"Given the wide moat around the firm's gum business, we feel pretty confident that Wrigley's cash flows will be higher 10 years from now than they were this year. We don't see the industry changing too much in the next decade, nor do we see demand for gum slackening off for some unknown reason or some upstart charging in and stealing a portion of Wrigley's estimated 50% share of the global market. And even if we are dead wrong and there is zero earnings growth over the next decade, the company still might represent a pretty compelling investment possibility from our vantage point."
I don't especially get a kick out of quoting myself, but I think this is a line of thinking that deserves some more examination. How can anyone make money from a company that's not growing?
Inherently, what we are trying to do as investors is determine what a company (or in our case, a small percentage share ownership of a company) is really worth. Some would say that a stock is worth whatever somebody else is willing to pay for it. That may work for stock market speculators who buy flavors-of-the-month based on what the big mutual funds are buying or what the current "market psychology" happens to be, but it probably won't work for us. We are all for understanding psychology, but buying a "hot" stock on the basis that "market psychology will take it higher" is not investing, in our book. It's guesswork.
With our 17-year time horizon and well-established performance goals, we need to have more than just a random guess about what might happen in the future. Instead, we need to have a pretty darn good guess. Of course, since no one can see perfectly into the future, some level of guesswork is always going to crop up in investing. Our goal, however, is to keep the guesswork to a minimum. (If, by chance, you happen to know of someone who can see the future perfectly, we have a job for them here at the Fool.)
Instead of developing theories about the future and selecting the stocks that work best with those theories from a top-down approach, we try to limit the guesswork of investing by working from the bottom-up. In other words, we are not ones to sit around and wait until we find instances where we think the market is wrong. Instead, we accept the hand that the market gives us and try to figure if the situation is one that will allow us to meet our investment goals.
In the case of Wrigley, the market is offering us an opportunity to buy a small piece of what we feel is a great business that, all told, is being priced at $8.7 billion, give or take a few million. If we take the bait and decide to purchase shares at this price, what kind of value can we expect to get in return?
Besides free packs of gum at the end of every year, purchasing Wrigley would give us a claim on all of the future cash that will go into and come out of the company over the life of the business. Discounted back to the present, the sum of those cash flows would give us the business' intrinsic value, as articulated by the economist John Burr Williams way back in 1938.
Of course, intrinsic value is the Holy Grail of investing. We don't know for certain what the future cash flows are going to be for any given company, and neither does anyone else. But in the case of Wrigley, we believe that we have a pretty good idea of what they will be at a bare minimum, which is at least a starting point.
We've mentioned in the past that Wrigley's earnings are actually a pretty good proxy for cash flow and that they are usually directed to one of two places -- roughly half are reinvested in the business every year and the rest are paid out to shareholders in the form of dividends. Under this scenario, the dividends are then the net or "free" cash flows of the company. Considering Wrigley had some $300 million in net earnings in 1999, we will assume that the free cash flows were 0.5 of that or $150 million.
What if those cash flows didn't grow for the next, say, 10 years? Could we still earn our 15.5% annual return? Here's how the discounted cash flow model would look for the 10-year period, using our 15.5% expected return as the discount rate:
Year Discounted present value
of $150 million
Net present value = $739 million
So, what does this little exercise tell us, other than the fact that we can use the nth function on our calculators? Essentially, it tells us that the whole wad of gum is worth at least $739 million, and probably much more considering that earnings will probably grow at some rate over time and our 15.5% discount rate is pretty steep. But in our opinion, cash flows of at least $739 million from this company over the next 10 years are a pretty safe bet. This is how a business with zero earnings growth can still be a great investment over time -- if the price is low enough.
At its current price, Wrigley is trading at about 12 times the net present value of these 10-year "safe bet" cash flows. Is that an attractive price? We'll delve further into that issue and try to come to an investment conclusion on Wrigley in another column soon.