Value-focused investors are always on the hunt for stocks that are priced below their intrinsic value. One such stock that merits attention is Alcoa Corp (AA, Financial). The stock, which is currently priced at 26.8, recorded a loss of 5.49% in a day and a 3-month decrease of 17.57%. The stock's fair valuation is $41.18, as indicated by its GF Value.
Understanding the GF Value
The GF Value represents the current intrinsic value of a stock derived from our exclusive method. The GF Value Line on our summary page gives an overview of the fair value that the stock should be traded at. It is calculated based on three factors:
- Historical multiples (PE Ratio, PS Ratio, PB Ratio and Price-to-Free-Cash-Flow) that the stock has traded at.
- GuruFocus adjustment factor based on the company's past returns and growth.
- Future estimates of the business performance.
We believe the GF Value Line is the fair value that the stock should be traded at. The stock price will most likely fluctuate around the GF Value Line. If the stock price is significantly above the GF Value Line, it is overvalued and its future return is likely to be poor. On the other hand, if it is significantly below the GF Value Line, its future return will likely be higher.
Unpacking Alcoa's Risk Factors
However, investors need to consider a more in-depth analysis before making an investment decision. Despite its seemingly attractive valuation, certain risk factors associated with Alcoa should not be ignored. These risks are primarily reflected through its low Altman Z-score of 0.98, and a Beneish M-Score of -1.1 that exceeds -1.78, the threshold for potential earnings manipulation. These indicators suggest that Alcoa, despite its apparent undervaluation, might be a potential value trap. This complexity underlines the importance of thorough due diligence in investment decision-making.
Decoding Financial Metrics: Altman Z-Score and Beneish M-Score
Before delving into the details, let's understand what the Altman Z-score entails. Invented by New York University Professor Edward I. Altman in 1968, the Z-Score is a financial model that predicts the probability of a company entering bankruptcy within a two-year time frame. The Altman Z-Score combines five different financial ratios, each weighted to create a final score. A score below 1.8 suggests a high likelihood of financial distress, while a score above 3 indicates a low risk.
Developed by Professor Messod Beneish, the Beneish M-Score is based on eight financial variables that reflect different aspects of a company's financial performance and position. These are Days Sales Outstanding (DSO), Gross Margin (GM), Total Long-term Assets Less Property, Plant and Equipment over Total Assets (TATA), change in Revenue (∆REV), change in Depreciation and Amortization (∆DA), change in Selling, General and Admin expenses (∆SGA), change in Debt-to-Asset Ratio (∆LVG), and Net Income Less Non-Operating Income and Cash Flow from Operations over Total Assets (∆NOATA).
Alcoa Corp (AA, Financial): A Brief Overview
Alcoa Corp is a vertically integrated aluminum company whose operations include bauxite mining, alumina refining, and the manufacture of primary aluminum. It is the world's largest bauxite miner and alumina refiner by production volume, and its profits are closely tied to prevailing commodity prices along the aluminum supply chain. The company segments include Bauxite; Alumina and Aluminum. It generates maximum revenue from the Aluminum segment. Geographically, it derives a majority of its revenue from the United States.
Alcoa's Low Altman Z-Score: A Breakdown of Key Drivers
A dissection of Alcoa's Altman Z-score reveals Alcoa's financial health may be weak, suggesting possible financial distress:
The days sales outstanding (DSO) is an important financial metric that denotes the average time a company takes to collect payment after a sale is completed. Looking at the historical data from the past three years (2021: 0.73; 2022: 0.89; 2023: 0.74), there appears to be a rising trend in Alcoa's DSO.
An uptick in DSO might indicate aggressive revenue recognition practices, and in some cases, potential earnings manipulation. To explain, when DSO increases, it means the company's receivables are growing. This could be a result of sales being recorded before customers have paid, which inflates the revenue figures. In extreme cases, a company may even recognize revenue from sales that may never be collected, an action that is considered earnings manipulation. A rising DSO figure warrants scrutiny as it can signal financial distress or questionable accounting practices within the company. Therefore, investors should closely monitor such trends for early detection of any potential financial risks.
The Gross Margin index tracks the evolution of a company's gross profit as a proportion of its revenue. A downward trend could indicate issues such as overproduction or more generous credit terms, both of which are potential red flags for earnings manipulation. By examining the past three years of Alcoa's historical data (2021: 19.12; 2022: 27.89; 2023: 6.30), we find that its Gross Margin has contracted by 8.46%. Such a contraction in the gross margin can negatively impact the company's profitability as it signifies lesser income from each dollar of sales. This could put a strain on the company's capacity to manage operating costs, potentially undermining its financial stability.
The change in Depreciation, Depletion, and Amortization (DDA) reflects the rate at which a company's assets lose value over time. Analyzing Alcoa's DDA data over the past three years (2021: 674; 2022: 642; 2023: 602), a decreasing rate might be a cause for concern. This decline may suggest that the company is prolonging the useful life of its assets, possibly to manipulate earnings. By extending the lifespan of assets, depreciation charges are spread over a longer period, thereby reducing annual expenses and artificially boosting reported profits. While this may create a more favorable short-term financial picture, it could also distort the true value and condition of the company's assets, misleading investors and potentially hiding underlying operational or financial issues.
The change in Selling, General, and Administrative (SG&A) expenses provides insight into a company's operational costs, encompassing expenses related to selling products and managing the business. Examining Alcoa's SG&A data over the past three years (2021: 208; 2022: 217; 2023: 214), an unexpected decrease may raise eyebrows. While reducing these expenses can be a sign of improved efficiency, an abrupt or unexplained decrease might indicate cost-cutting measures taken to artificially inflate earnings. By selectively reducing SG&A expenses, a company can create the illusion of higher profitability and operational efficiency. However, if these reductions are achieved by neglecting essential functions like marketing, customer service, or quality control, it might result in long-term negative effects on the company's growth, reputation, and sustainability. Hence, a decrease in SG&A must be carefully evaluated within the broader context of the company's strategy, industry norms, and competitive landscape to determine if it signals potential earnings manipulation or a legitimate improvement in operational efficiency.
Conclusion: Navigating the Thin Line Between Value and Trap
While Alcoa (AA, Financial) may appear undervalued based on its GF Value, the company's financial indicators suggest potential risks. The low Altman Z-Score and high Beneish M-Score, coupled with concerning trends in DSO, Gross Margin, DDA, and SG&A, indicate that Alcoa might be a potential value trap. This underscores the importance of thorough financial analysis and due diligence before making investment decisions. While the allure of an undervalued stock can be enticing, investors must tread carefully to avoid falling into a value trap.
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