Tuesday, September 16, 2008

Valuation - Discounted Cash Flow & Insights

Finance, as taught in universities around the country, is an art and science of understanding the impacts of economics and implementation of some financial modeling. Time value of money, growth, etc.

Discounted Cash Flow is the preferred tool of financial analysts to determine whether an investment is worthwhile. The problem with discounted cash flow is that it is really a crapshoot. Let's look at the variables involved:

Current Earnings/Cash Flow
Beta = covariance of the security compared to the market (usually the S&P 500)
Risk Free Rate = rate where there is no implied risk (usually t-bills or t-bonds)
Risk Premium = additional rate required to hold the risk bearing market to be valued

risk adjusted required rate = risk free rate + beta * risk premium

So let's look at Coca Cola:

Beta = .64
risk free rate = 4.08%
Risk Premium = 3%

Required Rate = 5.61%

Diluted EPS (ttm) = 2.471
Expected Growth Rate = 8%

Generally, the valuation equation is this:

Value = Future cash flows discounted at the risk adjusted required rate of return.

Coca Cola is a huge company that doesn't experience growth much beyond the growth of GDP. Over the past five years it has grown earnings at 8% annualized. It can reasonably be expected to grow over time at about the same rate. Therefore a perpetuity valuation could be applied.

The equation for this is: current diluted EPS * ( 1 + expected growth rate) / required rate or

Value = 2.471 * ( 1 + .08) / 5.61%

This provides us with a (rough) value of $47.56 versus the current market price of 54.85. Investors currently are paying a premium for KO and are thus over valuing it by $7/share.

For a company with relatively good earnings stability, this is relatively accurate (READ - the projected cash flows have relatively lower variance than a small cap growth company). The small cap growth company has very uncertain cash flows. This makes the variance in potential future cash flows much higher. A higher beta reflects this uncertainty, but it is still a mean projection.

All this discussion leads to what it the best predictor for future prices, values, or earnings. For earnings, the best predictor is current earnings. For future prices, the best predictor is price. So what is the point of forecasting the future price when the price you currently have is the best predictor of future price? This is probably why investors such as Warren Buffet advocate buy and hold and great traders preach following price action. They know that the best predictor of the future is what is the present.

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