Saturday, October 11, 2008

The Fundamentals of Value

The Dow is off about 33% in one year, with 20% of that coming in the last couple weeks.

I've been looking around for evidence that we have lost a third of our labor force, but that doesn't seem to have happened (in fact, labor supply has now increased tremendously, as some of our most productive workers decide they can't retire quite yet). And I looked to see if a hurricane or some kind of natural disaster destroyed a third of our capital base. Nope, nothing like that either. Not even a bad Supreme Court decision that would impact our still-strong legal regime of markets and private property.

Folks tell me that stock valuations are down because of fear that corporate earnings will be low.

Anyone who has done a discounted cash flow valuation of a company should be deeply disturbed by what is going on. In a typical valuation, with say 5 years of explicitly forecasted cash flows and then a perpetuity at the end, upwards of 75% of the total value will derive from the perpetuity value. Said differently, the first five years of cash flow make up only 1/4 of the total value of the company.

As an example: Suppose we have a very simple company that produces $10 of cash per year forever, and that the appropriate discount rate is 10%. The value of the company is then $100. Note this is a weird company, with no growth at all -- more like a bond than a company. Suppose a nasty recession next year is forecast to take the first year of cash flow away entirely. Wow -- the value of the company falls to $91. An even nastier recession is forecast, with no cash flows for two whole years -- and value falls to $83.

And bear in mind that in our real world, we are not looking at losing even one year of earnings, just lower earnings.

Folks also say that capital constraints will prevent companies from taking advantage of growth opportunities. That might be true for the short run. But are these growth opportunities going to disappear entirely? Doubtful. They will wait for capital constraints to release.

There have to be some real good deals out there right now. For instance, you could buy GM for about $3 billion. That's right, you can own all of General Motors for the low price of 3 billion dollars. One of the two largest auto manufacturers in the world, with a franchise in Europe that is to die for, and a great stake in Asia as well. And not exactly chopped liver in the US, especially if you get off the two coasts and get into the good old heartland, where folks still like to drive Chevys.

What a sale that is! KKR could write a check for $3 billion without even checking to make sure they have that much in their checkbook.

Sure, GM has some liabilities, and they have a lot of debt outstanding. But just think of the option value on that equity.


Anonymous said...


I like your analysis. The arithmetic is right. However, you may want to vary by putting a lower discount rate on early years and higher one on later years as investors feel more confident in projecting the next couple of years versus the back years. But the message is correct. What the market is saying today is that the discount rate has gone up significantly.

I agree with the fact that for the patient investor, there is a lot of value in the market for any one who has staying power. However, even with that the stocks might go even lower. A big destroyer of value to current shareholders is management raising common equity at these depressed levels. Essentially management is raising equity when the cost is the highest (fear is at extreme). Some companies have issued equity to replace their commercial paper programs so the cost of capital has gone up. The dilution takes a lot of the value away from current shareholders. This is another risk in this market that is quite signficant. Ultimately the discount rate is not going to stay at such high levels but if a company issued equity at today's cost of equity it diminished signficantly the value to existing sharehlolders.

For GM, the liabilities are quite significant. The unions are a big disincentive over improving things.


Robert G. Hansen said...

Yes, no doubt that the risk premium seems to be quite high right now. But did tastes or the real quantity of risk change that much that quickly?