ALEXANDRIA, VA (Dec. 5, 1997) -- Today's column inaugurates a tradition here in the Drip Portfolio. "Touchstone" Friday is something Jeff and I concocted as a means of bringing readers up to date with what is going on in the Drip Portfolio. So, for readers who are a new, or a little confused about what has gone on in the Drip Portfolio over the past week, Friday is your day. Any e-mail questions you send in to me (RandyB@fool.com) or Jeff (JeffF@fool.com), we will try to answer on Fridays.
Yeah, we do kinda make stuff up as we go along.
This week we continued to scour the ranks of "food" companies, loosely defined as any company that sells a branded food or beverage product in North America or the United States. Jeff did a kick-butt review of Nestle on Tuesday that was the tenth review we have done. We have about ten more, after which we will have a short list of companies from which to choose our next investment.
The reason we want to add a "food" company to the mix is because, by and large, these companies are great businesses. A huge chunk of the underlying economy is food. Food companies tend to be powerful and consistent cash flow generators that have been used by astute management as shareholder value creation machines over nearly two decades now, paying fat dividends and repurchasing lots of stock. Finally, food is a very visible product that is easy for an individual investor to track.
Yesterday, I tried to explain why we use Enterprise Value instead of just relying on market capitalization when looking at a company. As expected, my explanation only raised more questions in the minds of many readers. For some reason the concept of using enterprise value is a very alien to many investors. We are kind of biased here in the Fool HQ Research Department (which is really just me, Jeff, Alex, Dale, Rick, Jim, and Louis) because we so long ago agreed that enterprise value just made sense.
A lot of the confusion seems to hinge on the word "value." Value, unfortunately, is a very vague word. People use it both to indicate the current price of an asset (what is the value of that company today?) as well as the intrinsic value of a company derived through some valuation process (what is the ultimate value of that company given all of the available information?). When we use the phrase enterprise value, we really mean enterprise "price." What is the current selling price today of the company? What would another company have to pay in order to buy this company? This is the sense in which we mean value.
The next nexus of confusion seems to stem from adding the debt and subtracting the cash. One thing that continues to confuse me is that my house example tends to obfuscate the issue more than clarify it. People are accustomed to thinking of their equity in a house as a separate thing outside of the total value of a house. However, your equity in a house is completely contingent on the current value of the whole house. If the house is worth $60,000 and you have $40,000 in debt, your equity is only worth $20,000. If a bad market in your area causes the home's value to plunge to $50,000, it is your equity -- not the amount you owe the bank as a mortgage -- that shrinks by $10,000.
Companies are the exact same way. A company is worth a certain price based on the cash it generates and the assets it has at its disposal. If the company is worth $10 million and takes out $8 million in debt, the equity can only be really worth $2 million. Now, given that the market is a voting machine and not a weighing machine, this $2 million in equity does fluctuate independently, rising and falling with the whims of the market. However, from the perspective of someone analyzing the business, the intrinsic value does not change at all. Therefore, what you do when you use enterprise value (or price) is compare the real and actual current price to your intrinsic value.
Another reader asked why cash did not increase the value. The reason is simple. The market sets a price on the equity. The debt and the cash are fixed. Your job is to find situations where the market has mispriced the equity, considering the debt and cash a company has. If the market has gone crazy and says the stock of a company is worth $4 million when the company has no debt and $3 million in cash, when you calculate the enterprise value and get $1 million, you realize something might be wacky. When the company has $500,000 in trailing earnings and effectively trades with an enterprise value-to-earnings ratio of 2, you realize something might be even wackier.
Another way of expressing this that people use all of the time is the cash per share, which they subtract from the current stock price. If a share is worth $15 and the company has $5 in cash, many investors will say "you are really getting the stock for $10 a share." Enterprise value does the same thing, except it does it on a macro level for the whole business and includes the effects of debt as well. This is why we think that enterprise value is a much more accurate way to gauge the current price of a company than simply using market capitalization, which does not really take into account the powerful effect that debt and cash can have on a company.
Finally, a reader wrote in and asked if we were adding to Johnson and Johnson this month, given that we just got the price confirmation. Folks, I have a confession. Jeff takes care of all that stuff and he is skiing today. I know he sent a check to Intel and there ain't another check going out until Jeff gets back on Wednesday. Jeff gets all of the mail, so I don't even know the status of the Johnson & Johnson DRP without him here. If you picture us, picture me as the analytical muscle and Jeff as the operational brains of the team. If there is a fight and stock valuations are needed, you call me. If it is something to do with running things efficiently, you call Jeff.
Hope that helps. Fool on.
Day Month Year History Drip 0.62% 0.24% (10.42%) (10.42%) S&P 500 1.10% 2.97% 32.81% 3.41% Nasdaq 1.27% 2.08% 26.56% 2.52% Last Rec'd Total # Security In At Current 11/03/97 4.835 INTC $81.623 $77.563 11/14/97 1.000 JNJ $62.125 $65.188 Last Rec'd Total# Security In At Value Change 11/03/97 4.835 INTC $394.69 $375.05 ($19.64) 11/14/97 1.000 JNJ $62.13 $65.19 $3.06 Base: $900.00 Cash: $389.75** Total: $829.99 GOAL: The portfolio began with $500 on July 28, 1997, adds $100 on the 15th of every month, and the goal is to grow the port to $150,000 by August of the year 2017. **Transactions in progress: 11/24/97: $100 sent to purchase more Intel. The Drip Portfolio has been divided into