Streetwise

Lauren Rudd

Sunday, January 19, 2014

Slice the Proverbial Gordian Knot

With earnings season in full swing, many of you are going to be reevaluating current or potential investment positions. Therefore, let me again address the process of how to initially vet candidates. Bookshelves sag under the weight of numerous tomes that attempt to answer the selection issue. Moreover, being able to do so successfully is crucial to the success of your portfolio.

While the full specification of selection criteria is a bit too complex for a newspaper column(s), 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 is the dividend discount model.

In every case, the intrinsic value calculation is nothing more than projecting forward time wise a specific cash flow and then determining 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 15 to 20 percent higher than the market price. Moreover, if the intrinsic value is less than the current share price, move on. Out of approximately 10,000 listed companies, you are looking for 15 to 20. While there are exceptions, do yourself a favor 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 an example. 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 $1.89 incorporating a 5-year analyst average earnings growth rate of 8.90 percent and a discount rate of 15 percent.

The free cash flow to the firm model produces an intrinsic value of $3.99. The discount rate utilized is the average cost of capital, which for GE is 7.13 percent, along with a revenue growth rate of 12 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.