Efficient Market Theorists (technically shouldn't they be called Hypothesists?) would have you believe that in this age of instant information and high frequency trading, the quaint notion of Mr. Market is dead. This erstwhile character was developed by the father of value investing, Benjamin Graham, to illustrate his concept of intelligent investing as buying shares in a company for less than that piece of the business was worth.
Mr. Market was an emotionally unbalanced business partner who was constantly offering to either buy or sell a share of your business. On some days, a gloomy Mr. Market would offer to sell out at a price well below what the business was actually worth, and on others he would make you an outrageously high offer he hoped you couldn't refuse. Obviously, you would do well to wait until he offered you a great deal to buy, and cash out when he offered you a price well above what the business could hope to recoup over its remaining lifetime.
This seems like a simple concept. In fact, it often seems too simplistic to academics who feel the need to flex their mathematical muscle with arcane concepts like Sharpe Ratios, MPT, and CAPM. Instead of trying to determine what entire businesses should be worth, they dismiss this notion in favor of assuming the market is already telling you exactly what the business is worth by instantly assimilating all available information into the exact correct enterprise value like some Braniac Borg.
You can probably tell from my tone that I consider this to be complete bunk. Warren Buffett and other disciples of Ben Graham have proved that you really can use the concept of buying businesses for less than they're worth to get an edge on the market. I was reminded of this fact the other day by rereading Buffett's seminal work "The Superinvestors of Graham-and-Doddsville," a dismissal of the suggestion that he and other successful value investors are merely lucky outliers.
So if it worked for them, can investors still apply this concept to today's market to become better investors? Of course, as there will always be mispricings in the supposedly efficient market. Behavioral economists have refuted many of the assumptions upon which the Efficient Market Hypothesis is based, such as that market participants always behave rationally and that a crowd has the effect of smoothing out individual irrationality rather than exacerbating it through mob mentality.
Therefore, in a hopefully lengthy series of articles beginning with this one, I will try to seek out companies whose shares appear to be trading at much less than the intrinsic value of the business in which they represent ownership. The difference between cost of the shares and value of the business they represent is another brainchild of Graham, represented by his term "margin of safety." If the market cap of all the shares appears to deduce a value approximately equal to that of the business itself, there is no margin of safety, but if they suggest a per share price of only half the company's intrinsic value, then there is a margin of safety of 50 percent.
Since estimating the exact intrinsic value of a company based on its future business is at best an educated guesstimate, higher margins of safety are obviously more desirable. They can lead to higher returns if the company continues to perform well and the market begins to recognize its value, as well as lower losses when things go wrong, since at least some bad news was already priced into the shares.
So in this way, I will go about trying to identify companies that you can currently buy for much less than their true worth even in this bull market, which I believe is due for at least a minor correction and no less an authority than Buffett himself recently said was "more or less fairly priced." To find something to buy, I concentrated on the type of consistent, easy to understand businesses that Buffett favors. This led me to a company similar to one of Buffett's most successful purchases, Coca-Cola (NYSE:KO), which he bought in 1988 as the company was refocusing on its core business after a decade of diworsification, to use the Peter Lynch term, into unrelated businesses like wineries, as well as some other fiascoes like New Coke.
Still, the company had overcome these issues to post eight straight years of stock price appreciation even before Buffett finally bought in. Therefore, it wasn't obviously cheap, at least by traditional valuation metrics like Price-to-Earnings Ratio or Price to Free Cash Flow, which stood at about 15 and 12, respectively. However, Buffett recognized the long-term value of the consistently solid performance that was driven by the company's unimpeachable brand name. This allowed the company to maintain a high free cash flow growth rate, which when evaluated by a discounted cash flow analysis lent the company a much higher intrinsic value than the market had assigned to it at the time.
I believe this situation was not unlike the one another beverage company, the Dr. Pepper Snapple Group (NYSE:DPS), currently finds itself in. After being spun off from Cadbury Schweppes in 2008, the stock bottomed out along with the rest of the market in March of 2009 before more than quadrupling to a high above $50 a share earlier this year. However, it has badly lagged the market since then as concerns of slowing growth became apparent in the carbonated beverage market due to the rise of more health conscious consumers.
Dr. Pepper has still performed admirably in this challenging environment, growing earnings from $2.79 in 2011 to $2.92 last year, and are on their way to an expected $3.07 this year. They have also consistently raised the dividend after reestablishing it at the end of 2009, growing the payout from 90 cents in 2010 to over $1.50 this year, good enough for a nearly 20 percent annual dividend growth rate.
Cash flow has also stabilized after spiking in 2010 on a one-time payment from a Coke and Pepsi licensing deal and then dipping in 2012 when taxes had to be paid on this windfall. Dr. Pepper has used this cash to aggressively buy back their own shares, shrinking the float from over 250 million in 2009 to less than 200 million by the end of this year.
Now that the licensing deal has been resolved, Dr. Pepper should return to a more consistent free cash flow generation, which is expected to come in at $675 to $700 million this year according to estimates from the latest earnings call. The company remains committed to continuing to return the majority of this cash flow to shareholders through buybacks and dividends, so it will continue to benefit the true owners of the business, the shareholders.
Therefore, to determine whether you might want to count yourself among this class, we can perform a discounted cash flow analysis to try to calculate what we should be willing to pay for a piece of the business. We will do so using the simplest method possible, the Gordon Growth Model, to calculate the current value of all the expected future cash flows. To do so, we have to estimate the expected long term growth rate (GR) of the free cash flow (FCF), as well as the discount rate (DR) used to adjust future cash back to its present day value (PV), according to the formula:
PV = FCF*(1+GR)/(DR-GR)
Instead of restricting ourselves to a single value for each, we can consider a range of values in Excel to see how this affects the intrinsic value obtained for the company. Starting with the lower end of the range of expected free cash flow, $675 million, we obtain the following per share values for a range of growth and discount rates:
To further illustrate the concept of margin of safety, we can compare each of these values to the current share price of around $43.50 to see how much additional value we'd likely be getting in each case:
We can use these results to remind ourselves not to pay more than the long-term value the business is expected to have, represented by the upper right portion of the table where we have no margin of safety. If we don't think DPS can keep up even a meager growth rate or conservatively choose a high discount rate, we should probably not purchase shares at this time.
However, if you share my belief that Dr. Pepper's strong brand names and wide variety of much-enjoyed products will allow it to continue growing for many years to come, you can currently buy it at large margins of safety, approaching 50% if it can just continue to grow free cash flow at within 4% of the discount rate. Getting a business for half price even if it can just barely keep pace with inflation? Investors should drink that up.