Streetwise

Lauren Rudd

Sunday, January 22, 2012

Know Thy Cash Flow

With earnings season in full swing, many of you are going to be reevaluating current or potential investments. Therefore, let me once again address the issue selecting potential investment candidates and then determining their potential value?

My bookshelves sag under the weight of numerous tomes that attempt to provide answers to those two questions. Furthermore, those topics are a key part of the investment courses I teach.

The question of selecting companies is complex will have to wait for future columns. However, let’s slice the proverbial Gordian knot with regard to the question of valuation and couch the answer in terms of intrinsic value. Intrinsic value is the present value of a specific cash flow that a company could potentially generate into perpetuity.

One question that should immediately come to mind is that perpetuity is an awfully long time. Yes, it is. However, there are some mathematical techniques that solve the issue. Another integral part of present value is the discount rate used. How do you determine that rate? It is the rate of return you demand of your investments. Regular readers know that I usually require a 15 percent return. Finally, there is the question of what particular cash flow we are talking about.

The flow of cash could come from a variety of sources. Two of my favorites are earnings and free cash flow to the firm. A third commonly used methodology, which I use rarely discuss outside the classroom, is the dividend discount model.

In every case, the intrinsic value calculation is nothing more than projecting a specific cash flow, such as earnings per year, for some number of years and then determines the present value of that cash flow. For example, the dividend discount model projects dividends going forward, at a specific rate of increase, and then calculates the present value of that dividend flow.

Now I know what you are thinking, you have not seen the inside of a mathematics text book for many years and you would like to keep it that way. Not a problem. There are numerous Internet web sites, such as ValuePro.net and Quicken.com that require only a stock symbol and will in turn spit out an intrinsic value. In the case of ValuePro.net, the basis is free cash flow to the firm, while Quicken.com uses a discounted earnings model.

As a rule of thumb, the intrinsic value should be, at a minimum, between 30 and 50 percent higher than the stock price. Here is another rule of thumb. If the intrinsic value is less than the current share price, move on. There are nearly 10,000 listed shares. You are looking to build a portfolio of between 15 and 20. While there are certainly exceptions to every rule, make your life easy and pick the low hanging fruit.

Before you investment gurus fill my email inbox with all the possible permutations and combinations of investment criteria that should be investigated prior to removing a stock from consideration, keep in mind that this is merely the first hurdle but one that must be cleared to continue. When I write about a company, I always include the intrinsic value using the two techniques just described. I do so to enable you to duplicate what I did as a part of your own research. You are doing your own research of course.

Let’s look at two quick examples. While its more recent earnings news has been encouraging, General Electric (GE) has disappointed investors over the past several years. The intrinsic value of the shares using the discounted earnings model is $1.39 using a 5-year average earnings growth rate of 12.60 percent and a discount rate of 15 percent.

Using a discounted free cash flow to the firm model, the intrinsic value is zero. The discount rate being used is the average cost of capital, which in this case is 6.95 percent. At the risk of irritating Mr. Jeffrey Immelt, the company’s CEO, GE would not meet my initial criteria to continue an analysis of the company. Remember...low hanging fruit.