Talisman Energy, Inc. (USA) (TLM)

FOOLISH PICK OF THE DAY

This stock came to my attention as a CAPS personalized stock idea selection. Although flawed, I decided to look more closely. The analysis presented is based on a price of $14.66.

EPS has generally been growing for the 2001-2008 period, with a compounded annual growth (CAGR) of 35%. The return on equity (ROE) has been in double digits throughout the period and exceeded 20% for the past four years. The free cash flow, though, has not been consistently positive.

Before I look at the valuations, I look at three indicators of financial safety. For this stock, two of three are quite good. The Piotroski F is 8; 2 or below indicates caution, while 8 or 9 indicates that the stock is expected to rise within the next year. The Sloan accrual is -12.63; 5 or higher is high risk, while -5 or lower is excellent. The Altman Z, however, is 2.6 which is about midway between the risky 1.8 and safe 3.

I use more than one valuation method to gauge intrinsic value; the first three all provide a good margin of safety (MOS). The first three are standards in the valuation literature. The estimate based on Graham’s formula was $100 (85% MOS). However, capital expenditures wreaked havoc on the estimates for Earnings Power Value (value of the firm) and Discounted Cash Flow. When I lowered the ratio of CapEx to Depreciation to 150%; then the estimated EPV became, on a per share bases, to be $30 (52% MOS). Similarly, if the CapEx is halved, the Discounted Cash Flow estimate rises from $23 (36% MOS) to $79 (82% MOS). Before investing in my real account, I want to look more carefully at those Capital Expenditures and see why they are so high (comparatively speaking) and how they are impacting the bottom line.

The last two were based on a spreadsheet found on the AAII website; these are designed to mimic Buffett’s valuation methodology. One is based on projecting EPS growth 10 years into the future based on past EPS growth; I discount the resulting valuation to reflect the price at which the stock will realize a compounded earnings (including dividends when applicable) return of 15%. Based on this method the target purchase needs to be below $21, and at the current price there is a 31% MOS

The second is based on estimating EPS growth through the sustainable growth rate. The per-share projected book value is estimated by taking the previous year’s book value, adding EPS and subtracting dividends (when applicable). The projected EPS is estimated by multiplying the projected book value by the average Return on Equity, and the projected dividend is estimated by multiplying the projected EPS by the average payout ratio. I then discount the resulting valuation to reflect the price at which the stock will realize a compounded earnings return of 15%. Based on this method the target purchase needs to be below $19, and at the current price there is a 22% MOS

To ascertain that the price is attractive to me, I take one more thing into consideration. At the current price, would I expect an immediate 15% return on my investment (ROI) based on earnings and dividends? In this, the EPS represents about 21.8% of the share price by itself, so the 1.4% dividend yield is not needed. However, if the dividend had been needed to achieve the desired 15%, I also consider the risk that the dividend may be cut. This risk is assessed by evaluating several factors (Current Price, Current Yield, Current Payout Factor, Gross Margin, Operating Margin, Financial Leverage, EPS Growth). Based on this assessment, there is a moderate (most recent fiscal year) to moderate (TTM) risk that the dividend may be cut.

Because there are many stocks that meet all of my criteria, I will not actually invest in TLM at this time. However, for CAPS purposes, I feel that it will outperform the market as a whole and make a caveat-filled recommendation.