insurance company I wrote about in the April 2016 Press On Research issue.

All numbers below are in USD $ millions unless noted.
Assets
Financial Assets: Fixed maturity securities of 94.3 + equity securities of 4.9 + trading securities of 0.1 + loans of 1.9 + cash and cash equivalents of 6.8 + accrued investment income of 0.8 + premiums and other receivables of 11.3 + deferred income tax assets of 3.8 = 123.9
Operating Assets: Deferred policy acquisition costs of 8.5 + PP&E net of 2 + other assets of 13.9 = 24.4
Total Assets = 148.3
Liabilities
Equity of 44.9
Short-term debt of 0.9 and long-term debt of 17.4 = 18.3
Float: Future policy benefits of 35.2 + policyholder funds of 1.6 + unearned premiums of 29.9 + taxes payable of 0.1 + other liabilities of 18.3 = 85.1
Total liabilities are 103.4
Float/operating assets 85.1/24.4 = 3.49.
Float supports operating assets 3.49 times.
And Float is “free money” because (NAME REMOVED) earns consistent underwriting profits as it’s earned underwriting profits in six of the last nine years.
Pretax profits have changed to underwriting profit below because normal pretax profits mean nothing for insurance companies.
(NAME REMOVED) had an underwriting profit – profit from operations before taxes here – for the full 2015 year of 6.4.
Underwriting profit/total assets = ROA
6.4/148.3 = 4.3%
Compared to a Morningstar ROA of 3.2%
Underwriting Profit/(total assets – float) = levered ROA
6.4/63.2 = 10.1%
If I were to rely only on Morningstar to get estimates for margins (NAME REMOVED)looks below average at only 3.2%.
Yes I know this isn’t an apples to apples comparison. But normal profit metrics mean nothing for insurance companies.
When considering underwriting profit. Its ROA is a still below average 4.3%.
But (NAME REMOVED) float magnifies its ROA higher.
When considering float, its levered ROA goes up to 10.1%. Or 43% higher than what I calculate it’s normal ROA as.
Having a levered ROA of 10.1% isn’t great compared to normal companies I invest in… But for an insurance company this is a great margin.
One of my investment icons the great insurance investor Shelby Davis looked for insurance companies having an ROA above 10% so this meets his threshold.
Another important metric for insurance companies is ROE. Most great insurance companies fall in the 10 – 15% ROE range.
I calculate (NAME REMOVED) ROE – underwriting profits/shareholders equity – as 14.3% not levered by any float. Compared to Morningstar’s ROE estimate of 10.7. This puts (NAME REMOVED) into the great insurance company category. And there’s still more.

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I continue on from here detailing this great small insurance company but now let’s get back to talking about how float affects valuation.

The unedited valuations below are from the April 2016 Press On Research issue except for the removal of the company name and ticker.

My notes talking about float now are bolded and capitalized.

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How Does Float Affect Valuation?

As Warren Buffett once said, “Price is what you pay, value is what you get.”
The price of a company is what the market says it is. But how do I establish value?
When I recommend a stock, I try to find its “intrinsic value.” Intrinsic value measures a company’s true value considering tangible and intangible assets and the company’s operations.
Think of intrinsic value this way: What would this company be worth if we were to buy it outright? It’s like appraising the value of a house or car.
If I find the intrinsic value of a company to be higher than its market price, that’s a good sign of an undervalued stock.
I valued (NAME REMOVED) four ways.
The first is by assuming 1% interest rates for the long-term. And that (NAME REMOVED) float won’t grow over time.
The second is an asset reproduction valuation.
The third is adding the reproduction value of (NAME REMOVED) to 1/5^th of its float and then dividing by its number of shares.
And the fourth is adding (NAME REMOVED) float and equity together then dividing this by its number of shares.
Valuations done using (NAME REMOVED) 2016 10K. All numbers are in millions of US$, except per share information, unless otherwise noted.
(NAME REMOVED) current market cap is (REMOVED; BELOW $100 MILLION) and its current share price is $15.20 per share.
Float X 1% Interest Rate + Equity Valuation
This valuation is expecting 1% interest rates for the long-term and no growth in float over time.
(float X 10%) + Equity = estimated value/number of shares.
(84.9 X 10%) + 44.9 = 53.4/2.5 = $21.36 per share.
This valuation is the minimum (NAME REMOVED) should sell for because interest rates won’t stay as low as they are forever. And it still shows (NAME REMOVED) is selling at a 28.8% discount.
(NAME REMOVED) has consistent underwriting profits and conservative managers so float should grow over time as well.
JUST THIS COMPANIES FLOAT EQUALS $33.96 A SHARE. OR 223% HIGHER THAN ITS THEN TOTAL SHARE PRICE. REMEMBER THOUGH THIS NEEDS TO BE DISCOUNTED IN MOST CASES BECAUSE OF THE LONG TERM NATURE OF MOST FLOAT AND BECAUSE THEY’RE LIABILITIES. WE’LL TALK ABOUT THIS FURTHER BELOW.
Next up is the asset reproduction valuation.
Asset Reproduction Valuation
Assets Book Value Reproduction Value Notes
Fixed Maturity Securities 94.3 84.9
Equity Securities 4.9 3.9
Trading Securities 0.1 0
Loans 1.9 1
Cash and Cash Equivalents 6.8 6.8
Accrued Investment Income 0.8 0
Premiums and Other Receivables 11.3 6.9
Deferred Policy Acquisition Costs 8.5 5.1
Deferred Income Tax Assets 3.8 2
PP&E Net 2 1
Other Assets 13.9 8.3
Total Assets 148.3 119.9
Minus
Future Policy Benefits 35.2 21.1
Policyholder Funds 1.6 0
Unearned Premiums 29.9 17.9
ST Debt 0.9 0
LT Debt 17.4 10.4 I could have discounted this even further since its not necessary for insurance companies to carry debt. This would have made reproduction value even higher below.
Taxes Payable 0.1 0
Other Liabilities 18.3 11
Total Liabilities 103.4 60.4
Equals 44.9 59.5 The note above also explains why reproduction value is higher than net asset value. This is rare when I find this.
Divided By Shares 2.5 2.5
Equals $17.96 $23.80
Current share price = $15.20 $15.20
Discount to current share price = 15.40% 36%
This valuation does not take into account any of (NAME REMOVED) float. This is an asset – at least in the short-term – because of (NAME REMOVED) long sustained history of underwriting profits.
And as mentioned throughout this issue these act as a cost-free form of positive leverage which boosts (NAME REMOVED) value.
Even in this still ultra conservative valuation (NAME REMOVED) is selling at a 36% discount to its current share price.
Asset Reproduction + 1/5 of Float Valuation
Add float (1/5 of float after reading this discussion in part 1 of the On Float series here) asset reproduction value gets us to:
59.5 + (84.9 X 20% = 16.98) = 76.48/2.5 = $30.59 per share. Or more than a double from its current $15.00 share price.
This also considers no growth in float. Any rise in interest rates. Or a turn to a better insurance market. All which will help (NAME REMOVED) shares explode but this valuation still shows it’s selling at a 50.3% discount.
REMEMBER THE DISCOUNTING TALKED ABOUT ABOVE? HERE IT IS.
USING ONLY 1/5TH OF THIS COMPANIES FLOAT – OR $6.79 PER SHARE – FLOAT ADDS SUBSTANTIAL VALUE TO THE COMPANY.
IN THE CASE OF THIS VALUATION 22.2% TO THE COMPANIES VALUE. 1/5TH OF FLOAT MAKES UP 45% OF THE COMPANIES THEN CURRENT SHARE PRICE.
AS TALKED ABOUT THROUGHOUT THE APRIL 2016 PRESS ON RESEARCH ISSUE THIS COMPANY IS CONSISTENTLY PROFITABLE AS WELL. AND THIS VALUATION DOESN’T COUNT ITS VALUABLE OPERATIONS AT ALL.
I DON’T WHEN EVALUATING INSURANCE COMPANIES BUT IF I WERE TO ADD A MULTIPLE OF ITS TTM UNDERWRITING PROFIT TO THIS VALUATION SO THE VALUE OF ITS OPERATIONS ARE CONSIDERED IN THIS VALUATION IT WOULD BE WORTH…
6.4 x 8 + 76.48 = 127.68/2.5 = $51.07
THIS IS A CONSERVATIVE ESTIMATE OF THE COMPANIES REAL INTRINSIC VALUE. THE VALUE A CONTROL INVESTOR MAY EXPECT THE COMPANY TO BE WORTH WHEN ACQUIRING THE WHOLE COMPANY.
PROFITABLE OPERATIONS COMBINED WITH LOW COST OR COST FREE FLOAT HAS IMMENSE VALUE AS SEEN FROM THIS VALUATION.
AND REMEMBER THIS ALSO ASSUMES NO GROWTH IN FLOAT GOING FORWARD.
AGAIN, THIS IS THE POWER OF FLOAT ILLUSTRATED. THIS WILL ALL HELP COMPOUND THE VALUE WITHIN THE COMPANY OVER THE LONG-TERM BARRING SUDDEN POOR MANAGEMENT.
Float + Equity Valuation
Float + Equity = estimated value/number of shares.
59.5 + 44.9 = 129.8/2.5 = $51.92 per share.
This high end valuation doesn’t discount float at all. But also doesn’t expect any growth over time. And still shows (NAME REMOVED) is selling at a 71% discount to its current share price.
So not only is (NAME REMOVED) an ultra conservative and safe to own insurance company. But it’s also undervalued by as much as 71%. And we should expect to earn at least 28.8% owning them.
But there’s still more that makes (NAME REMOVED) a safe investment…

***

From here I continue detailing the company in the issue but let’s finish talking about the insurance company above.

All insurance companies have a lot of float that makes up the value of the company. This is because most of any insurance company’s balance sheet and operations are based on float.

Now let’s go to the non insurance company talked about in On Float Part 4 to see the contrast here. And also that float can still add substantial value to non insurance companies.

Non Insurance Company Float and Valuation

All numbers below are in millions of dollars unless noted.
Financial Assets: Cash and cash equivalents of 2.7 + deferred tax assets of 1.9 = 4.6
Operating Assets: Accounts receivable of 39.1 + Inventories of 12.6 + prepaid expenses of 1.1 + other CA of 0.3 + net PP&E of 73.7 + goodwill of 2.4 + other IA of 0.6 = 129.8
Total Assets = 134.4
Liabilities
Equity of 86.2
Debt of 14.4
Float = Accounts payable of 13.3 + Taxes Payable of 0.5 + accrued liabilities of 8.9 + other CL of 1.3 + deferred tax liabilities of 1.4 + pensions and other benefits of 8 = 33.1
Total liabilities 47.5
Float/operating assets = 33.1/129.8 = 25.5%. This means (NAME REMOVED) float supports 25.5% of its operating assets.
Pretax profits/total assets=ROA
7/134.4= 13.9%
Compared to a Morningstar ROA of 10.1%
Pretax profits/ (total assets-float) = levered ROA
7/101.3 = 18.5%

Now that we remember this let’s continue to show how float affects this companies valuation.

The information below is an unedited excerpt from the January 2016 Press On Research issue except for the removal of the company name and ticker.

***

As Warren Buffett once said, “Price is what you pay, value is what you get.”
The price of a company is what the market says it is. But how do I establish value?
When I recommend a stock, I try to find its “intrinsic value.” Intrinsic value measures a company’s true value considering tangible and intangible assets. And the company’s operations.
Think of intrinsic value this way: What would this company be worth if we were to buy it outright? It’s like appraising the value of a house or car.
If I find the intrinsic value of a company is higher than its market price, that’s a good sign of an undervalued stock.
I valued (NAME REMOVED) five ways.
The book value per share valuation talked about above. An asset reproduction valuation. A float plus equity valuation. A 8 and 11 times EBIT + cash – debt valuation. And a combined asset reproduction and 8 and 11 times EBIT + cash – debt valuation.
Book Value Per Share Valuation
The first way I valued (NAME REMOVED) from earlier shows (NAME REMOVED) should be worth $11.18 a share. An 11.5% premium to what its selling at now at $9.90 a share at the time of this writing.
This is the absolute minimum (NAME REMOVED) should be selling for because it doesn’t count any of its valuable and profitable operations at all. Or any growth.
Next up is the asset reproduction valuation below.
Asset Reproduction Valuation
Assets Book Value Reproduction Value
Cash and Cash Equivalents 2.7 2.7
Accounts Receivable 39.1 33.2
Inventories 12.6 7.6
Deferred Income Taxes 1.9 1
Prepaid Expenses 1 0
Other CA 0.3 0
Net PP&E 73.7 44.2
Goodwill 2.4 1
Intangible Assets 0.6 0
Total Assets 134.3 89.7
Minus
Short Term Debt 4.1 4.1
Accounts Payable 13.3 6.7
Taxes Payable 0.5 0
Accrued Liabilities 8.9 4.5
Other CL 1.3 0
LT Debt 10.5 6
Pensions And Other Benefits 8 6
Total Liabilities 46.6 27.3
Equals 87.7 62.4
Divided By Shares 7.6 7.6
Equals $11.54 $8.21
While (NAME REMOVED) is selling above its reproduction valuation – and it should since it’s a great company – it’s selling below its net asset valuation. The middle bar above.
This is also an ultra conservative valuation that shows (NAME REMOVED) is undervalued by 14.2% now.
Float Plus Equity Valuation
The third way I valued (NAME REMOVED) was by adding float to equity and then dividing by its numbers of shares.
33.1 + 86.2 = 119.3/7.6 = $15.70 per share.
This again is an ultra conservative valuation because it doesn’t include cash. Or (NAME REMOVED) valuable and profitable operations.
But this still shows (NAME REMOVED) is undervalued by 37% now.
EBIT Valuation
The fourth way I valued (NAME REMOVED) is by using its TTM EBIT. Multiplying this by eight and 11. Adding cash. Subtracting debt. Then dividing this by the number of diluted shares outstanding.
8X 19 + cash of 2.7 – 14.6 = 140.1/7.6 = $18.43. This means (NAME REMOVED) is undervalued by 46.3% now. Almost a double from current share price.
11X 19 + 2.7 – 14.6 = 197.1/7.6 = $25.93. Or undervalued by 61.8% now. Or more than a double from current prices.
Yet again this doesn’t show the whole story because this valuation doesn’t include its valuable assets.
EBIT Plus Reproduction Valuation
Adding in the net value – after debt – of its estimated reproduction assets gets us values of:
140.1 + 62.4 = 202.5/7.6 = $26.64 per share. Or 2.69 times higher than its current share price.
197.1 + 62.4 = 259.5/7.6 = $34.14 per share. Or 3.45 times higher than its current share price. Or a 3.45 bagger from current prices.
THIS COMPANIES THEN CURRENT SHARE PRICE WAS $10. ITS FLOAT EQUALS $4.36 PER SHARE. THIS MEANS JUST ITS FLOAT MADE UP 43.6% OF ITS THEN CURRENT SHARE PRICE.
IN OTHER WORDS FOR ONLY $5.64 YOU GET THIS COMPANIES CONSISTENTLY PROFITABLE GREAT MARGINS, ASSETS, OPERATIONS AND EVERYTHING ELSE OTHER THAN FLOAT.
WHEN EVALUATING NON INSURANCE COMPANIES I DON’T INCLUDE FLOAT IN THE VALUATIONS MOST OF THE TIME BECAUSE AS ALWAYS I LIKE TO BE AS CONSERVATIVE AS POSSIBLE.
BUT IF I WERE TO ADD 1/5TH OF THIS COMPANIES FLOAT ($6.62 MILLION OR $0.87 PER SHARE) TO THE EBIT PLUS REPRODUCTION VALUATION THIS WOULD GET US VALUES OF $27.51 AND $35.01 RESPECTIVELY ABOVE.
1/5TH OF FLOAT ADDS ~3% TO THIS COMPANIES VALUE. NOT MUCH IN THE SHORT TERM BUT REMEMBER IF FLOAT IS USED WELL OVER A LONG TIME IT COMPOUNDS AND COMPOUNDS THE VALUE WITHIN THE COMPANY.
MOST PEOPLE DON’T CONSIDER FLOAT AT ALL WHEN EVALUATING NON INSURANCE COMPANIES.
AT THE TIME THE COMPANY WAS A ~$75 MILLION COMPANY. IF THE COMPANY CONTINUES TO COMPOUND FLOAT AT 3% OVER 10 YEARS THE COMPANIES INTRINSIC VALUE WILL COMPOUND BY ~$26 MILLION TO $101 MILLION.
AND THIS ASSUMES NO GROWTH IN FLOAT. NO GROWTH FROM ITS VALUABLE OPERATIONS. AND NO ADDITIONS OF NEW CAPITAL FOR 10 YEARS. ALL SHOULD CONTINUE TO GROW AT THIS GREAT COMPANY.
THIS COMBINED AFFECT OF COMPOUNDING FLOAT, INTERNAL VALUE, AND OPERATIONAL PROFITABILITY COULD EXPLODE THIS COMPANIES SHARES OVER TIME.
BUT I DON’T COUNT ANY OF THIS POSSIBILITY IN ANY VALUATIONS DUE TO CONSERVATISM.
THIS IS WHY FLOAT IS IMPORTANT EVEN FOR NON INSURANCE COMPANIES. IT CAN ADD SUBSTANTIAL VALUE TO A COMPANY EVEN IF ITS ONLY ICING ON THE CAKE AS I OFTEN VIEW IT.
The above means that we’re buying (NAME REMOVED) at a massive discount to its true value.

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Again, from here I continue detailing this great company. For now let’s sum this all up before moving on to the next part of this now extended series. Is Float Ever Bad? On Float Part 6.

Summary

If I’ve explained everything well enough in the series so far we should understand –

What float is.
Why its important.
How companies can use float as positive leverage.
How Buffett got so rich using float.
How to find float on a balance sheet.
How to evaluate float.
How float affects a company and its margins.
Maybe the most important thing why float affects a company and its margins.
And how float affects a company’s value.

In the next and sixth chapter – yes I’ve now added two more parts to this now extended series – I’ll answer the question is float ever bad.

Knowing what we know now we should have a gigantic advantage over other investors who either don’t know about float. Or aren’t willing to put in the time to learn what it is and what it can do for a company and investment.

If you have any questions, concerns, or comments on float up to this point please let me know in the comments section below.

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