Benjamin Graham taught that Intelligent Investors must do a thorough fundamental analysis of investment opportunities to determine their intrinsic value and inherent risk. This is best done by utilizing a systematic approach to analysis that will provide investors with a sense of how a specific company compares to another company or by reviewing the 5 Most Undervalued Companies for the Defensive Investor – April 2015. By using the ModernGraham method one can review a company’s historical accomplishments and determine an intrinsic value that can be compared across industries. What follows is a specific look at how Red Hat Inc. (RHT) fares in the ModernGraham valuation model.
Company Profile (obtained from Google Finance): Red Hat, Inc. (Red Hat) is a global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, virtualization, middleware, and, storage and cloud technologies. Red Hat employs an open source software development model that uses the collective input, resources and knowledge of a global community of contributors who collaborate to develop, maintain and enhance software. The Company distributes its software offerings under open source licenses that permit access to the software’s human-readable source code. It provides its software offerings primarily under annual or multi-year subscriptions. A subscription generally entitles a customer to new versions of the software, security updates, fixes, functionality enhancements and upgrades to the technology.
Defensive Investor – must pass at least 6 of the following 7 tests: Score = 3/7
- Adequate Size of Enterprise – market capitalization of at least $2 billion – PASS
- Sufficiently Strong Financial Condition – current ratio greater than 2 – FAIL
- Earnings Stability – positive earnings per share for at least 10 straight years – PASS
- Dividend Record – has paid a dividend for at least 10 straight years – FAIL
- Earnings Growth – earnings per share has increased by at least 1/3 over the last 10 years using 3 year averages at beginning and end of period – PASS
- Moderate PEmg ratio – PEmg is less than 20 – FAIL
- Moderate Price to Assets – PB ratio is less than 2.5 or PB x PEmg is less than 50 – FAIL
Enterprising Investor – must pass at least 4 of the following 5 tests or be suitable for a defensive investor: Score = 2/5
- Sufficiently Strong Financial Condition, Part 1 – current ratio greater than 1.5 – FAIL
- Sufficiently Strong Financial Condition, Part 2 – Debt to Net Current Assets ratio less than 1.1 – FAIL
- Earnings Stability – positive earnings per share for at least 5 years – PASS
- Dividend Record – currently pays a dividend – FAIL
- Earnings growth – EPSmg greater than 5 years ago – PASS
|Value Based on 3% Growth||$12.40|
|Value Based on 0% Growth||$7.27|
|Market Implied Growth Rate||39.77%|
|Net Current Asset Value (NCAV)||-$2.92|
Balance Sheet – February 2015
Earnings Per Share
Earnings Per Share – ModernGraham
Red Hat does not pay a dividend.
Red Hat Inc. is not suitable for either the Defensive Investor or the Enterprising Investor. The Defensive Investor is concerned with the low current ratio, inconsistent dividend history, and the poor PEmg and PB ratios. The Enterprising Investor is concerned with the level of debt relative to the current assets along with the lack of dividends. As a result, value investors following the ModernGraham approach based on Benjamin Graham’s methods should explore other opportunities. As for a valuation, the company appears to be overvalued after growing its EPSmg (normalized earnings) from $0.45 in 2011 to $0.86 for 2015. This level of growth does not support the market’s implied estimate of 39.77% growth, leading the ModernGraham valuation model, based on Benjamin Graham’s formula, to return an estimate of intrinsic value well below the price.
The next part of the analysis is up to individual investors, and requires discussion of the company’s prospects. What do you think? What value would you put on Red Hat Inc. (RHT)? Where do you see the company going in the future? Is there a company you like better? Leave a comment on our Facebook page or mention @ModernGraham on Twitter to discuss.
Disclaimer: The author did not hold a position in Red Hat Inc. (RHT) at the time of publication and had no intention of changing that position within the next 72 hours. Logo taken from Wikipedia for the sole purpose of identifying the company; this article is not affiliated with the company in any manner.