Whodathunk that over the last year, long-haul powerhouses such as Microsoft (NASDAQ:MSFT) and United Technologies (NYSE:UTX) would have posted stock returns basically in line with those of the small-cap-centric Russell 2000 benchmark?
Indeed, during the worst phase of the market's summer-to-fall swoon, that trend line was writ large. The Russell 2000 small-cap benchmark outperformed its larger brethren in the Russell 1000, even as the market's fear/greed pendulum swung hard in the direction of "fear."
The bigger they are ...
You might think that big boys such as Microsoft and United Technologies would be precisely the kinds of companies to excel during troubled times, benefiting from a fabled investor "flight to quality." With impressive long-term track records of cranking out loads of free cash flow (FCF) -- the ultimate lifeblood of any company -- these companies are the very definition of "stalwart." Yet both trade with price-to-earnings (P/E) multiples that currently hover in single-digit territory.
Compare that with the likes of Amazon.com (NASDAQ:AMZN) and Research In Motion (NASDAQ:RIMM). Sure, these are great businesses, too, with demonstrated operational acumen. But despite far lumpier cash flow histories, each trades with a P/E that surpasses the broader market's and positively dwarfs Microsoft's and United Technologies' multiples.
Why? In large measure, it comes down to earnings forecasts.
Even in this troubling environment, analysts project far rosier earnings-growth scenarios for these racier companies than for our pair of cash cows. Admitting in a companywide memo that Microsoft "is not immune to the effects of the [deteriorating] economy," CEO Steve Ballmer laid out a series of cost-cutting initiatives, including 5,000 layoffs. United Technologies is also announcing layoffs in response to lower demand for business jets. In short, investors have reasons to be somewhat skeptical of these companies.
This line of thinking would be fine, except:
- Earnings forecasts frequently dissipate on contact with reality.
- Earnings lend themselves to accounting obfuscation, frequently via deferred or "one-time" charges that make apples-to-apples comparisons virtually impossible.
Free cash flow, on the other hand, is money in the bank, a crucial metric that can help answer the one question every investor must ask:
Is the price right?
We've all heard the adages about buying low and selling high, but to correctly identify the right price at which to buy requires some way to estimate what the stock is worth.
To do so, you'll want to determine the rate of return you require, given the business risk of the company you're considering. This figure is known as a "discount rate," and for the sake of simplicity, you should consider going with the market's historical rate of return (roughly 10.5%) for the Microsofts and United Technologies of the world. As you step down the market's cap-range ladder into mid- and small-cap territory, be sure to dial that figure up accordingly. You should also follow that trend line for riskier companies and racier growth plays.
For steps two and three, examine a company's cash flows, and then sneak a peek (with a large grain of salt) at analyst earnings-growth forecasts for the company. That data is available for free via Yahoo! Finance, where you'll also be able to snag two last vital signs you'll need to make a viable estimate of your prospect's truth worth: How many shares the company has outstanding, and its current stock price. Armed with those bits of readily available information, you'll be well-equipped to estimate a fair price for your prospect -- and to determine whether that price provides a sufficient downside cushion.
Ta da!
The process we've just outlined is known as "discounted cash flow analysis" (DCF), and it lends itself particularly well to companies whose cash flows are relatively steady, though they don't necessarily have to be spectacular. Here's an example of how to run a DCF.
If you're looking for a worthy candidates to hone your DCF skills on, consider valuing beaten-down blue chips like IBM (NYSE:IBM), Johnson & Johnson (NYSE:JNJ), and 3M (NYSE:MMM). Like Microsoft and United Technologies, these long-haul keepers currently look very cheap on a P/E basis, relative to both the broader market and their own histories. Doing the DCF work will help you confirm whether or not that discount is warranted.
We also provide Inside Value members with an easy-to-use DCD calculator that does all the legwork for you. If you're not yet a member, you can access the calculator and get all the details on our favorite stock ideas with a 30-day free trial to the service.
Value hound that I am, I'm biased, but I suspect that adding DCFs to your investing repertoire will simplify your buy and sell decisions. That should help make your investing life much simpler and -- with apologies for the pun -- much richer, too.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire investment service. Microsoft and 3M are Inside Value recommendations. Johnson & Johnson is an Income Investor selection. Amazon.com is a Stock Advisor pick. You can check out the Fool's strict disclosure policy right here.
