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An essential aspect of the evaluation of investment risk is taking on the roll of a Las Vegas odds maker-and not just when it comes to earnings, cash flows or revenues.

For example, in its June 30 10-Q, filed last week, pawn lending, cash advance and check cashing firm Cash America (CSH), a strong producer of Free Cash Flow, wrote:

Certain consumer advocacy groups and federal and state legislators have also asserted that laws and regulations should be tightened so as to severely limit, if not eliminate, the availability of certain short-term products to consumers, despite the significant demand for it. In particular, both the executive and legislative branches of the federal government have recently exhibited an increasing interest in debating legislation that could further regulate short-term consumer loan products. The U.S. Congress has debated, and may in the future debate, proposed legislation that could, among other things, place a cap on the effective annual percentage rate on consumer loan transactions (which could encompass both the Company’s consumer loan and pawn businesses), place a cap on the dollar amount of fees that may be charged for short-term loans, ban rollovers (payment of a fee to extend the term of a short-term loan), require the Company to offer an extended payment plan, allow for minimal origination fees for advances, limit refinancings and the rates to be charged for refinancings and require short-term lenders to be bonded.

In addition, the United States Congress recently passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This legislation authorizes the creation of a consumer financial protection bureau with broad regulatory powers over consumer credit products such as those offered by the Company. The Company cannot currently predict how, when or if the Bureau will impose additional regulations that could affect the credit products offered by the Company. However, if the Bureau were to promulgate regulations that adversely impact the credit products offered by the Company, such regulations could have a material adverse effect on the Company’s business, prospects, results of operations and financial condition.

In addition to state and federal laws and regulations, the Company’s business is subject to various local rules and regulations such as local zoning regulation and permit licensing. Local jurisdictions’ efforts to restrict pawnshop operations and short-term lending through the use of local zoning and permitting laws have been on the increase. Actions taken in the future by local governing bodies to require special use permits for, or impose other restrictions on pawn lending locations or short-term lenders could have a material adverse effect on the Company’s business, results of operations and financial condition.

While I haven’t determined the approximate cash flow impact of future or recently passed legislation on CSH (or the power of the people who use their services), it is certain I would mark-up their cost of capital (the discount rate used to determine fair value), to account for such possibilities, the amount dependant on my assessment of their probability and the expected “haircut” to Free Cash Flows the firm could expect. You might say: “Aren’t my assessments just a guess?” The answer is “yes,” but, even if the probability I assign is off the mark, by recognizing and factoring additional and possible risk metrics into my discount rate, regardless of how small their probability, I have a more accurate estimate of fair value.

Has anyone reading this not witnessed small probability events (black swans) become reality during the past few years? While the investor should not overly penalize a firm, you will find by making small adjustments to account for risk not recognized by others, you will gain superior investment performance. How? By avoiding large losers you might have otherwise owned.

For risks of the sort mentioned in the CSH 10-Q, I normally adjust the discount rate anywhere between 0.2 and 0.6 percentage points over the risk-free rate (10-year Treasury yield). If one were to add more risks to the equation, unless Free Cash Flow growth was staggering, the discount rate would balloon to make such an investment difficult, although not impossible. Greater potential risk, including loss of a patent (e.g., Pfizer (PFE)) without an assured replacement, or key executive (e.g., NCR (NCR) with Mark Hurd), would result in a greater penalty. But qualitative risk also includes not being adequately insured (e.g. BP (BP), a topic clearly covered in their 20-F. (Click to enlarge)

As seen from the tables above, by changing the probability factors to include a higher level of risk, with no change in free cash flow estimates, the fair value of Cash America is brought down by 14%. We are assuming $3.00 in Free Cash Flow and 5% annual increases. If, after reading a firm’s 10-Ks, 10-Qs as well as interim filings and news events, the investor believed the Free Cash Flow forecasts were still warranted, however, the probability of a (or new) material(s) event were to cause a higher re-assessment of risk, one might choose to mark up the required return (cost of equity) to 13%, which would result in a drop to fair value to $32.49. If the Free Cash Flow estimates were brought down to an initial estimate of $2.50 (followed by 5% annual increases), fair value would fall down to $27.39. As you can see, risk is almost as important as the Free Cash Flow projection-yet is minimally scrutinized by analysts, especially for the qualitative risks.

You can be sure that, while analysts are aware of these intrinsic danger points, they are not factoring them into their cost of equity-and that’s an important advantage for readers of this space. The probability of a negative surprise must be factored into the investor’s price he or she is willing to pay via their required return for assuming such risks.

Disclosure: No positions

Source: Cash America: The Connection Between Free Cash Flow and Fair Value