Businessman Investor

Touching base with the rational business psyche of stock market investors

Sunday, September 25, 2011

How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

Foresight? In stocks, hindsight is clearer and easier. While we know by hindsight what the excellent business is capable of performing, we downplay our prospects of it, and content ourselves with the more likely, easily achievable, conservative scenario.
This is Part 1 of a Series.

I’m starting to be more inclined towards fast but very conservative approaches in rate of return and intrinsic value appraisals. Because no matter how detailed, elaborate, or complex our models are, if the assumptions, programming, or the projections themselves are too optimistic and aggressive, then the likelihood of achieving these forecasts would be thinner. And the same thing goes with achieving superior returns.

What we simply want to do is downplay our prospects, minimize our expectations, and be happy and content ourselves with the safe, very achievable, conservative scenario, and pay a reasonable price for that—all these despite knowing by hindsight that the business is much more capable and can offer more!

Again, instead of buying a stock at a deep discount from an intrinsic value estimate derived from very aggressive, too optimistic assumptions, we’d rather buy one at a reasonable price derived from very conservative, easily achievable assumptions. Indeed, rather than just being one of the steps of the appraisal process (i.e. a quantitative discount application in the end), the margin of safety, as a principle, is innately tied in the whole investing thought process—and that starts with banking on very conservative assumptions.

Working Backwards

I’ve written a lot about figuring out what’s the likely intrinsic value (or safe purchase price) of a stock given its reported financials. We derive the usual, essential metrics we’re interested in such as free cash flow and cash hoard, then use 15% as our discount rate (with it being our required rate of return) to arrive at an intrinsic value estimate. But now, let me turn and demonstrate how to assess a likely long-term rate of return given a stock’s current price and deduce from there whether the stock merits investment or not. It’s somewhat working backwards.

Keep in mind that while we start with the analysis quantitatively, we should be very much aware of qualitative factors to assess whether the business is worth appraising. But I’d rather not delve on the specifics of this at the moment.

The quick, conservative, quantitative assessment process is simple:
  1. Review and compare the company’s Historical Net Incomes and Free Cash Flows.
  2. Ascertain Compounding Power by taking note of the following:
    • Free cash flow growth
    • Net income growth
    • Return on equity
  3. Ascertain a safe, conservative Perpetual Free Cash Flow.
  4. Compute Market Capitalization Net of Cash Hoard (i.e. Market cap. less Cash hoard).
  5. Compute Conservative Free Cash Flow Yield (i.e. Conservative perpetual free cash flow/ Net market cap.)
Note: The current market capitalization represents the theoretical prospect price we’d be paying for the whole company assuming we do purchase it at the current market price level. We deduct Cash Hoard from it because we’re certain that upon acquisition of the stock, we, viewing ourselves as part owners of the company and mindful of its free cash on hand at its level as a business, immediately possess this cash hoard (it’s like saying, if I buy a profitable business which has Php100 on hand, and pay for it Php200, then I’m effectively buying the franchise aspect of the business (i.e. its future cash profits) for Php100 (Php200 purchase price – Php100 company’s cash on hand). Continue to Part 2: Republic Cement as an Equity Bond with an Expanding Coupon

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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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