Boring Portfolio

FelCor, Bristol Merge
...and Part 2 of DCF valuation
By Greg Markus
(TMF Boring)

ANN ARBOR, Mich. (July 28, 1998) -- Stocks resumed their southbound run Tuesday, although the benchmark averages closed off their intra-day lows. The S&P 500 fell 1.49%, while the Nasdaq dropped 1.93%.

Daily losses were slightly less awful for the Boring Portfolio. It fell 1.23%, as small- and mid-cap stocks once again took a beating.

REITs have been particularly hard hit this year, and our investment in FelCor Suite Hotels (NYSE: FCH) exemplifies that vividly. FelCor stock fell $5/8 to 28 7/16 in fairly heavy trading.

Actually, I should say "FelCor Lodging Trust." The REIT changed its name today as its acquisition of the Bristol Hotel (NYSE: BH) properties became official following yesterday's shareholder meetings at FelCor and Bristol.

FelCor is acquiring 109 Bristol hotels in return for 31.1 million shares of newly issued FelCor common stock. Based on yesterday's closing stock prices, the transaction is valued at approximately $1.7 billion, including the assumption of approximately $700 million in Bristol debt. With this transaction, FelCor's market capitalization is approximately $4 billion, and the REIT will own approximately 195 hotels with nearly 50,000 rooms and suites.

According to FelCor's press release, the average Bristol hotel has 266 keys and more than 8,000 square feet of meeting space. FelCor acquired the Bristol properties at a price of approximately $59,000 per key.

FelCor's modus operandi is to buy properties at a reasonable price and then upgrade and reposition them in order to increase average room revenues. With this sizable slug of hotels -- predominantly Crowne Plazas and Holiday Inns, and Holiday Inn Selects -- FelCor has ample opportunity to do its thing.

According to information supplied by First Call, all 13 analysts who follow FelCor continue to rate it as either a "strong buy" or a "buy." Those analysts estimate that FelCor's funds from operations will come in around $3.85 this year and rise 13% to $4.35 in 1999.

Despite those upbeat expectations, FCH now trades at 7.4 times 1998 estimated FFO and only 6.5 times the 1999 forecast. Invert that 6.5 figure and you've got the equivalent of a 15.4% yield on the stock -- a very attractive investment in this market, if you ask me.

In other Boring news, Cisco Systems (Nasdaq: CSCO) did a little back-to-school shopping and decided to purchase Summa Four Inc. (Nasdaq: SUMA) of Manchester, N.H. Summa Four is a leading provider of programmable switches.

Under the terms of the agreement, Cisco will exchange between 1.0 and 1.4 million shares of its highly-prized common stock for all outstanding shares and options of Summa Four. That works out to a price tag of around $116 million.

Summa Four's technology extends Cisco's ability to offer value-added telephony applications to new and existing service providers as well as extending these services to a voice-over-IP (Internet Protocol) infrastructure.

Speaking of Cisco -- something of which I never tire -- I'd like to continue yesterday's discussion of valuing The kid's stock.

Yesterday, I endeavored to lay the groundwork for a valuation based on estimates of Cisco's future free cash flows, discounted back to the present. That groundwork consisted of what I hoped was a fairly painless overview of the notion of "present value."

I continue here with Part 2 of the three-parter, which will conclude later this week.

The basic principle of investing is that the intrinsic value of an asset is equal to the net present value of the future cash flows an investor can expect to receive by acquiring the asset. That holds true whether the asset is an annuity, a bond, a stock, a piece of real estate, a rare coin, or a baseball card.

Of course, some of these assets are riskier than others. A Treasury bond is considered to be risk-free, in the sense that it's backed by the "full faith and credit" of the U.S. government. (No investment is literally risk-free, of course. There is some non-zero chance that the United States government could go belly up before you redeem your bond. But that's a conversation we'll save for some other day.) A corporate bond is riskier than a Treasury note, with the risk varying with the creditworthiness of the company.

A common stock is riskier yet: stock prices can fluctuate a lot, and in the event of a corporate bankruptcy, holders of the company's common stock could discover that their investments are essentially worthless. It has happened before, and it will happen again.

Investors in riskier assets typically demand an expected rate of return (or, equivalently, a discount rate) higher than the prevailing risk-free rate, to reflect the level of risk they are willing to assume with their money. For example, between 1926 and 1992 the average annual rate of return on common stocks was 12.4%, as compared with 5.8% for long-term corporate bonds, 5.2% for long-term government bonds, and only 3.6% for U.S. Treasury bills (see: Damodaran, Investment Valuation, 1996, p. 23).

With stocks, investors for much of this century considered dividends as the primary return they would receive on their investment. And so the valuation of a stock depended essentially entirely on the expected stream of dividends the stockholder would receive over time, discounted back to the present.

The valuation math for the so-called "dividend discount model" is a bit more complicated than our annuity problem -- primarily because investors generally expect dividends to increase over time rather than remain constant. And of course there is the matter of deciding what discount rate one is willing to accept, depending upon the perceived risk of the stock. Other than that, though, the valuation of a stock and an annuity are no different.

For example, if a stockholder believes that dividends on a stock will grow at a steady annual rate of, say, 5%, and if the rate of return the stockholder requires to reflect the risk of the stock is, say, equal to the "market" average of 12.4%, and if the stock's current annual dividend is, say, $4, then the fair value of the stock (for this individual) is:

$4 / (12.4% - 5%) = $4/.074 = $54.05

In general, for a stock with a current annual dividend, D, with dividends assumed to grow at an annual rate, g, and using a discount rate, r, the present value of the stock can be shown to equal

V = D/(r-g)

This handy equation is known as the "Gordon growth model," after M.J. Gordon, who discussed the model in his book The Investment, Financing and Valuation of the Corporation (1962).

Fine and dandy, but what if it's not reasonable to assume that the dividends will grow at a nice steady rate "forever"? What if it's more likely, for example, that they'll grow relatively quickly early on and then slower later on, as the company matures?

Or, even more problematic, what if the stock is one such as Cisco or Microsoft (Nasdaq: MSFT), which pay no dividends at all and aren't expected to for the foreseeable future? Are CSCO and MSFT worth zero?

Clearly not.

But first things first. For the case of dividends that are expected not to grow at a single steady rate, textbooks on valuation offer "two-stage" and "three-stage" growth models (see, e.g., Damodaran, 1996, ch. 10). With these models, the investor inserts his or her best guesstimate of the dividend growth rate for each of two (or three) distinct stages in the growth of the company of interest. The number of years in each of those stages can be varied to reflect the investor's assumptions.

So, the investor could value a stock using a scenario in which dividends grew, say, 10% annually for five years and then slowed to 5% annual growth after that. Or, the company's growth scenario could be subdivided into three periods -- one of rapid growth (and, by extension, rapid dividend growth), a second of more mature growth, and a third steady-state period of low single-digit annual growth.

In fact, with the advent of spreadsheet applications, there's no particular reason to be limited to two- or even three-stage models. Any plausible growth scenario (or even implausible ones, for that matter) can be readily plugged into a spreadsheet (as we'll see, soon).

Just bear in mind that, over the really long haul, even a Coca -Cola (NYSE: KO) or Pfizer (NYSE: PFE) can not consistently grow at a rate much faster than the macroeconomy in which it operates, or its market capitalization would eventually outstrip that of the entire economy. So don't get carried away with projecting superior growth rates far, far into the future.

(In that regard, as is obvious from inspection of the Gordon growth equation (above), if the presumed long-term growth rate, g, is not appreciably less than the discount rate, r, the valuation model will "explode.")

Okay, enough about dividends. What about growth stocks that pay no dividends at all, or only nominal ones, such as Intel (Nasdaq: INTC). How to value them?

Good question, Grasshopper.

The answer lies in Part 3.

FoolWatch -- It's what's going on at the Fool today.

07/28/98 Close

Stock  Change    Bid 
 ANDW  -  1/4   17.50 
 CGO     ---    36.50 
 BGP   +  1/8   33.00 
 CSL   -2 1/2   43.13 
 CSCO  -1 1/2   96.00 
 FCH   -  5/8   28.44 
 PNR   -  3/16  39.31 
 TBY   +  3/16  8.44 
                   Day   Month    Year  History 
         BORING   -1.23%  -2.87%   1.28%  27.44% 
         S&P:     -1.49%  -0.33%  16.46%  81.81% 
         NASDAQ:  -1.93%   0.06%  20.73%  82.13% 
     Rec'd   #  Security     In At       Now    Change 
   2/28/96  400 Borders Gr    11.26     33.00   193.17% 
   6/26/96  150 Cisco Syst    35.93     96.00   167.16% 
   8/13/96  200 Carlisle C    26.32     43.13    63.82% 
    3/5/97  150 Atlas Air     23.06     36.50    58.29% 
   4/14/98  100 Pentair       43.74     39.31   -10.13% 
   5/20/98  400 TCBY Enter    10.05      8.44   -16.00% 
   11/6/97  200 FelCor Sui    37.59     28.44   -24.35% 
   1/21/98  200 Andrew Cor    26.09     17.50   -32.92% 
     Rec'd   #  Security     In At     Value    Change 
   6/26/96  150 Cisco Syst  5389.99  14400.00  $9010.01 
   2/28/96  400 Borders Gr  4502.49  13200.00  $8697.51 
   8/13/96  200 Carlisle C  5264.99   8625.00  $3360.01 
    3/5/97  150 Atlas Air   3458.74   5475.00  $2016.26 
   4/14/98  100 Pentair     4374.25   3931.25  -$443.00 
   5/20/98  400 TCBY Enter  4018.00   3375.00  -$643.00 
   1/21/98  200 Andrew Cor  5218.00   3500.00 -$1718.00 
   11/6/97  200 FelCor Sui  7518.00   5687.50 -$1830.50 
                              CASH   $5528.69 
                             TOTAL  $63722.44