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RCM Financial Group LLC - Professional Investment Evaluation Series:
Part I
Since Earnings Do Not Count, Ignore Them. Cash and Value Are the Only True Measures That Matter.
I have created this article for both the professional speculator and the novice investor who is serious about making informed decisions about selecting securities. I have constructed a comprehensive valuation methodology for equity securities which I will use to value several well known securities. Please read and accept our DISCLAIMER at rcmfinancial.com, before going forward.
Why do you think MSFT is offering preferred equity, along with guaranteed floors and price caps? For those who do not understand what this means, MSFT is actually buying puts and embedding them in their propsepctive new preferred stock issue. Consequently, they are underwriting a guarantee on a portion of their investor's principal so that you can lose but so much money if the stock drops to zero. On top of that, you will get current income through dividends, and you can participate in the stock's appreciation up to about 30%. Is Bill Gates playing Santa Claus?
Morgan Stanley and Goldman Sachs have most likely analyzed MSFT and came up with a killer sales pitch to Bill. Begin Speculation - "The market is severely undervaluing your common stock (contingent on your company continuing its current rate of growth). Why don't you let us underwrite a preferred offering and you can use the proceeds as a low interest loan? This loan will be lower than the rate of return on your $9 billion in the bank and lower than any loan you could ever get in this current interest rate environment. What you do is you use the preferred offering proceeds to buy back those undervalued shares (before the market realizes how valuable they are) and significantly increase the intrinsic value of the remaining outstanding, your self and your employees." - End Speculation. Well, if this is speculative melodrama is true, then those that can see through it are bound to benefit. I will attempt to empirically prove that the market is truly undervaluing the common share of Microsoft, among other widely held, liquid securities. Please read on...
Misconceptions in Valuation
Microsoft has recently released blowout earnings accompanied by a warning that earnings will decrease in the near future, as new ventures are pursued, and development is increased. Decreasing margins, in the sense that MSFT has put it are practically meaningless. Decreasing revenues are coming in small increments (which will be offset by revenues from new products). NT4.0 revenues will start really showing up in the next few quarters. Microsoft, like many other companies, use accrual accounting methods, which do not reflect real life business practices and cash flows. Microsoft defers revenue (squirrels money away in a reserve that is treated as a liability until it is offset by being earned) An example of this is the receipt of 100 miliion revenue dollars from software X sales. 25 million are recognized as revenue this year, and 75 million is put in an unearned revenue account (or its equivalent, I am not an accountant, so please excuse any misnomers). This 75 million is then "earned" as the so-called liabilities associated with it are satisfied. The primary liabilities in the software business are servicing and tech support. The dilemma is that while all of this money is sitting in a reserve as a liability and not included in "earnings", it is producing investment income and has the chance to be put to real use (i.e. R&D, marketing, etc.), therefore shouldn't it be considered income for the year produced and not in the year recognized. Since FASB (Financial Accounting Standards Boards) does not require software companies to defer revenue, Microsoft can do it in any ethical way they deem fit. By saving revenue (therefore earnings) for a rainy day, it can smooth out its volatile upgrade revenue cycle and relatively effortlessly manage Street expectations. Office '97 will probably outsell Office '95; just read the rave reviews in comparison to '95 (the Office suites constitute the bulk of MSFT revenue). Those who fail to upgrade MSFT will be lost (and I am sure they will be many).
As I alluded too earlier, the alleged decrease in margins are not truly decreased margins, but a redirection of internal investment. When companies like MSFT or Merck make money, what do you think happens to the money? They do not pay dividends, do they? They take the money and invest it internally, externally, or bank it. MSFT and Merck are investing the money internally (R&D and marketing) and are making active external investments such as acquisitions. Assuming management is competent, they will get a higher return on their investments than T-bills or the average investor. The problem is, if you invest heavily in R&D, marketing, or make an acquisition of a mutually agreed upon company of great value (thereby having to amortize the premium paid over market price for that company as goodwill), you will be increasing the value of your company by making strategic investments with your earned cash. These investments have historically increased the values of U.S. companies (Microsoft, Intel, Merck, Rubbermaid, etc.). Remember that capital is not free, and in order for a company to really gain in value, it must produce a profit that overcomes its cost of capital combined with all operating expenses. This sounds like a good common sense practice, doesn't it? Well guess what. Many managers forego synergy-producing acquisitions. Some limit the amount of cash contributed to R&D and marketing to the "just enough to get by " level. Why do such silly things? To fall into the sell side analyst trap. You see, some people truly believe that earnings are what drive stock prices. The problem is that is just not true. It is value that drives stock prices. Yet, when management feels that they come to the crossroads of tradeoffs, where they have to make a decision between earnings and value, some choose earnings. The reason? Like many retail investors, they believe that high recurring earnings will impress the Street and drive their stock prices higher.THIS IS WRONG, and it does not make much sense.
If you have the opportunity to buy a company that provides a synergistic fit with your operations and will significantly increase your competitive advantage, you should but it, right? However, if it carries a premium to its price (regardless if the premium is easily justified and compensated for by excess cash flows), earnings hungry companies will forego it. This is because they will take a significant earnings hit due to the goodwill. This is a PURE accounting term. The combined companies are worth more, but the earnings say they are worth less. In my opinion, management who conducts business in such a fashion is incompetent. Why then, do we always hear earnings this, and earnings that. It is because the majority of contact that retail investors have with the Wall Street crowd comes in the form of sell-side institutions. Sell side analysts and brokers do just what their name implies, SELL. It is not always in their best interests to have the retail investor perceive the true value of a company that they either hold in their inventory, do business with, or both. On the other hand, there is the buy side analyst, whose primary function is to find out the truth. They do exactly what their name implies, BUY. They strive to get the best value for their clients. Why don't most of us rely on buy side analysts' opinions? Because most of us cannot afford them. Since they are not paid to tout a bank or brokerages inventory or push a recent offering, they have no incentive to spread the word around. Competitive info is valuable, therefore SECRET. They work for the big boys such as George Soros and Warren Buffet, and they often know what they are doing. That s not to say that sell side analysts are not talented. They just have ulterior motives. It has always been my contention that investors cannot truly rely on sell side analysts and broker's opinions, for they have too many inherent conflicts or interests. Too often, they are touting a company for whom they provide some form of institutional (read multimillion/billion dollar) service. With such a large volume of money flowing between the two, how does the average retail investor with his $100,000, or $1,000,000 dollar account expect to get fair, unbiased advice. Hence the reliance on archaic accounting terms such as earnings, PE, EPS, book value, etc. You almost never hear the terms return on net invested capital, cost of capital, economic value added, market value added, etc.
Let us walk through an example:
Assumptions:
1.) R&D has a 1 year payoff, with a 70% successful development ratio ex. 7 out of 10 projects produce something useful.
2.) Each company earns 5% on their cash balance
3.) Marketing and advertisement increase sales by 15% per $15 dollars spent
4.) Both companies have a 30% operating margin (in accrual accounting, that includes depreciation, amortization, interest expense, R&D, Advertising etc. - RCM adds all of those non-cash expenses back into operating margin, since the money is not truly spent, we should not pretend it is - R&D and advertising should be considered investments and not expenses)
Company X:
Revenue: 100
Minus Operating Expenses: 70
Minus R&D: 10
Minus Marketing and Advertising: 10
= Net available to common: 10
Company Y:
Revenue: 100
Minus Operating Expenses: 70
Minus R&D: 5
Minus Marketing and Advertising: 5
= Net available to common: 20
Now, both companies have a operating profit of 30%, but according to analysts, Company Y is more valuable because it "earned" twice as much money as Company X. But this young upstart from rcmfinancial.com says that company X is the most valuable. Lets move forward to next year so I can illustrate my point (investing in equities involve ongoing forward activities, it is always too late to get paid from money made last year).
Company X (year 2):
Revenue1: 129
Minus Operating Expenses: 70
Minus R&D: 10
Minus Marketing and Advertising: 10
plus investment income: .05
= Net available to common: 39.05
Return on Invested Capital =(Rev. - operating exp.) /(Prev. Rev. - operating exp.) 196%
(100 revenue plus $14 yield from $20 of R&D plus 15% return of advertising and marketing - you know that thing that MSFT does so well that all the techies hate that they do so well, I hope the techies find solace in the fact that all of that advertising reduces earnings thus the value of MSFT - at least according to sell side analysts and accountants - sorry, I got carried away back to the little income statement)
Company Y (year 2):
Revenue: 108.5
Minus Operating Expenses: 70
Minus R&D: 5
Minus Marketing and Advertising: 5
plus investment income: .06
= Net available to common: 28.56
Return on Invested Capital 128%
The spread gets bigger as time goes on. Company X earned 68% more in its invested capital than company Y by ignoring earnings and following value.
The cost of capital for MSFT is 11.16% (factor in total debt, market demand for debt, price, total cash, total equity and beta) if one were to subtract cost of capital from the returns of X and Y (net of operating expenses, of course) you will get the actual economic value created, or DESTROYED, destroyed by each company. It is this measure that should be used by all investors, and it is this measure that is used by the big boys.
If you count earnings (a function of accounting class and not actual $$$), you are allowing companies to hoodwink you in regards to their actual performance, and you will never be able to value the company correctly. Many in the Silicon Investor threads did the same thing with NSCP, and you see where that stock went. NSCP is still overvalued as of my penning this article.
Valuation Concepts
The RCM (Reginald C. Middleton) Valuation Beta takes into account momentum, money flow, fundamental valuation, interest rates, cash flows, and the general market environment when calculating equity valuations. As you will see, this is an extensive process, but very comprehensive. It consists of primarily fundamental analysis techniques although momentum analysis is applied to gauge market sentiment of the securities in question. The stocks which meet the momentum and fundamental screen then have extensive fundamental data input into a Discounted Cash flow analysis and Economic Value Added model, which also produces inputs (in accordance with GAAP accounting rules) for a market relative valuation model. This module compares the outputs of the DCF model with that of the general market and/or the equities peers. The purpose of the Worksheets in the DCF model is to break the company's financials down to their lowest common denominator and apply a discount to their cash flows. The resultant figures are then ground through the economic value added model, and an imputed market value added number is then extracted. The market relative valuation model is more or less to display results in the terms that everybody wants to see (archaic accounting terms such as earnings, PE, etc.)
This comprehensive fundamental/technical analysis (known as rational analysis hereinafter) is believed by RCM to be the most comprehensive and accurate valuation model available to the institutional and retail investor alike.
An alpha version of the model is available for download. It maintains updates (via the web) and values a portfolio of stocks using five different traditional fundamental methods. Free cash flow, discounted cash flow, option pricing, and economic value methods will be added soon. Please fill out the form at rcmfinancial.com in order to join the software distribution list. This allows you to receive updates to the model, along with content on a regular basis (bi-weekly). Afterward, you can download the model from the download link at the top of the page. With this model on your system, you can follow me as I construct a model portfolio of about 16 widely held, yet undervalued stocks. Afterwards, I will go into some overvalued stocks and leveraged buyout and acquisition candidates.
Note: The statements made by Reginald C.Middleton and RCM Financial Group are commentary and opinion and are not solicitations or recommendations to buy or sell securities, but rather a guideline to interpreting data released to the public by publicly listed corporations and recognized valuation methodologies. This, any information used to illustrate the concepts mentioned herein should only be used by investors who are aware of the risk inherent in securities trading. To make this very clear in plain English, neither Reginald Middleton, nor RCM Financial Group are offering any advice whatsoever, or asking anyone to buy or sell securities. |
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