FOOL ON THE HILL
An Investment Opinion
How Revenues = Share Price Bill Mann (TMF Otter)
November 17, 1999
Continuing the theme from my prior articles (see Fool on the Hill, Nov. 3 and Fool on the Hill, Nov. 5) of general investment concepts, I'm going to focus today on what exactly investors are purchasing when they buy stocks.
I know, this type of review may be about as much fun as watching the furnace run, but really, it's important, and although it seems that everyone who owns equities THINKS they know what it is they have purchased, I'm here to tell you, it ain't necessarily so.
So today, we're gonna do some math. No heavy lifting, just some simple precepts. The Fool isn't about turning investing into rocket science; we've got the Wise for that. What we're going to do here is provide a little background on what companies are expected to do by virtue of their per share prices.
What is a stock price based on? Is it how many people like the company? Is it an election that just never ends? Well, sort of, from a short-term perspective. A share price is the representation of what the last people who bought or sold a stock believe its value will be with all the information available AT THAT TIME.
But that's still kind of squishy, isn't it? So let's take it a step farther: The price of the stock is representative of all future earnings discounted at an appropriate rate. Let's break this down into bits. I'm sure that most Fools "get" this, but I see so many Verve-Airlines-is-runnin'-to-60-type comments that I'm sure that a refresher would not hurt.
Two basic components here:
All Future Earnings -- Pretty simple, right? How much profit is the company going to make from now until the cows come home? Notice that this does not say "revenues." Revenues in and of themselves do not inherently add value to a company if it does not have prospects for delivering a profit in the process of operations. For example, Verve Airlines' (Ticker: BARF) 1998 gross revenues were $3.6 billion dollars. From these revenues, Verve Airlines reported a net operating loss of $1.6 billion. How much value should a prudent investor attach to those revenues? The answer, if we're looking at this number in a vacuum, is zero.
Discounted at an appropriate rate -- Also not too tough, but a bit more conceptual. The best way to look at this is by using the "Present Value of Money." If you are guaranteed to make $100 per year in profit for your fish-eyeball rendering work, the money you make this year is more valuable to you RIGHT NOW than the money you will make in the year 2020, even though both are $100. Why? Due to probable inflationary pressure (even at 2% per year, 20 years from now $100 is worth $68.12). Other intangible beasties that can eat away at the present value of future profits include opportunity costs, income stability, risk of realization, and sunspots.
Don't worry, we'll chew into this in a way that's understandable.
Stick these two components together and you are ready to try to analyze the intrinsic value of the company you are researching. In Security Analysis, Ben Graham defines intrinsic value as "that value which is determined by the facts." By "facts" he is including assets, dividends, income, and the stability thereof.
So let's take a couple of examples. First, let's look at a fairly stable company, one in an industry that we tech-minded Fools rarely venture to, but without which our refrigerators would smell terrible. I'm speaking of Church & Dwight (NYSE: CHD), makers of all the products marketed under the name Arm & Hammer. Not exactly a momentum stock, right? Let's break down this company's earnings, straight from its most recent 10-Q:
(In millions except per share)
Earnings (trailing 9 months): $34.00 Earnings growth (98-99): 59% Revenue growth (98-99): 9% Per share earnings (ttm): $1.06Look at that earnings growth!! Pretty staggering, eh? Certainly one would expect a profit margin increase of this size from a more immature market. Church & Dwight's product lines are not positioned in an area of enormous top-line growth, and in the long run the bottom-line percentage growth should generally track revenues, with good companies exceeding by a percent or two. Additionally, the company has shown a consistent, albeit slow, history of revenue growth. On average, over the past five years, Church & Dwight's net profit growth has been closer to 10%, so we'll go with that figure.
So here comes the art portion of defining a company's present value (i.e., the stock price). You have the earnings, you have the rate of growth. But what do you discount at? This is where you get to add your concepts of risk in. For me personally, the lowest percentage I would ever use would be the current long bond rate, and I would only use that for companies that are so stable that their earnings could best be described as "annuities." Church & Dwight comes close to this definition, in my opinion, though not quite. For the sake of the exercise, I am going to discount its earnings at 7% per year.
By using these variables, I get a valuation of the company.
Year Income Growth Discount Pres. Value Pres. 1.06 10% 7% 1.06 1 1.17 10% 7% 1.08 2 1.27 10% 7% 1.10 3 1.39 10% 7% 1.11 4 1.51 10% 7% 1.13 5 1.65 10% 7% 1.15 6 1.79 10% 7% 1.16 7 1.96 10% 7% 1.18 8 2.13 10% 7% 1.19 9 2.32 10% 7% 1.21 10 2.53 10% 7% 1.23 11 2.76 10% 7% 1.24 12 3.01 10% 7% 1.26 13 3.28 10% 7% 1.28 14 3.57 10% 7% 1.29 15 3.90 10% 7% 1.31 16 4.25 10% 7% 1.33 17 4.63 10% 7% 1.35 18 5.05 10% 7% 1.37 19 5.50 10% 7% 1.39 20 6.00 10% 7% 1.40 Total: $24.76(Total represents aggregate present value of all future earnings.)
The current share price of Church & Dwight is $29.25, which means that the current consensus among those holding the company is for somewhat more aggressive growth in revenues than I have shown in this simple model. Is that a probable outcome? Sure, given the 59% growth in earnings over last year, my forward estimate looks pretty conservative. In doing this exercise I can make an initial determination as to whether a company is valued properly, but it requires my own assessment of the potential profit growth for the company as well as an adequate discount for risk.
It is for this reason that I, personally, do not "get" the valuation of Amazon.com (Nasdaq: AMZN). This has nothing to do with the ability of Bezos & Co. to make a profit. In the long run, I will be surprised if they do NOT make the company profitable. But to my mind, the valuation levels for Amazon make it absolutely necessary for the company to hit a grand-slam each and every year. Let's look at it this way. If Amazon.com becomes profitable in 2001 (I'm talking about operations here, it's not quite fair to count a company's merger and acquisition activity against it), it's going to have to average 62% profit growth over the following 18 years. Again, to show how this is NOT exact, I've assigned a relatively high rate of risk, 18%, because the company has no history of operating profits. A lower rate of risk would allow me to assign Amazon a lower growth rate, but at the same time, Amazon IS high risk, thus the higher rate. For really high-risk companies, (Indonesian gold mines and the like), I'd assign discount rates that approach loan shark levels.
But each person must determine his or her own rate of risk. Fortunately, it is a sliding scale. You can use a simple model like the one above on companies for which you believe you know the future return and move outward into higher growth companies from there.
'Til next time, Fool on!