Businessman Investor

Touching base with the rational business psyche of stock market investors

Monday, August 22, 2011

Intrinsic Value and the Equity Bond Theory

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and Bond Valuation

Equity Bond. A stock can likewise be thought of as a bond whose worth is just the sum of all its discounted free cash flows. The difference from your regular bond being: the equity bond yields expanding coupons!
Following the line of rational thinking usually applied in bond valuation, a business, in the same manner, is only worth all the discounted future cash flows it can provide. A business, therefore, can be thought of as an “equity” bond. The question now is: which cash flows should we consider and discount?

An extreme take on this paradigm is the Dividend Discount model. Taking on the assumption that the significant cash flows are only those dividends actually paid to the shareholders, the model intends to value a stock based only on these dividends. The immediate problem on this extreme view is how detached it is from the real, internal cash-generating capacity of the business. For one, it can be deceptive since dividends by themselves say nothing of the operating realities of the underlying asset—they can even be financed through externally sourced debt at the immediate pleasure of naive, detached “owners”, but at the immense detriment of long-term, business sustainability. Another reason is that, there's also those companies which are really good at making money but are not in the habit of disbursing them as cash dividends. It's not that they don't want to share the profits, but that even the board of directors and the shareholders favor income retention because management is capable of further deploying these profits in investments that would further compound wealth.

Thus, to overcome this problem, investors, businessmen and financial analysts turn to free cash flow in piercing through that isolating corporate veil and, in return, be more intimate with equity and business ownership.

Thoughts: The idea of using free cash flows immediately takes on the paradigm of a concerned, business-minded shareholder (in contrast to an aloof, dividend-conscious stockholder) who views the company as an extension of himself with the company assets as partly his own. Unlike a creditor or a bondholder who immediately views his paid price to acquire a bond as an immediate outlay and likewise treats interest payments as inflows only upon actual receipt, an attached shareholder need not to personally have actual receipt of free cash flows just so to consider them as inflows (likewise, his outflow is not necessarily his paid up stock market price; rather, his outflows are those cash expenses and capital expenditures at the level of the business)—his perspective is that: when the business receives free cash inflows, he, as an owner, already receives those free cash inflows as well.

The Discounted Cash Flow (DCF) model attempts to capture the intrinsic value of an Equity Bond from a cash-bias point of view. It attempts to project all future free cash flows the business would be internally generating in its tenure and discount them at a certain rate preferred, required, or dictated by a prospecting investor.

There are many DCF model variations of which below being just my personal take on it:

Intrinsic Value = Cash Hoard + Discounted Growing Free Cash Flows + Terminal Value

Cash Hoard is a self-contemplated financial concept of mine which attempts to capture all previously accumulated free cash flows. You just have to think: all those previous free cash flows (net of cash paid for dividends and share buybacks) must have accumulated somewhere; these free cash pool is exactly what Cash Hoard tries to represent. You no longer have to discount this since this is what you immediately receive and possess upon acquiring a stock.

Discounted Growing Free Cash Flows are projected free cash flows (usually spanning 5 to 10 years) growing at a certain rate (I prefer and use ROE as the growth rate). The growing nature of free cash flows is based on the idea that predictable, quality businesses can be likened to a bond with an expanding coupon which is driven by its expanding equity base; it's the compounding power of a stock in action.

Terminal Value assumes that free cash, despite perpetually flowing, would, at a certain point, no longer grow. It tries to conservatively capture the perpetual nature of businesses; that is, the assumption that the business would exist forever, and you, as a committed shareholder/business owner, shall hold on to it indefinitely.

Example: What is the worth of a business that has a cash hoard of Php500k, 20% ROE, and with an initial free cash flow of Php100k if your required rate of return is 15%?

Cash Hoard = Php500k
Year 1 FCF = 100k
Year 2 = 120k (100k x [1+20%])
Year 3 = 144k
Year 4 = 172.8k
Year 5 = 207.36k
Year 6 and beyond = 248.83k

Discounted Cash Flows
Cash Hoard = Php500k
Year 1 FCF = 100k/(1+15%)^1 = 86.96k
Year 2 = 120k/(1+15%)^2 = 90.74k
Year 3 = 144k/(1+15%)^3 = 94.68k
Year 4 = 172.8k/(1+15%)^4 = 98.80k
Year 5 = 207.36k/(1+15%)^5 = 103.09k
Year 6 and beyond = 248.83k/15% = 1.66M => 1.66M/(1+15%)^6 = 717.18k
Sum of Present Values = Php1.69M

The Intrinsic Value of this business should be at Php1.69M. That is to say, if you intend to earn a 15% rate of return from buying this business, then that is the right price to pay, but you would have to hold it forever. Noteworthy, don't you think, that even the DCF model hinges on that assumption that stocks are perpetual, and thus, for the long haul. Buying, therefore, on this basis, theoretically and rationally ties you to owning the business indefinitely if you do really want to earn that discount rate you based your stock valuation on.

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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