Wednesday, November 07, 2007

Can First Marblehead be worth $10?

Seeking Alpha asks: First Marblehead: Worth $10 or $60? Without going into the arguments presented, which weren't particularly quantitative anyway, I don't see how you could value the stock at $10. $60 or $30 or nothing seem better guesses.

Let's take the case for the business being worthless. Basically, if management is somehow fraudulent and has stolen or wasted all of the cash in the coffers while rendering the residuals on the balance sheet valueless. Throw in a lawsuit or ten for good measure. In that case, the company is headed for bankruptcy court. Otherwise, cash and residuals are worth about $10.80 a share all by themselves. Perhaps the residuals are carried on the books at a higher price than if they were sold on the market, but First Marblehead doesn't need to sell them at market prices as long as it's still in business. And as long as the company is still in business, its value is higher than the $10.80 per share book value.

A dividend discount model prices the current $1.10 a year dividend at $33 1/2 even if the dividend never increased. To state it another way, income of $1.10 a year forever discounted to the present at 11% is worth more than $30. Forever sounds like a long time, but it's important to remember the discount model explicitly weighs income from distant years less than income in the near future. Because the dividend in 2100 is much less likely than the dividend in 2010 it also provides a much smaller portion of the present value of the dividend stream.

Ok, so if First Marblehead isn't a complete disaster or a static income stream, what other possibilities exist? Well, it could continue to grow at a healthy, though maybe not rocket-like, pace. Presumably, the dividend cannot continue to grow at 77% like it did last year nor can earnings increase by 57%, 48%, or 112% as they did in the last three years. So let's assume the dividend grows by 10% or earnings grow by 15% over the next five years. In those scenarios, I calculate First Marblehead shares are worth about $60 each. Given some growth in First Marblehead's business, I don't think many would consider these growth rates aggressive.

At this point, you could put together an expected value based on the odds of the $0, $30, and $60 scenarios panning out, but I don't think I'll bother. The $0 and $30 values are based on completely unlikely possibilities in my opinion. They might be 5% possibilities combined. I'd say my $60 scenario has a better than 5% chance of being far too conservative, but we don't need to consider that to see that at $33 1/2 FMD is a bargain.

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