Boring does a Buffett
Friday, April 3, 1998
by Greg Markus (TMF Boring)
PRINCEVILLE, Hawaii (April 3, 1998) -- Benchmark stock indices closed mixed Friday, with the Dow backing off after crossing the 9,000 mark, but the S&P 500 and Nasdaq closing modestly higher.
The Boring Portfolio ended a good week by closing essentially unchanged. Cisco (Nasdaq: CSCO) reached an all-time closing high of $70 11/16. Borders (NYSE: BGP) gained $1/8 to $33 7/8 in unusually heavy trading. On the downside, Andrew Corp. (Nasdaq: ANDW) slipped back under the $20 mark.
One of the books I brought along to read on vacation is Robert Hagstrom's The Warren Buffett Way. In it, Hagstrom lays out the approach that Buffett uses to value a business before deciding to buy. The method, familiar to any Finance 101 student, is to estimate the net present value of the stream of free cash flows a business will generate over time.
To do that requires "only" two ingredients: (1) the company's stream of future cash flows and (2) an appropriate discount rate. Unlike, say, a 10-year Treasury bond, neither of these things is known with any certainty for a stock. And so they must be estimated. Good estimates of a stock's value depend on sensible estimates. Good numbers in, good numbers out. Garbage in, garbage out.
Some folks regard the discounted cash flow (DCF) model's dependence on the input numbers as a flaw in the method, but it is nothing of the sort. Rather, DCF simply makes explicit the hidden assumptions that one is making when buying a given stock at a given price. Moreover, you're always free to try out alternative scenarios of cash flow streams and discount rates to get an idea of the kinds of assumptions that are required in order to justify a stock's current price.
I tried out Buffett's approach on a half-dozen stocks currently being considered for the Borefolio, and I found the results to be quite interesting. (Why I might be engaging in such an exercise while on vacation is another matter, best left for some other day.)
Warning: there's a bit of math ahead, but nothing beyond high school algebra. And, as I say, I think you'll find the story worth the effort. At least I did. Anyhow, here goes.
Consider the case of Newell Corp. (NYSE: NWL). Newell has come up a number of times in our recaps this year as a possible Borefolio buy. The company makes and distributes to mass marketers like Wal-Mart (NYSE: WMT) and Target a staggering array of consumer, household, and office products -- everything from Ace Combs to Levolor Blinds to Anchor Hocking glassware to Sharpie markers. Newell's management team is highly regarded, and the company has consistently generated solid sales and earnings growth.
The question for me, then, is not the company, it's the stock. Even a great company can be a mediocre investment if the stock is too expensive. So what's a fair value for Newell?
Here comes the math. First we need to know what Newell's "free cash flow" is -- what Buffett calls "owner earnings." This is basically the cash a company earns minus the cash it needs to reinvest in the business to keep it operating satisfactorily. Specifically, we first add together a company's net earnings and the (noncash) charge set aside for accounting purposes as "depreciation and amortization" (or D&A). This is often referred to as "cash flow."
But what we want is free cash flow -- the part that's available to the company's owners -- i.e., its shareholders. So from the "cash flow" figure we subtract what the company used for capital expenditures, or "cap ex." Whatever's left is "free cash flow."
All three numbers -- net earnings, D&A, and cap ex -- can be found in a company's cash flow statement, which is found in its annual report and/or 10-K filing with the Securities & Exchange Commission.
Once we have a company's most recent numbers, we move on to the guesswork part. We have to provide a (plausible, we hope) projection of free cash flow (FCF) for future years.
In Newell's case, the company has increased its net earnings at an annual rate in the mid-teens for some time, with D&A and cap ex growing more or less in step. Analysts who follow the company project (perhaps optimistically) that Newell can continue to do so for a good number of years yet.
For my purposes, I posited that Newell would continue growing at 15% per annum over the next three years and that the rate of growth would gradually decline to 10% at year nine (i.e., the year 2006), after which it would grow at a 5% annual rate "forever." Folks who disagree with that scenario are free to try out their own versions.
Next, we need a discount rate. For a 30-year Treasury bond, the current rate is a tad under 6%. Stocks are presumably riskier than Treasuries and consequently require a steeper discount. Here again you're free to use whatever rate you believe makes sense. Newell is a somewhat less risky than the average stock (in the sense that its share price fluctuates less than the S&P 500 does), but to be on the safe side, I used a 12% discount rate -- more or less equal to the long-run annual gain that one can expect from investing in U.S. equities.
So, first I projected out what Newell's free cash flow would be for each year 1998 through 2006, using the growth scenario I described above. These FCF values are listed in the fifth row of the table below.
Then I had to discount those future values "backwards" into the present.
Question: At a 12% annual interest rate, how much would you need to deposit today in order to have $370.2 million (principal plus interest) a year from now?
Answer: $330.5 million, because $330.5 million x 1.12 = $370.2 million. So $330.5 million is the 1-year discounted present value of $370.2 million. (Look at the "Year 1" column in the worksheet below.)
Now, using the 12% discount rate we can calculate the "present value" of each future year's estimated FCF value -- or rather we can let a spreadsheet do it for us. Those discounted values are shown in the seventh row of the worksheet. Add up the discounted future FCFs, and you have the "present value" of Newell through 2006.
After 2006 (in which Newell would generate FCF of $948.8 million under my scenario), I assume that Newell will grow at a "steady state" annual rate of 5%. That implies FCF of $996.3 million for the year 2007. With a "capitalization rate" of 7% (i.e., the 12% discount rate minus the 5% steady growth rate), it would take $14,233 million to generate that $996.3 million in FCF. So $14,233 million is what Newell would be worth at year 10, in its "steady state."
Discount that $14,233 million back to the present and you get $5,132.4 million. Add that amount to the discounted sum for years 1 through 9 (i.e., $3124.6 million) and you get an intrinsic value for Newell under this scenario of -- voila! -- $8,257 million.
Divide that amount by the approximately 160.2 million (diluted) shares of Newell stock outstanding, and you get a 1998 fair value of around $51.50 per share.
Newell closed today at $48. Interesting, huh?
That's more than enough math for a Friday in paradise. Enjoy the weekend, folks. I'm outta here!
Boring's Newell Worksheet
(Expand screen to view table)
Year (t) 1997 1 2 3 4 5 6 7 8 9 ------------------------------------------------------------------------------------ Growth rate(%) 15 15 15 13 13 12 12 10 10 Net earnings 290.4 334.0 384.1 441.7 499.1 564.0 631.6 707.4 778.2 856.0 D & A 129.9 149.4 171.8 197.6 223.2 252.3 282.5 316.4 348.1 382.9 Cap exp. 98.4 113.2 130.1 149.7 169.1 191.1 214.0 239.7 263.7 290.0 FCF ($mill.) 321.9 370.2 425.7 489.6 553.2 625.1 700.1 784.2 862.6 948.8 Discount factor .8929 .7972 .7118 .6355 .5674 .5066 .4523 .4039 .3606 Discounted value 330.5 339.4 348.5 351.6 354.7 354.7 354.7 348.4 342.2 Sum of discounted values ($mill.) = 3124.6 Discount rate (k%) = 12.0 Discount factor = (1/(1+k))**t Residual Value Calculation FCF year 9 ($mill.) 948.8 Growth rate (g%) 5.0 FCF year 10 996.3 Capitaliz. rate (k-g) 7.0 Value 14232.6 Discount factor 0.3606 Present value of residual 5132.4 Intrinsic value ($mill.) 8257.0 # shares (mill.) 160.2 Value per share ($) 51.54
Stock Change Bid ANDW - 3/4 19.81 CGO + 1/8 33.13 BGP + 1/8 33.88 CSL - 1/16 49.44 CSCO + 7/16 70.69 FCH --- 37.31
Day Month Year History BORING -0.04% 0.74% 1.82% 28.12% S&P: +0.24% 1.90% 15.69% 80.61% NASDAQ: +0.13% 1.07% 18.15% 78.24% Rec'd # Security In At Now Change 2/28/96 400 Borders Gr 11.26 33.88 200.94% 6/26/96 150 Cisco Syst 35.93 70.69 96.72% 8/13/96 200 Carlisle C 26.32 49.44 87.80% 3/5/97 150 Atlas Air 23.06 33.13 43.66% 11/6/97 200 FelCor Sui 37.59 37.31 -0.74% 1/21/98 200 Andrew Cor 26.09 19.81 -24.06% Rec'd # Security In At Value Change 2/28/96 400 Borders Gr 4502.49 13550.00 $9047.51 6/26/96 150 Cisco Syst 5389.99 10603.13 $5213.14 8/13/96 200 Carlisle C 5264.99 9887.50 $4622.51 3/5/97 150 Atlas Air 3458.74 4968.75 $1510.01 11/6/97 200 FelCor Sui 7518.00 7462.50 -$55.50 1/21/98 200 Andrew Cor 5218.00 3962.50 -$1255.50 CASH $13625.51 TOTAL $64059.89