There are no guarantees in equity investing. Management does not have to pay a dividend. Equities do not have a maturity date. Even if there was a maturity date, many companies have a zero par value. Historically, par value protected investors against management issuing stock to others at a more favorable price. Investors today do not have that protection. To make matters worse, when a merger is proposed management has the authority to use your stock as currency.
For the neophyte investor to the advanced practitioner, it is essential to identify a margin of safety in every investment we consider. The extraordinary powers given to corporate management can lead to investment losses. Overpaying for bad management can lead to even higher losses. We must do our homework.
With the proposed merger of Comcast (CMCSA, Financial) and Time Warner Cable (TWC), we must study the numbers of each company. For the observant investor, one will notice the currency being used is company stock. When a company purchases another company with stock, no cash is transferred. Using stock to purchase an asset heavy company is an extremely lucrative strategy for companies with few assets but a high market capitalization, like AOL in 2000. For the company paying, like TWC's cousin Time Warner Incorporated (TWX), the high price paid could be financially devastating.
Observe below TWX decline in intangible assets. This is a chart of the declining value of the AOL "assets" Time Warner Incorporated purchased in 2000. Next to the declining intangible "assets," is Time Warner Incorporated stock price.
Since the proposed Comcast purchase of Time Warner Cable includes stock, let us examine one of the multiple ways to determine a margin of safety. Revenue is the most basic statistic. Comparing revenue to the price paid should often be the first margin of safety check an investor must do. Below is a chart of Time Warner Cable's price plotted over revenue. The astute investor would notice how cheap TWC revenue was priced in the 2009 doldrums. Investors also must observe what happened the last time TWC revenue was priced at today's levels.
Viewing those same numbers in a different format, the Price to Revenue chart makes it clear how expensive TWC revenue was in 2007 and how cheap it became in 2009. At $0.50 for $1.00 of revenue, investors in 2009 had a large margin of safety. When $1.00 of revenue was priced $3.50, investors in 2007 experienced major losses. With a proposed buyout at $158 per share, Comcast is paying $1.90 for $1.00 of revenue. Nearly quadruple the price of revenue in 2009, the price being paid is not cheap.
However, the trick is Comcast is paying in company stock. Being a stock for stock transaction, a tax free exchange sounds great. The clincher is the price of Comcast Cable currency being used. Using Gurufocus Interactive Charts, the intelligent investor would plot a chart of revenue and overlay price. Look at the historical price of Comcast's revenue. Find when the revenue was expensive by looking for times when the P/S ratio was at the highest levels. This is your homework.
Create your own charts of Comcast Cable and share your thoughts of this merger in the comment section below.
Thank you to Gurufocus for providing the Interactive Charts.
