Minyan Mailbag - Homies
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.
I have a basic question about the homebuilders. I tried to get a handle on their free cash flow by looking at standard sources, i.e. I didn't analyze the SEC filings myself. It seems that most of these builders have little, if not negative, free cash flow. If this is true it seems to me that these companies are reinvesting profits in the purchase of more land. Clearly, this has been a winning strategy to date. However, this makes it difficult to analyze the true profitability of these companies. How much of their profits come from building a house for x and selling it at x plus and how much of their profits come from rising land values? So what are their, "normalized" level of earnings?
In addition, the great Warren Buffet has repeatedly told investors to focus on "owner earnings", i.e. free cash flow. He says that earnings and EBITDA are to be ignored and that we should focus on free cash flow. When I began my cursory look at the home builders I expected to see that they were generating gobs of free cash flow. It appears to be the opposite.
Any light you can shed on this would be appreciated.
Hi Bruce -
The debate of how to value the shares of homebuilders is as old as dirt (pun intended).
The popular media can't get away from looking at P/E's to argue that homebuilders are still grossly undervalued. In my opinion concluding that homebuilders are a "good buy" because they have below market P/E's is tantamount to arguing that a biotech company with no marketed product should never be bought because it's astronomically expensive on a P/E basis. If anything, if one does not buy into the argument that this housing cycle is different, and housing has not reached a permanent plateau of prosperity (as some argue), then homebuilders remain the quintessential cyclical play, which you would buy when their P/E are through the roof and you would sell when the stocks look cheap.
In any event, precisely for the reasons that you pointed out, i.e. the constant reinvestment of profits in new land, I prefer to look at homebuilders' valuations on a Price/Book basis. This ratio presumably captures the premium the market affords the company above its book value, which includes earnings reinvested in land.
I went back to 1990 (1994 in Beazer's case) and looked at the average Price/Book ratio and Price/Book Growth Rate for Lennar (LEN), Beazer Homes (BZH), Toll Bros. (TOL), Ryland Homes (RYL) and Standard Pacific (SPF). Here is what you get through 2004:
TICKER AVG. P/B AVG. BV Gr. % P/B on 1/31/05
LEN 1.188 16.5% 2.176
BZH 1.060 19.1% 1.574
TOL 1.943 21.3% 3.042
RYL 1.237 12.1% 2.906
SPF 1.082 10.4% 1.691
Average: 1.302 15.8% 2.278
Not unlike an analysis of P/E's to EPS growth rates, with the exception of TOL - which I suspect it is given a premium because of its high-end less economically sensitive target customer, and BZH for the precise opposite reason - the historical P/B premiums are about 2x the BV rate of growth (a PEG of 2 if we want to go back to a more familiar set of statistics).
As you can easily see, today's BV premiums seem to have completely lost touch with reality, running at about 8x BV growth rates. Keep in mind that once the current boom goes bust, the companies' BV will get hammered not only by the slowing earnings, but also by the downward marking to market of the already purchased land (I am assuming that companies will be honest about this, which is a major leap of faith).
The point of this exercise is not to convince people that homebuilders are overpriced. As with anything, numbers can be found to support one's opinion.
My view that the housing market is in a bubble does not rest on any specific ratio or statistic, but rather on the scores of anecdotes of insane prices/psf., ever more clever lending schemes, lotteries for access to sales auctions, etc., which reveal the same frothy psychology that I saw before the market cracks of the late '70's and the late 80's - early 90's.
The one difference I notice currently relative to the past crazes, is the degree of obliviousness toward the downside risks of paying any price to buy a house. There seems to be no trepidation in people's minds that your house might actually end up being worth less than what you have paid, or that one may owe more on the mortgage than the house is worth.
As to when the psychology will change, your guess is as good as mine, but at that I suspect that no amount of number crunching, be it free cash flow, book values, or P/E's will make much difference.
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