By Jason Voss, CFA
The deal to take U.S. computer maker Dell Inc. (DELL) private provides an answer to a question that initially occurred to me many years ago while working as a portfolio manager during the dot.com era. My idea was to check the stock market's discounting abilities with a real world example. Put another way, I dreamed of looking at the market capitalization of a business over long periods of its life to see how accurate the market discounted the value of the business based on future streams of actual net income, plus an estimate of terminal value.
This is much harder than it sounds. Discounted cash flow analysis requires a terminal value to account for the value of a business as a going concern in cases where the business continues operating beyond the forecast period. When businesses are acquired a kind of terminal value is established. But M&A transactions are often executed using overpriced stock as currency to purchase the shares at depressed valuations. In such cases, terminal value is distorted by market vagaries. Other businesses simply go bankrupt and their assets are sold to the highest bidder (think: Hostess brands selling its Twinkies franchise). In the Hostess case, the assets were sold at fire-sale prices, further distorting the observed terminal value. Even if that weren't the case, how would you separate out the historical cash flows generated by a single, profitable business line from those earned by less profitable business lines in the event of dissolution of an entire business?
But now, suddenly, my research dream has been fulfilled. On 5 February, Dell announced that rarest of corporate transactions: a deal to take itself private.
Specifically, founder Michael Dell and private equity firm SilverLake Partners are paying $24.4 billion for the privilege of running Dell outside of your purview (i.e., privately). Thanks to their proposed transaction, financial analysts have a definitive opportunity to look at the wisdom of markets and their estimates of value over long periods of time for a business.
Here I consider three important values assigned to Dell over three different kinds of time periods to answer three key questions:
- How well did investors do in discounting the future value of Dell from its peak valuation on 22 March 2000 to the time of its proposed going private deal?
- How well did investors do in discounting the future value of Dell at its trough valuation (16 November 2012), after achieving its peak valuation?
- How well did the average investor do in discounting the future value of the company from its peak valuation over its average remaining life?
Before I answer these questions, let me first justify why I am using net income rather than some other measure of corporate flows. I am using net income because I would like to focus attention not on the right cash flow measure but rather on the market's ability to discount flows from a business. So there are no adjustments for depreciation and amortization, capital expenditures, maintenance capital expenditures, share issuance, share buybacks, options issuance, follow on debt offerings, et cetera. Most investors use net income somewhere in their analyses and therefore I think using net income as a starting place for a discussion, rather than as the discussion itself, is justified.
Now to the analysis…
On 22 March 2000 investors bid up the value of Dell to $148.3 billion, clearly expecting the company to dramatically grow future profits. Investors that day would have needed all subsequent net income and the terminal value to be, on average, 9.23% higher each and every quarter than was actually the case. Put another way, all subsequent undiscounted net income and undiscounted terminal value (i.e., Dell's "take private price" of $24.4 billion) received amounted to only $56.6 billion. Ouch! Here is clear evidence of dot.com era froth.
What if we look at the lowest market capitalization ascribed to Dell and see how well those investors might have done had they held on until 5 February 2013? An admission: I think it is spurious to do this analysis. Why? For starters, Dell was a much smaller business when it first became a public company in June 1988. So I think it would be better to judge the wisdom of the market after it was better understood just what Dell was, and could be, as a business - and as represented by the high water mark of its market capitalization.
Following its peak market capitalization in 2000, Dell's trough market capitalization of $15.4 billion was achieved on 16 November 2012. Had you bought shares that day, you would have experienced no net income in the intervening quarter. But you would have received the cash terminal value (again, $24.4 billion). On a compounded basis, these investors earned a whopping 704.4%. Uncompounded the return was still an impressive 58.8% over 81 days.
How did the average investor do who bought shares of Dell subsequent to the company's peak market capitalization? Here, my assumption is to use the average net income from 22 March 2000 to 5 February 2013, or $631.8 million each quarter. I am also using the midpoint in terms of time, or 26 quarters, as the average holding period. Subsequent net income plus terminal value amounted, then, to $40.2 billion, as compared to an average market capitalization of $39 billion.
In other words, the financial markets did a remarkably good job of discounting Dell's average future value after its dot.com era peak. While the coefficient of variation of Dell's market capitalization after its peak valuation is a high 71.2%, the result is, nonetheless, impressive.