I'll admit it. I'm always looking for a shortcut. Is that really so bad? OK, maybe it is. But I think that laziness, properly channeled, can be good for your financial life.
I've written about this at greater length than it probably warrants, but my reasoning is this: If you stick with companies whose businesses are simple enough for you to understand and value, you'll probably be a better investor.
Unfortunately, it's not always easy to find those "buy once and forget about" stocks, like Starbucks (NASDAQ:SBUX). And when you find them, it usually turns out that everyone else has the same idea as you, with the result that the company is never very cheap. Again, like Starbucks.
So, in the spirit of constructive laziness, I'm going to share a couple of my favorite value-investing shortcuts with you today: the DCF calculator, and the concept of margin of free cash flow. But before we get to the payoff, we need a bit of setup. Bear with me.
Thanks in part to the boneheads on the jumbotron, there are plenty of low prices out there. Just check the new low lists and see. Something's always hitting the floor with a resounding thud. Unfortunately, there are very few times when the market makes it obvious that the price is a steal, like Home Depot (NYSE:HD) and McDonald's (NYSE:MCD) a couple of years back. Or Coke (NYSE:KO) after the "new Coke" disaster -- and maybe now. So how do you tell the difference between stocks that are being punished for good reason and those that are screaming "Buy me, puh-leeeze!"?
Ah, if only there were a simple answer, Grasshopper. If there were, we'd all be sitting on tropical beaches with frozen, parasol-shaded beverages and not a worry in our minds except for avoiding the occasional falling coconut. Since it's not so simple, folks like the cheapskates at Inside Value -- we prefer the term value investors, by the way -- can suggest several ways for you to judge whether you're getting three tens for a twenty, or the bum's rush.
Concentrate on cashMost people who are familiar with the concepts of value investing figure it's all about the P to B, or the PE: the price to book, or the price to earnings ratio. The lower the better, right? Well, I'm going to say "not really." First of all, book value is a mirage based on age-old accounting costs. It may or may not mean anything. Moving on to the second of these chestnuts, remember that there's no PE without the E. In other words, if you're judging companies by PE, you've got no way to judge companies with losses. And, of course, we all know that earnings are a mere opinion, right? It's free cash flow that counts.
Let me put it to you this way. You buy half my business. (Let's sell those little umbrellas for frozen drinks.) Now, at the end of the year, how are you going to collect your return? You want half of my opinion of how much money we made? Or do you want your half of the cash that came in?
I thought so.
When it comes down to it, the owner of a business wants to know this: How much cold hard cash can I expect next year -- and the year after that, and the year after that? And that's how we think as part owners. The next step is to figure out whether we're getting a bargain or not. That's why most of us who play by the value rules end up coming to terms with discounted cash flow analysis, the goal of which is pretty simple: to figure out how much to pay for a company based on what you expect it to pay you back.
If you click here, you'll get a clearer explanation of what we're talking about.
What I mean by those 50-cent phrases is this: How much should I pay now for the future cash flows of this company?
Simple gets complexUnfortunately, present value is more easily conceptualized than figured. Unlike a straight interest rate payment, companies are unpredictable. So, in order to arrive at a ballpark valuation, we need to decide the following:
- What's the real free cash flow produced by this company?
- How much is it likely to grow?
Alas, this is an imprecise mathematical exercise. The "art" part of valuing companies comes in making the judgment calls in order to "normalize" free cash flow. That is, can we strain out the temporary noise in order to understand what kind of money will really be flowing when the business is running, well, normally.
A lesson from successLet's take a look at one example, bankruptcy survivor MCI (NASDAQ:MCIP). When Philip made it a pick for Inside Value, he wrote "Without these short-term commitments, MCI would have produced $700 million in free cash flow in 2004, and I estimated a further improvement to approximately $1 billion for 2005. At zero growth, I put the value of the company at $25 per share."
The emphasis is mine, but you see the point. While the Street was looking at a nasty earnings picture, the value guy was straining out the muck to get a picture of what regular cash flows would look like once the ship was righted. Of course, from September until the buyout price today, that company returned 44%.
While I'm not as intrigued by the bankruptcies and other complex situations that Philip fancies, at the core, much of our valuation method is the same. Ever wonder how we can stick an intrinsic value, like the $25 above, on a company? The answer is with that dreaded, complex -- cue the spooky, monster-movie organ chords -- discounted cash flow analysis I mentioned above. But here's where we get to a couple of devices that can save you some time.
The lazy investor's shortcutThe first tool is a little wonder -- worth the price of admission to Inside Value by itself, in my opinion -- the discounted cash flow calculator.
By plugging in a few items, like expected earnings growth, current stock price, and free cash flow, the calculator spits out an estimate of intrinsic value, along with a margin of safety from the current share price.
Let's take a look back at a little value stock from last summer that treated me well: Nokia (NYSE:NOK). With the Finnish giant hovering around $12 a share and free cash flow was nearly $5 billion, what was it worth? Well, plugging the numbers into the calculator -- and assuming nearly no growth at all -- pegs the value at $17 per share, for a 35% margin of safety back then. In fact, I sold most of my shares just a few months later, near that $17 mark, for a 40%-ish gain.
That was right about the time all the analysts started coming out of the woodwork and pronouncing Nokia a "buy" once again -- in other words, after the real sale was over. Those of us who bothered to see through the short-term problems were rewarded for our work.
Shortcut for the shortcutNow, to my mind, the toughest number to come up with when running these simplified DCF numbers is the normalized cash flow. The traditional way to arrive at the figure is to pore over the financials and strain away the one-time benefits and charges. This can take a really long time, so before I do that, I perform a more simplified normalization routine by using a historical margin of free cash flow. For all I know, this is a standard analysis tool with a fancy name. I just think of it as the MoFCF.
Computing it is relatively simple. Grab a few years' worth of 10-Ks. (No excuses, now. It's free and easy.) Go to the cash flow sheet. Find cash from operations, and subtract capital expenditures. This is the (much simplified) free cash flow. Now, flip back to the statement of operations. Divide your FCF by net revenues, and voila, you have your MoFCF. This is the percentage of sales that returns to the company as cold, hard cash. Do this for a few years' results and you have a pretty good picture of how a company operates when business is running as usual.
What's it worth? Well, it lets you see through the temporary screen of bad news. After all, every company has a bad year. All those restructuring charges, hurricane and asteroid losses that have dropped earnings and spooked the Street? Applying your historical MoFCF to current and expected revenues may just give you a truer picture of the firm's cash-generating potential. Take this number up to the DCF calculator, give it a run, and see what you find.
Now, in Nokia's case, the MoFCF had actually been declining over the years, from 16% three and four year ago, to the current 12% and change. Obviously, this isn't the greatest long-term trend, but once I had a handle on the reality, it allowed me to calculate the intrinsic value based on more conservative numbers (and I think more accurate numbers) than the Street is probably using now that it is hot for Nokia again.
The MoFCF is also useful for spotting patterns that you will miss if you have your eyes on earnings. How lumpy is this company's cash flow? Does the FCF come in cycles? Where are we in that cycle?
The Foolish bottom lineLet's be honest, very few of us have time to dissect every firm that piques our interest. The beauty of shortcuts like our DCF calculator and the MoFCF is that they allow you to run rough valuations on more companies with less work. Once you see something that looks like a major bargain, you can dig in and perform a detailed workup. And, if you want someone to double-check your work, there are plenty of sharp investors in the Inside Value community. You can join them free for a month.
For related Foolishness:
- Where do you hunt for value?
- See? The answer's in the margins.
- Yes, you can profit from bankruptcy.
- Present value for pretenders.
At the time of publication, Seth Jayson held call options on Nokia, but had no position in any other firm mentioned. View his stock holdings and Fool profilehere. Fool rules arehere.
