Ruger: Overvalued at $27

Ruger stock soared today with its 15% jump to around $27. Its second-quarter earnings of $.57 per share beating analyst expectations by $.15 started a buying frenzy. It led me to place a sell order.

Cyclical stocks like Ruger are hard to value. Nevertheless, I did my best with a two-stage discounted cash flow valuation model. I used Year 0 cash flow of $15 (the average over the last five years), a discount rate of 11%, a growth rate of 10%, going down incrementally to 6% at Year 10 and to 4% after that. That gives a per-share valuation of $15.98. Being a little more generous in these assumptions led me to a value of around $20 per share. At $27 per share, Ruger is overvalued by 35% to 69%. I like Ruger as a company (I wouldn't have bought its stock otherwise), but it's now an overvalued, cyclical stock. To my way of thinking, it's time to sell, not to hang on hoping for more earnings that blow away analyst predictions.

How did they beat expectations? According to today's conference call, Ruger recently introduced the 1911 handgun, which has been flying off the shelves. Some of their other new products have sold well and had better returns. Much of it has had to do with improved efficiency in their operations--and there's only so much efficiency a company can gain. On the down side, they've been able to raise their prices about 1%; a competitor seems to have started a price war. (As an aside, my favorite quote from the conference call: "About half the people who say they don't like Obama will go out and secretly vote for him." Gun enthusiasts are notoriously non-Democrat.)

A hat tip to my father for telling me what he knew about Ruger last year when it showed up on the Magic Formula stock screener--even though my phone call woke him up.

Guns, Numbers and a Late-night Phone Call

"Risk comes from not knowing what you're doing." -Warren Buffett

About a year ago, a familiar name popped up on the Magic Formula stock filter: Ruger (RGR). In the house I grew up in, this name was as well-known as Smith & Wesson and Colt Firearms are to others. My father used to be a hunter and gun collector, he checkered the grips on some of his guns, reloaded his own ammo, and even made bullets on the stove top. When I saw Ruger on the list, I immediately called him.

Dad: "Hello?"

Me: "Hi, Dad."

Dad: "Hi, Lori."

Me: "Are you in bed?"

Dad: "Yes."

Me: "I'm sorry. As long as you're awake, though, I wanted to ask you about something."

Dad: "What is it?"

Me: "Ruger stock is selling at a bargain price. Is that a good brand of guns?"

Dad: "That's one of the best there is."

Dad went on to tell me about other brands whose ownership and quality had changed back and forth, and another who had turned to using poor quality steel. But Ruger was one who made the good stuff. And their financials looked good to me. According to the spreadsheet I made then, for 2009, Ruger had no long-term debt, a return on equity of 22%, gross profit margin of 32%, adjusted debt to shareholders' equity* of 37%. Results for 2008 and 2007 were more or less similar. It looked like a company with a durable competitive advantage selling at a good price.

I bought Ruger at $12.29 on April 5, 2010, and at $13.14 on October 1, 2010. It last traded at $17.51, a gain of 42% since April 5 and 33% since October. That doesn't include dividends. In comparison, the S&P 500 (no dividends) has gained 11.15% since April 5 and 15.15% since October 1.

*Total debt / (shareholders' equity + treasury stock)