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Now, today's column. On Tuesday, we ran a discounted cash flow (DCF) model on Wrigley (NYSE: WWY) that assumed 11% growth and a 15.5% desired rate of return. Our beastly DCF model spit back $59.64 as the price at which to consider the shares when hoping for a 15.5% return. The stock is about $20 higher.
You may or may not notice that a correction is in order. Yesterday, the column reached a $46.27 target price when going for a 15.5% return, not $59.64 as I just cited. I found a math error that I made yesterday. Yesterday's $5.373 billion number should be $6.924 billion. I mistakenly divided the continuing value number (approximately $19 billion before being discounted) by 0.155 twice as I discounted it, rather than just once. The difference between the calculations came to $1.6 billion and moved the share price $13 higher to $59. That's good news and this was corrected in yesterday's column. However, today we're assuming a lower growth goal anyway.
Recognizing that food and beverage companies are not hypergrowth organizations, today we knock our desired rate of return down to 13%. This is still immodestly aggressive, but we want to see how this tweak in our goal changes the outcome.
Below are our numbers assuming 11% growth starting from 1998's net operating profit after taxes (NOPAT) at Wrigley, while discounting the value of future NOPAT at 13% instead of yesterday's 15.5%.
($ in thousands) Discounted Year NOPAT Value 1999 $311,501 $275,664 2000 $345,766 $270,785 2001 $383,801 $265,993 2002 $426,019 $261,285 2003 $472,881 $256,660 2004 $524,898 $252,118 2005 $582,636 $247,655 2006 $646,727 $243,272 2007 $717,867 $238,967 2008 $796,832 $234,737 -------------- $2,547,136$2.54 billion is the presumed current value of the company's next 10 years of net operating profit after taxes starting from last year's results and assuming 11% annual growth. To find the company's continuing value from the year 2009, we divide year 2009's NOPAT by the difference between our discount rate (13%) and the company's growth rate from year 11 forward. In this example, we'll assume 10% growth after year 10, rather than 11%.
NOPAT in 2009 is assumed to be $876,515. We divide that by 0.03, which is our discount rate (0.13) minus the assumed growth rate (0.10). Doing this math, we arrive at $29,217,167,000 in continuing value before discounting it. This is far above yesterday's $19 billion. Discounted at 13% to the tenth power, we arrive at $8,607,037,000 ($8.6 billion) in continuing value after year 10. Adding that to our first 10 years of value, we get $11,154,173,000 ($11.15 billion).
With 116.1 million shares outstanding, we could supposedly pay $96 for the stock and still hope for a 13% annualized return when we assume 11% annual NOPAT growth for 10 years and 10% growth indefinitely afterwards (assuming no share dilution, which isn't realistic even though Wrigley has kept the share count basically flat for years). So, $96. $96?
These results show how sensitive these models can be. If you desire 15.5% returns, pay no more than $59. If you want 13% returns, you can pay $96. How can that be?
The main problem arises when the discount rate is too close to the growth rate. It can skew the model. (And if your growth rate is higher than your discount rate, the model really doesn't work.) In today's case, our discount rate is too close to the assumed growth rate. So what are we to do? We'll try again. Our discount rate is the more important part. We hope for a certain return. The growth we slap on the company is a guess either way. We'll assume Wrigley will grow less than 11% and 10% next time, but we'll have a considerably higher discount rate.
If anything, today points out the vulnerability of these models. A good model will be realistic and give likely results (as likely as can be, anyway, which often isn't very likely). However, sometimes your desired return and the company's assumed growth rate can make for a questionable model. I believe our model from yesterday: buying under $60 could reasonably result in a 15.5% average return for years. However, I don't believe that we can buy at $96 and receive 13% returns. No way. If that were true, we could buy today at $77 and wallop the market even more than 13%. Humph! Not going to happen.
Right now, I'm betting that with these models we'll find attractive value prospects in the stock at about $70 and below, with $59 and lower being ideal prices on which to jump to action.
Let's assume almost all of the above again. Our hurdle rate is still 13%, but we expect only 9% continuing NOPAT growth from Wrigley after 10 years (again, not unrealistic we hope). In this case, our continuing value is over $21 billion. Discounted, it's $6.45 billion. Adding that to our 10-year value, we have about $8.99 billion. That equates to about $77 per share before share dilution. With dilution, we'd look for a price in the low $70s, tops. While we've done this study, Wrigley has drifted towards that price. At $74 now, Wrigley is $4 above its 52-week low. We'll keep an eye on it, of course. There is still much more to say about valuation, that nebulous beast. It's too early to assume anything other than a price range that may interest us ($70 and lower, ideally).