Although the point of stock investing is sometimes lost in the wild fluctuations of share prices, what one is buying is really very simple: the rights to a proportionate amount of future cash flows from the company. Rule Makers are by definition companies that have a better-than-average chance for superior appreciation, and this means that they must also be able to create significant amounts of free cash.

Traditionally, the point of investing was to gain access to the cash dividends that were generated by operations. The share price became a way of handicapping the amount of dividends that were to be received, less a discount for the time value of money.

"Wait, wait. Time Value of Money? What is that? I thought you buy stocks to hopefully sell them again at a higher price." Yes, this is true. But stock prices have to go up and down based upon a fundamental reason. Stocks are not proxies for a popularity contest. Think of it like a sports team. (Oh, great, a sports analogy.) Does a sports team succeed by virtue of how popular it is? No, successful sports teams tend to have a higher number of fans, but in the end, they've still got to get it done on the field. Businesses work the same way. A rising stock price is certainly great, and it's a nice sign of investor confidence. But if it is not underpinned by a company with increasing prospects for success, then the stock price is sure to fall back down.

So, Time Value of Money. Three components. Time. Value. Money. It works like this: Grape Utilities (Ticker: PHIL) earns in net profit (the amount that is left over after all expenses are taken out) $1 per year per share of stock, before dividends. So one dollar per share is attributed to you each year for each share you own. But money that you have now is much more valuable to you than the same amount of money one, two, or ten years from now. Thus, the farther out those revenues will be earned, the less they are worth right now. Time, value, money.

What you must do is determine the appropriate discount rate. This is the percentage that you discount the money earned in the future for each year between now and the time any earnings will be realized. This is one reason why the Federal Reserve actions matter to companies. Basically, the higher the interest rates, the higher discount you should apply to future earnings. It's very similar to valuing a bond. Bonds have a coupon and a maturity date that determine its cash flow. Add all the coupons and divide by an appropriate discount rate and you should have the current price of the bond.

But what rate to use? The lowest rate that would make any sense is the current rate of the U.S. 10 year bond (currently about 6.40%), but this would only be appropriate for companies with very low levels of business risk, such as Grape Utilities. For higher-growth companies, higher rates of discount would be appropriate, as high as the implied interest rate on the company's debt, some as high as 30% per year.

For Grape Utilities, let's use the discount rate of 7%. Since we have a growth rate of zero, all we need to do is run the discounting on $1 per year. So for Year 1 we gain $1 in earnings, Year 2 is $0.93 (1 / ($1 - 0.07)), Year 3 is $0.864 (1 / ($1 - 0.07)^2), and so on. As you can guess, you can extrapolate out this amount forever if you wish, but the present benefit for each dollar will approach zero. In the case of Grape Utilities, the intrinsic value of its future cash flows is $14.27.

You'll notice that I'm not giving a precise method here. Well, I'd like to, but none really exists, and unfortunately the discount rate used can cause wide variances in valuation. For example, with Grape Utilities, if we used a rate implying more risk in its future earnings, the current value drops dramatically. At 11%, a rate we would apply to most blue chip companies, the intrinsic value would drop to $9.09. At a rate more appropriate for a higher-risk company such as Yahoo! (Nasdaq: YHOO) of, say, 28%, those future earnings are worth $3.57.

So it is important to state right here that although there are methods to reduce the universe of companies from which you run these future cash flow methodologies, keep in mind that these calculations do closer resemble art than science. Still, it is better to be generally correct than precisely wrong, so these exercises have a great deal of value.

But we haven't even added in a growth rate yet. Investors in Grape Utilities would be exchanging the potential for growth for a guaranteed bond-like return. For companies that we expect to grow, these exercises become more fun. Let's use a Rule Maker like Coca-Cola (NYSE: KO). I'm going to use a method that was introduced to me in Robert Hagstrom's book The Warren Buffett Way. How this method works is that you imply a rate of growth (another reason why knowledge about a company is so important) for the initial 10-year period and then an assumed rate of growth of 5% for years 11 onward.

For simplicity, we'll use Coke's fiscal 1999 earnings per share of $0.98 as our starting point. (For those comfortable with free cash flow, the same method can be applied. In the case of Coke, as a mature company, its earnings approximate free cash flow.) If we assume a growth rate of 11% and use a discount rate of 9% we get the following:

              Year...1      2      3      4      5
Prior Year        0.98   1.09   1.21   1.34   1.49
Growth Rate        11%    11%    11%    11%    11%
Owner Earnings    1.09   1.21   1.34   1.49   1.65
Discount Rate      .91    .83    .75    .69    .62
Net Present Value  .99   1.00   1.01   1.02   1.03

    (cont'd)  Year...6      7      8      9     10
Prior Year        1.65   1.83   2.03   2.26   2.51
Growth Rate        11%    11%    11%    11%    11%
Owner Earnings    1.83   2.03   2.26   2.51   2.78
Discount Rate      .57    .52    .47    .43    .39
Net Present Value 1.04   1.05   1.06   1.07   1.08

Present Value of Earnings Years 1-10 = $10.35

Owner Earnings Year 10            2.78
Growth Rate                         5%
Owner Earnings Year 11            2.92
Capitalization Rate                 4%
  (Discount Rate - Growth Rate)

Value at End of Year 10          72.98
  (Owner Earnings / Cap. Rate)

Discount Rate Year 10             0.39

Present Value of Residual       $28.46

Intrinsic Value Per Share = 10.35 + 28.46 = $38.81

So we have the present value of all the money that Coca-Cola would be expected to yield per share if these rough assumptions held true. Given the recent history of Coke, I'd say that an 11% rate of growth is aggressive. Still, the average analyst's growth rate estimate for Coke is currently 13.38%, so 11% may not be too unreasonable.

Hopefully you can see the potential for mischief here, or of having the ends justify the means. It's pretty easy, for example, if your value at a 9% discount seems too high, to increase the rate to 10% to yield a more "reasonable" number. Certainly the future is not knowable; we don't get tomorrow's Wall Street Journal today. (If you do, please call me. Collect.) But this exercise is most valuable if the risk rate and the growth rate are developed blind of what the results would be.

This is a lot of information to digest, but discounting cash flows (what we have just done above) is among the key calculations that can help to determine whether a company provides a better-than-average chance at superior returns.

As always, do a little homework, try some of these numbers with different companies at home, and tell us what you think on the discussion boards.

Fool on!

Bill Mann, TMFOtter on the Fool discussion boards

Related Link:

  • Motley Fool Research: Dividend Discount Model