Hasbro (HAS): Part Two - Quick & Dirty Stab at Valuation

So I'm attracted to Hasbro because it appears relatively cheap at around 11x price-to-net earnings, has a respectable 10-year track record (per Morningstar's collection of its financial data), and has stable of toy brands that look strong, many of which I remember loving as a child.

We start off by listening to a Mattel presentation on the merits of the toy industry. It suggests good growth opportunities and stability through the roughest times. The past is no guarantee of future performance, but it's a pretty good place to start. I'm much more at ease extrapolating a long history of good performance into expectations for the future than I am looking at track record of bad results and expecting the business to change. So we invest a little more time to see where our research takes us.

In mid-2010 I created a humble model, a stress test of sorts, through which I would run prospective investment opportunities to see if they present a comfortable margin of safety. In simplified manner, it works something like this:

First, I look at the business's growth rates over the past seven to ten years, paying particular attention to owner earnings it generates (more or less operating income plus depreciation minus taxes minus interest minus my estimates for cash needed for maintenance capex and maintenance working capital growth) and what it does with those earnings  (i.e., does it let it accumulate as cash reserves? plow it back into the business? use it for acquisitions? pay it out as dividends? buy back shares?). Most importantly, I want to see whether owner earnings are growing at a healthy clip, staircasing in an up and to-the-right trajectory, and being used in shareholder friendly ways. 

Then I calculate the compounded annual growth rate of the owner earnings AND CUT IT IN HALF to build a margin of safety into my assumptions as early as possible. I apply that growth rate to the last full year numbers from the business. If it were to grow at my calculated rate, I want to know what its overall owner earnings will be five years from my initial investment. 

Let's just go ahead and use Hasbro as an example. Using fiscal year 2010 numbers, I calculate its owner earnings to be $360 million. Its compounded annual growth rate since 2003 has been 10.1 percent, so I'm going to use 5.05 percent in my conservative estimates. Meaning, at the end of 2015, its owner earnings would be $460 million. 

I assume that after paying dividends and reinvesting back into the business, excess cash will go to share repurchases. Without getting into all of those details now, my calculation is that Hasbro's outstanding shares would drop from 129 million today to 108 million at end of 2015. A quick bit of division and I see that Hasbro would generate 4.24 in owner earnings per share at the end of five years. 

Now I apply a multiple that those earnings. Most value investors would be aghast at this practice. After all, you should never try to guess the mind of Mr. Market! I find it no more arbitrary than trying to calculate business performance out to infinity by running a formal discounted cash flow analysis. Hasbro's current multiple is about 12. A quick look at its historic owner earnings multiple shows that it has ranged - on the low side - from 11.8x to 36.9x over the past nine years. That makes me feel comfortable that 12x is plenty conservative for my margin of safety needs. I'll use it.

So 12 times 4.24 gives me a conservative share value of 50.90. Now I add back accumulated dividends, assuming that Hasbro will continue paying out at its recent rate of 36 percent of owner earnings. I think that's pretty conservative since it means the five year dividend growth rate will only be about five percent (the same as owner earning growth rate for obvious reasons) instead of its historical 26 percent compounded rate. 

The dividends are 6.41 plus the share value of 50.90 gives me a total value of 57.31. Starting at about 33 per share today, that means the value will appreciate a total of 73.7 percent or on a compounded annual basis of 11.7 percent.

Now, where should we start quibbling about the errors in calculation or thought process? They are plenty. The point, however, is to make a quick and dirty stab at valuing the business five years hence using conservative assumptions. Each step of my process is meant to lead to an easy way to screen out investment candidates that don't merit more of my research time. Hasbro passed the early tests, meaning I thought it worthy of investing an hour to push it through this margin of safety stress test.

What do I want to discover from this stress test? That the conservative inputs suggest the likelihood of a satisfactory return for my investment. I'm not looking to thread the needle with businesses promising only  marginal upside after making ambitious assumptions of their performance. I'm looking for meaningful compounded growth after chopping their growth prospects down to earth.  As a prominent investor once said (and I paraphrase), it should be so obvious you could drive a truck through it.

Rough calculations suit my needs at this stage.

Hasbro shows promise of about 12 percent compounded growth in this test. Since the business has modest needs for reinvested capital, the bulk of the benefit comes from using owner earnings to payout investors via dividends and share repurchases. I prefer to see a clear and easy path to 15 percent compounded returns, but my impression is that Hasbro is of high enough quality that I can invest my time and take it to the next stage of research.