If one values a share of stock using the same analysis and judgment as that of owning a US Treasury bond, they would consider its worth to be the present value of its tax-adjusted free cash flows plus a terminal value; for that is how bonds are indeed valued.
And this is how we value stocks—except the discount rate (cost of equity) we use at CT Capital is a more accurate representation of the uncertainly of those payment flows than security analysts employ today.
For example, the risk of a firm should theoretically rise if it increased its percentage of its cash flows from a questionable foreign jurisdiction, its tax rate were expected to rise, or any number of other cash flow, credit or miscellaneous factors. If an entity receives a significant portion of its cash flows from a non-U.S. geography, the risk to those cash flows must be assessed, with a markup to the cost of capital where appropriate. This is especially true for companies operating in emerging markets, where a markup to the cost of capital is always made, even if the cash flows from those areas are currently strong and without incident.
If the investor knew with certainty the prospective free cash flows and the rate of inflation (which in itself impacts firms differently and must be part of the discount rate analysis) then pricing of the security should be a relatively easy calculation.
Taken a step further, if the value of that stream of cash flows were priced underneath its intrinsic value, then one could also easily compute the expected return to achieve fair value as well as the expected total rate of return.
For example, on August 31, I calculated the fair value of Hewlett-Packard (NYSE:HPQ) at $42.62. If HPQ were selling at that price, and the cost of capital were correctly estimated, it would yield an 8.75% rate of return. As HPQ is currently selling at $38 per share, one could say it is priced to yield 19.58%, which on its face appears attractive, especially given a 10-year Treasury rate of 2.83%.
Why then, would one investment "A" grade entity be priced to yield 19.58% when, say Oracle (NYSE:ORCL), another “A” rated concern, is priced to yield 9.2% using the same methodology? The answer could only be investors do not believe HPQ’s free cash flows will grow by 2% per year, which is the growth rate CT Capital used in its model, Oracle’s free cash flows are underestimated, or a combination of both. In fact, if HPQ is able to generate $8.5 billion in free cash flow (which is slightly below its current level) then investors are incorrect in their current analysis and valuation placed on the company.
Yet analysts have not been reducing their earnings estimates, leading one to believe they are either late in making such adjustments, investors in general have been implying a greater amount of risk for HPQ than is realistic, or the current price does is incorrect.
We would suggest investors begin to look at firms in this manner, rather than the age old accounting-based metrics and simple versions of free cash flow which do not account for the ability of the firm to maximize its free cash flow, or make important adjustments to cash flow from operating activities. They must also begin to spend as much time on cost of capital as they do with their revenue, net income and cash flow forecasts.
Disclosure: No positions.