In yesterday's Rule Maker article, I touched upon a topic that is quite ignored in many investing discussions -- that of discounting cash flows to determine the value of a company. Judging from the response, I've hit upon something that a certain subset of people would like to hear about more often. Discounting cash flows is not a simple concept, nor is it all that accurate, but if there were a tool that would truly answer if a company is "overvalued" in relation to its projected earnings, this would be it.
But in trying to make the concept of discounting cash flows palatable to the novice, I oversimplified and left out a pretty key concept. Fortunately our Fool Community is populated by people who are bright, inquisitive, and, most importantly, willing to share their time, talents, and experience. Case in point: this post by WonderPup, who reminds me that I have used a discount rate, when I should have used a discount factor instead. WonderPup paraphrases Stephen Kellison's book on the subject, The Theory of Interest, to improve upon and correct what I wrote yesterday:
"To plagiarize Kellisonï¿½ here is an example of the difference between the two. If you borrow $100 at an interest rate of 7%, at the end of the year you will owe the original $100 plus the year-end interest payment of $7, for a total of $107. If you borrow $100 at a discount rate of 7%, the $7 fee is withdrawn immediately, giving you $100 - 7 = $93 for use during the year. At the end of the year, you owe the amount of the loan, $100. In both cases, the fee was $7; but a 7% interest rate gave you the use of $100 for the year, while a 7% discount rate gave you the use of $93 for the year. Obviously, the former is more advantageous."
How simple is that? And it does make a difference over time. To recall yesterday's case of discounting Coca-Cola's (NYSE: KO) cash flows at 9%, the discount factor per year is the inverse of one plus the interest rate, or 0.917 (1 / 1+.09), as opposed to 0.91 (1 - 0.09), as I stated yesterday. This makes the net present value of the first 10 years of earnings $10.85, nearly 5% higher.
The next question that arises from this exercise is the appropriateness of increasing or decreasing the discount factor based upon the risk of the company. The thought is, particularly for high-growth companies, that there is insufficient risk factored into a standard discount factor and, thus, there may be the need to add in more "risk factor." For this, some use a variable of the company's beta, such as a Dividend Discount Model variation. I use the company's bond interest rate, or that of a company rated the same by Moody's if the one in question should have no outstanding debt.
Others believe that the discount factor should be a constant, and it is more appropriate to adjust the growth factor to account for risk. I see validity in both arguments, and I am reminded of the fact that both models depend on significant guesswork by the investor. So while applying a risk factor by adjusting growth may be more mathematically correct, this would involve trying to determine what the growth rate would be, not just for one year, but for all years in the range. This is patently impossible to do with much accuracy. I find it just as appropriate to use the company's debt ratings given by Moody's, who are experts on determining the debt default potential for companies, and using their work as the discount factor. As I said, there are many ways to approach this, and you can make it as complicated or as broad-brushed as you like.
So, as we all know right now, the Federal Reserve raised the target for the federal funds rate by 50 basis points from 6.00% to 6.50%. The purpose of this tightening move is to increase the cost of individual and, more importantly, commercial debt to slow the rate of growth of the economy. The overarching concern of the Fed remains that the economy is growing so quickly since equity dollars are so easily and cheaply leveraged with debt dollars that it fears that the rate of inflation will pick up, decreasing the value of future earnings.
The theory is that consistent, slower growth is healthier for the overall economy than explosive, lumpy growth. In order to foster this, the Federal Reserve theoretically removes liquidity to limit growth when it gets to be too high, and adds liquidity when the rate of growth stagnates. It doesn't always work this way, because the economy is much more complex than a stimulus/response automaton, but this is one of the few tools the Fed has. (The other big one is the federal limits on margin interest. Oh, and Greenspan's bully pulpit.)
While Greenspan is not specifically going after the "irrational exuberance" of the stock market, he has let it be known that he's concerned about the wealth effect to the health of the economy, pointing out the huge gains in equities and real estate. So while stocks and the underlying operations of companies are by nature held down somewhat in higher interest markets, there is a strategy that can help. Take a look at the companies you own and see which ones are funding their growth out of cash flow. Companies that are drinking at the debt or equity trough are going to have a much harder time for each incremental raise in rates. The no- and low-debt companies like Cisco (Nasdaq: CSCO), Microsoft (Nasdaq: MSFT), and Nokia (NYSE: NOK) are in a much stronger position to weather rate increases than are capital-intensive companies.
In the end, though, rates have been this high before, and they will at some point be this high or higher again in our lifetimes. Heck, it seems like they'll be higher next month. If you're invested in companies that are optimally designed for long-term growth, you've got a great hedge against interest rate hikes. A company that can execute its business plan under less-than-optimal conditions, one that can maintain pricing power even when overall demand drops, should be held on to for dear life.
Thanks to all for the feedback.
Bill Mann, TMFOtter on the Fool Discussion Boards.