Valuing Stocks
Investors' approach to equity participation in companies has matured this century from that of a subordinated banker's view of needing to be paid regular cash dividends to the view of an owner participating in growing a business. Formerly, the value of an equity investment was calculated strictly in terms of the future expected stream of dividends, with minimal if any growth assumed for the dividend stream. With the advent and steady improvement of accounting standards and SEC regulations following the 1929 market crash, better, more reliable information led to decreased volatility in equities and a greater sense of participation by shareholders. As a result, shareholders have gradually de-emphasized dividends, a trend encouraged by unfavorable tax treatment of dividends paid to individuals. In fact, the modern view of the corporation is as a storehouse of economic value, a portion of which belongs pro rata to the shareholder. The modern shareholder prefers corporate actions regarding dividends, share buybacks, and debt that increase overall shareholder value, not just actions that result in direct compensation. Consequently, a company that can return a higher marginal return on assets than can most investors would be expected to retain and work the assets, rather than distribute them to shareholders. The anticipated reduction of the capital gains tax will provide an additional boost to this tendency, causing average dividend yield to continue its downward slide into obscurity. (Accordingly, you should ignore any market doomsayer who refers to historically low dividend yields as justification for a market crash.)
This modern appreciation of shareholder assets in a company gives rise to a more general economic means of valuing those assets. Following Warren Buffett's lead, we can define intrinsic value of a equity as the amount required to fully capitalize the future stream of cash that can be taken out of the company over its remaining lifetime.
A dividend-paying, slow-growing company in a mature industry can be viewed and valued much like a long-term bond with known interest obligations not without risk. A fast-growing company that has no intention of paying a dividend anytime soon can be valued similarly to a zero-coupon bond with a tax-deferred, variable interest rate, also with risk. Both instruments are subject to similar economic valuation, even though the latter will not return cash payments until maturity.
Although the financial market rarely prices a stock precisely in accordance with intrinsic value, if you buy the stock at the intrinsic value or less, you are guaranteed to receive a return at least equal to the capitalization (discount) rate over the long term. This guarantee is irrespective of the multiples the current market believes is appropriate for the stock, due to manias, doctors' beliefs about trailing PE ratios, money manager shenanigans, the Fed decisions about short term interest rates, short sellers, or anything else.
This guarantee strikes at the notion that the financial market somehow is the arbiter of stock values. It means that the market is subject to absolute valuations, not some ephemeral, floating, relative valuations reflective of how benevolent the market wants to be to us today and hopefully tomorrow. Like us, the market is only guessing about value, and often is best ignored.
With all these nice properties, it is indeed unfortunate that intrinsic value doesn't lend itself to straightforward calculation. If you try to calculate intrinsic value, the first thing you will find is that 90% of the calculated intrinsic value of the company will accrue to cash anticipated to flow more than ten years in the future. Think about it. The primary value of the company you own is due to a future time period well beyond your ability to forecast with any confidence whatsoever.
Equally disheartening, if you use the wrong discount rate, say you are off by a mere 100 basis points (like using 7% when you should have used 8%), then your estimate of intrinsic value may be nearly twice as high as it should be.
You don't have to be a rocket scientist to see that something is wrong with this picture. This definition of intrinsic value provides a conceptual framework, but one that is impractical to calculate in a straightforward fashion. We need a more robust estimate of intrinsic value, one based on events that we can realistically anticipate occurring over the next few years.
A way to approximate intrinsic value that meets these criteria is to calculate an estimate after a number of years in the future using the following formula:
Value = Present Value Free Cash/Share thru n
+ (PC * Free Cash n/Share) / (1+r)^n
where n is the number of years, PC is a Price/Free Cash ratio as discussed below, Free Cash n/Share is the free cash earned during year n, and r is the discount rate. The first term is the sum of each year's free cash earned divided by (1+r)^n, starting with current available free cash.
In words, an approximation for the per share intrinsic value for any future year, n, of any stock equals the per share present value of all free cash earned by year n plus the present value of a PC ratio times free cash/share earned in the nth year. This formula has the property that it will converge to the theoretical intrinsic value as n is increased, irrespective of the PC ratio used, while also being reasonably accurate when applied to mid-term estimates using an appropriate PC ratio. However, the fewer the years used for estimating future free cash, the greater is the importance of picking the proper value of the PC ratio used. I'll give you guidelines on how to pick a PC ratio below, but first, we need one more simplification.
Software companies are different from many other companies in that generally they have very simple balance sheets, with little need to depreciate or amortize assets. Partly this is because the true value of software almost never is reflected in capitalized assets. As a result, earnings from operations and free cash are nearly interchangeable. Rather than attempt to assess actual future cash requirements, a reasonable substitute applicable to many software companies is to assume that free cash equals retained earnings less a portion needed to underwrite continued expected growth, that is, add to Working Capital. Thus, we define the Potential Pay-Out ratio, PPO, as the portion of earnings that can be paid out by the company without retarding expected growth. When this simplification applies, free cash per share can be approximated by PPO*EPS.
The appropriate discount rate depends on your perspective. If you want to cost out the economic value to a market willing to treat forward earnings with absolute credibility, then the long-term risk-free rate of return, about 7%, would be appropriate. A capitalization rate for a blue chip, Buffett-like equity, probably would be the high-quality corporate bonds rate, or about 8%, which is also similar to margin interest, a common cost of buying an equity. Since our interest revolves around a small, high-tech stock, one might argue that a higher rate that reflects greater perceived risk would be appropriate, say 10% to 15%. To preserve options concerning the discount rate to use, I will consider three rates: 8%, 10% and 15%.
You should calculate intrinsic value as far out as you are comfortable projecting earnings, but never much beyond five years, and sometimes no more than two or three years. No matter how you feel about any company, it is risky to count on uncommon performance much beyond a time horizon of five years - even for a growth investor prepared to stare regression to the mean in the face. (You wouldn't be human if you didn't peek farther out, but don't invest on the basis of expected occurrences far into the future.)
While the earnings growth rate is a factor affecting appropriate value for PC, this can be finessed somewhat by thinking of PC as being proportional to the growth rate, so we just need the constant of proportionality - which is independent of growth rate.
It is not possible to estimate PPO directly from WIND's income statements and balance sheets, because over the last few years Working Capital has not been managed at the minimal level needed to promote growth. With the IPO in 1993, and a secondary offering in 1996, year to year changes in Working Capital bear no relation to net income, the expected future source of continued financing. However, adjustments to Working Capital can be made to get some idea of necessary year to year additions needed to fund operations. Examining growth in adjusted Working Capital as a percentage of the prior year's net income results is a rapidly decreasing series, which should converge to a percentage probably well under 10%. To be safe, I assume 15%, which makes PPO equal to 85%.
Now, let's put it all together and try to value WIND. To be conservative, assume that EPS will grow only for five years at 40% per annum. Assume growth then slows to 25% per annum for another five years; then to 12% for another five years; and finally to 6% indefinitely. Assume we start with next year's estimate of 57 cents EPS and around $3 existing cash/share. The intrinsic value is around $375 discounted at 8%; $190 discounted at 10%; and $64 discounted at 15%. The above approximation applied to a 5-year estimate works well with PC multiples of 6.7, 3.6 and 1.4 times that year's EPS growth rate, respectively. In other words, if you are looking out about five years for WIND, use a PC ratio of 6.7 times that year's EPS growth rate to correspond to an 8% discount rate; use a PC equal to 3.6 times that year's growth rate to correspond to a 10% discount rate; and 1.4 times that year's growth rate for the 15% rate.
Certainly out-year EPS growth of 12% falling to 6% is not indicative of a great growth company, corresponding instead to a company regressing to the mean sooner than fans of WIND expect. If WIND can continue growing at 25% for another 10 years, then regress to, say, 10%, the impact on valuation is awesome. Neither 8% nor 10% discount rates can dampen the compounding growth, so neither leads to a sensible value. Even the 15% discount rate doubles to $116 from our previous calculation of $64.
Stop and look at these numbers. If WIND actually becomes a great growth company, it will out-perform the conservative assumptions I used to calibrate the PC ratio, meaning that by any measure WIND's intrinsic value is vastly undervalued today. Unfortunately, we don't know exactly when the market must reflect intrinsic value in the price of the stock. Thus, you might ask: "We understand that long-term economic reward awaits the patience investor of great growth companies, but (forgive us Warren Buffett) what's going to happen to the stock in three to five years?"
We can compare the current market price with a reasonable estimate for what the market should be willing to pay in a few years as a reality check on short-term share value. The formula is the same, as the approximation above, but with a different PC ratio and by setting PPO = 1 in the out-year term. Rather than attempt to insert the ratio appropriate to the discount rate and down-stream growth, estimate what multiple the market is likely to pay for future earnings. (Now, PC actually takes on the role of a traditional Price/Earnings ratio.)
Here is how you can do that safely. If your EPS estimates show stable or increasing growth through the out-year used for the calculation, then you can safely use the current trailing PE ratio as a lower bound. If the EPS growth declines year on year, then reduce the PE ratio to be no greater than the ending year's growth rate, and possibly as little as one-half that amount.
The estimate this provides is a reasonable expectation of the present value of the market value in n years. Applying the formula to 40% EPS growth for 5 years, and using a PE ratio of 60 and discounted at 10%, equates to a current market value of about $97. This suggests that you can pay up to $50 per share for WIND and expect to earn a return more than 20% (10% on $97) over five years while also doubling the value of your investment. If WIND grows EPS at a consistent but even higher rate, the value of the investment will grow at a staggering rate.
The importance of a consistent EPS growth rate cannot be overstated. Suppose WIND increases EPS by 40% consistently for years. If the stock were magically valued perfectly at its intrinsic value in the beginning, the stock price would start out very high, but only increase about 10% per year. But this would not, and has not, happened. The reason is the market will not discount much of the future into the price with the amount of uncertainty it faces with a small, essentially unknown company. Thus, as each period performance becomes known to the market, the stock price will increase at a rate in excess of 40% per year, perhaps as much as doubling - in order to adjust to an increasing earnings base, and to price in more of the future. This is what has been happening to WIND's stock since mid-1994, amounting to a ten-fold increase within three years. The price will continue to out pace earnings growth (within the bounds of intrinsic value which is substantially above current market price), as long as the growth rate remains relatively stable or continues to increase.
Only by understanding the miraculous benefits of relentless compounding of earnings, can the investor fully appreciate the importance of looking ahead for inevitable earnings growth rather than at stagnate past measures of value. In this Buffet is right. The most important quality of a successful investor is his/her ability to investigate and understand the potential of a company. So is Jeff Poppenhagen, a very successful growth fund manager, quoted the Investor Business Daily saying, "There are always superior companies that should sell at superior multiples. At times like these there are always people who are always amazed that there are companies that sell at significant premiums. But I think great companies should always sell at big premiums. What I try to do is buy the dominant franchise companies, those with long-term competitive advantages, and let that compounding work for me."
If there is any consistent theme to stock market valuations over the last year or two, it is that investors are developing a growing awareness of the value of consistent, year over year growth, which is only possible for businesses that dominate their markets with an effective franchise. With the global participation in private enterprise, and with the technology to tie far-flung pieces of enterprises together, clearly the growing belief is that economies of scale and preference for established, sizable market leader provide an insurmountable advantage.
This change in kind occurring in the market place is forcing investors to value stocks by looking forward like never before. Value investing in high-tech stocks may continue to provide above-average rewards, but not without growing risks that beat-up companies will never regress upward to the mean, because there is no mean, there is just one giant market leader. Personally, I am trying to force myself to ignore "give away" stock prices, or stocks temporarily on a fast run up, and to stay focused on a small number of solid companies that are not only best in what they do in a growing market, but (hopefully) cannot be stopped by competition. Once identified, I run the numbers to verify that the price is at least fair or better, then buy enough to be significant. Probably not one stock in one hundred can satisfy these criteria if objectively administered.
Allen |
