Intrinsic Value
...Conclusion of a three-part series
by Greg Markus
(TMF Boring)
ST. PAUL, Minn. (July 31, 1998) -- Friday's Boring recap comes from the home of Pentair (NYSE: PNR), one of the Boring Portfolio's investments. Pentair's various divisions make things like power tools, pumps, and those gray steel boxes that house electrical equipment. Boring, right?
Well, apparently ultra-cool Wired magazine doesn't think so. Wired's August edition displays a full-color photo of Pentair's latest pride and joy, the Porter-Cable "Bammer" cordless nailgun.
According to Wired, "The Bammer can sink nails through 2.5 inches of oak as quickly as you can squeeze the trigger."
The Bammer is the first nailer with an oil-free internal combustion engine. It uses volatile gas propellant to propel around 3000 shots per fuel cell. All of which explains, I guess, why Wired featured this cool tool in its "Fetish" section.
The balance of tonight's recap concludes a three-part series on stock valuation using the discounted free cash flow method. Cisco Systems (Nasdaq: CSCO) serves as our example.
Part 1 of the series discussed the concept of "present value." Part 2 showed how that concept can be used to value a stock by means of the discounted dividends approach.
Many growth stocks -- Cisco, for one -- provide no dividends at all, however. How to value them?
That's what we cover here.
The owner of a share of common stock owns a piece of a business, and that piece has value whether or not the business currently (or ever) pays dividends to shareholders. What the shareholder "owns" is a share of the cash profits that remain after the business has covered its expenses. Financial texts refer to this as "free cash flow." Warren Buffett has a more descriptive name for it. He calls it "owner earnings."
There are various ways that folks calculate free cash flow, and some are more complicated than others. For our purposes, we'll use the method that Buffett uses, as described in Robert Hagstrom's book, The Warren Buffett Way. In a nutshell, free cash flow (or "owner earnings") is the cash a company makes minus the cash it needs to reinvest in the business to keep it operating satisfactorily.
Specifically, Buffett first adds together a company's net earnings and the (noncash) charge set aside for accounting purposes as "depreciation and amortization" (or D&A). The resulting sum is commonly referred to as "cash flow." The "Value Line" for a stock, as provided in that highly useful publication of the same name, is based on just such a definition of cash flow, by the way.
What we want, though, is free cash flow -- the part that's available to the company's owners -- that is, the shareholders. To arrive at this, we follow Buffett's lead and subtract from cash flow the amount the company requires for its capital expenditures, or "cap ex."
All three numbers -- net earnings, D&A, and cap ex -- can be found in a company's Statement of Cash Flows, which is found in its 10-K filing with the Securities & Exchange Commission. That filing, in turn, can be obtained by request to the company or, more conveniently, directly from the SEC's EDGAR website.
The table below shows the net earnings, D&A, and cap ex values for Cisco on a per-share basis for the fiscal years 1994-97. (Cisco's fiscal year ends in July.) Certain one-time items (acquisition-related expenses, mostly) have been excluded from the presentation.
Fiscal Year 1994 1995 1996 1997 Net earnings $0.40 $0.58 $0.91 $1.37 D & A .05 .08 .16 .25 "Cash flow" $0.45 $0.66 $1.07 $1.62 Cap ex .08 .14 .29 .33 Free CF $0.37 $0.52 $0.78 $1.29
Note that Cisco's free cash flow increased by 41%, 50%, and 65% in FY 1995, '96, and '97, respectively. That's impressive, to say the least. Cisco is among the most powerful free cash flow generating engines on the planet.
There is such a thing as too high a price to pay for part-ownership of even as impressive a free cash flow machine as Cisco, however. Determining how high is "too high" is what this exercise is all about.
The answer to that question depends less on where Cisco has been than it does on where it is going. A valuation of a stock requires "only" two things: (1) a stream of future free 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 upon sensible estimates of future cash flows and a plausible discount rate. Good numbers in, good numbers out. Garbage in, garbage out.
Some folks regard the discounted free cash flow (DFCF) model's dependence upon the input numbers as a flaw in the method, but it is nothing of the sort. Any valuation method has assumptions built into it. DFCF simply makes explicit those assumptions. Moreover, you're always free to try out alternative scenarios of free cash flow streams and discount rates to get an idea of the kinds of assumptions implicit in a stock's current price.
For my purposes, I used analysts' current estimates of Cisco's free cash flow for FY98 (which ends today) and FY99. I further assumed that Cisco's FCF would increase at an annual rate of 25% for the four years thereafter (i.e., FY 2000 through FY 2003). Finally, I posited that annual growth would slow to 20% for three additional years and would further decline to a mature rate of 8% per annum "forever" after that.
As I say, folks who disagree with that scenario are free to use their own versions, changing the growth rates and the time spans for such growth as they wish. There's nothing magical about my assumptions. They merely reflect what I would personally be willing to accept in deciding whether or not to buy Cisco stock. Alternatively, you can think of them as the kind of assumptions required to support the fair value for the stock that we're about to calculate.
Next, we need a discount rate. Here again, you are free to use whatever rate makes most sense to you. I used 12.5% -- more or less equal to the long-run annual gain that one can expect from investing in U.S. equities. Depending upon the degree of risk you associate with Cisco actually obtaining the kind of future growth posited here -- or depending upon the return you could obtain at an equivalent level of risk by investing in something else -- you could alter the discount rate higher or lower.
With your assumptions in hand, all that remains is to do the math to arrive at an estimate of fair value.
First I projected out Cisco's trajectory for free cash flow using the growth scenario described above. Those FCF values are listed in the table below.
Then I had to discount those future values "backwards" to the present. (For example, at a 12.5% annual discount rate, how much would you pay today in order to receive $2.09 a year from now? Answer: $1.86, because $1.86 x 1.125 = $2.09.) Using the 12.5% discount rate, we can calculate the "present value" of each FCF value as described on Monday in Part 1 of this Boring series. Or, rather, we can let a spreadsheet do that work for us.
Those discounted values are also shown in the table below.
Add up all those discounted FCF values, and you have the "present value" of Cisco's annual FCFs through 2006: $21.27.
After 2006 -- in which Cisco would generate FCF of $8.82 under my scenario -- I assume that the company will grow FCF at a "steady state" annual rate of 8%. That implies FCF of $9.52 for the year 2007.
Next, using the Gordon growth model described in Part 2 of this series, we calculate the fair value in the year 2006 of a stock that would provide FCF of (approximately) $9.52 in the following year and additional FCF increasing at 8% annually thereafter, with a discount rate of 12.5%. That's simply
$9.52 / (.125 - .08) = $211.61
Almost done.
Discount that $211.61 value back to the present (i.e., multiply by 0.3897...) to get $82.47. Add that amount to the discounted sum for fiscal years 1999 through 2006 (i.e., $21.27) and you get an intrinsic value for Cisco under this scenario of -- voila! -- $103.74.
That's within a dollar or so of the new high that Cisco set recently.
Interesting, huh?
Fiscal Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 Net earnings $1.75 $2.16 D & A .35 "Cash flow" $2.10 Cap ex .40 Free CF $1.70 $2.09 $2.61 $3.27 $4.08 $5.10 $6.12 $7.35 $8.82 Discount factor .8889 .7901 .7023 .6243 .5549 .4933 .4385 .3897 Discounted value $1.86 $2.06 $2.29 $2.55 $2.83 $3.02 $3.22 $3.44
Sum of discounted values = $21.27
Discount rate (r%) = 12.5 Discount factor = (1/(1+r))**t
Residual Value Calculation FCF year 9 $8.82 Growth rate (g%) 8.0 FCF year 10 $9.52 Capitalization rate (r-g) 4.5% Residual value $211.61 Discount factor 0.3897 Present value of residual $82.47 Intrinsic value: $21.27 + $82.47 = $103.74
Stock Change Bid ANDW + 3/16 17.50 CGO -1 5/8 36.88 BGP -1 1/8 31.38 CSL - 1/4 43.94 CSCO -2 11/16 95.75 FCH - 7/16 27.63 PNR --- 39.75 TBY - 7/16 8.19 |
Day Month Year History
BORING -2.13% -3.92% 0.19% 26.07%
S&P: -1.95% -1.16% 15.48% 80.28%
NASDAQ: -2.46% -1.18% 19.23% 79.87%
Rec'd # Security In At Now Change
2/28/96 400 Borders Gr 11.26 31.38 178.73%
6/26/96 150 Cisco Syst 35.93 95.75 166.47%
8/13/96 200 Carlisle C 26.32 43.94 66.90%
3/5/97 150 Atlas Air 23.06 36.88 59.92%
4/14/98 100 Pentair 43.74 39.75 -9.13%
5/20/98 400 TCBY Enter 10.05 8.19 -18.49%
11/6/97 200 FelCor Sui 37.59 27.63 -26.51%
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 14362.50 $8972.51
2/28/96 400 Borders Gr 4502.49 12550.00 $8047.51
8/13/96 200 Carlisle C 5264.99 8787.50 $3522.51
3/5/97 150 Atlas Air 3458.74 5531.25 $2072.51
4/14/98 100 Pentair 4374.25 3975.00 -$399.25
5/20/98 400 TCBY Enter 4018.00 3275.00 -$743.00
1/21/98 200 Andrew Cor 5218.00 3500.00 -$1718.00
11/6/97 200 FelCor Sui 7518.00 5525.00 -$1993.00
CASH $5528.69
TOTAL $63034.94
