What's the Discount?

In pretty much any endeavor that looks out toward the future, I take it as a matter of fundamental truth that while the devil may be in the details, he most certainly makes his permanent home in the assumptions. As any analysis of a business for investment purposes is fundamentally concerned with the future, one is confronted with the chore of using historical data to forecast “that which is likely to be.” When the analysis is concerned with a company’s earnings, the weapon of choice is the Discounted Cash Flow (DCF) model. When using discounted cash flow (DCF) analysis to determine a value for a stock, the two primary assumptions one must make are the earnings growth rate and the rate at which future cash flows should be discounted.

An earnings growth rate is very easy to come up with. You can look at a company’s historical performance and in the light of what you consider their future prospects to be, come up with an assumption, that if inaccurate (a synonym for assumption) at least has the illusion of reasonableness. Better yet, use a range of possibilities, thereby adding the illusion of thoroughness to the analysis.

The discount rate assumption, which is often nothing more than a screaming wild-ass guess (SWAG), is one that is better built from the ground up. This gives, not only the illusion of reasonableness but of statistical veracity as well. Here is how I come up with a discount rate.

First, since inflation will make tomorrow’s dollars worth less than they are worth today, a long-term inflation rate is entered into the mix. I use 3%

Next, add in a “risk-free rate of return.” I use the rate on ten-year treasuries, currently 3%. By the way; I round up. This isn’t rocket science, and more places to the right of the decimal adds zero accuracy… which would be the illusion of being an Economist.

To these figures, I add a simplistic weighted average cost of capital (WACC). This number is derived, for debt, by taking a company’s interest expense and dividing it by the debt load. For the equity portion of the WACC, I look at earnings yield. A hypothetical example using five years of data is as follows.

	2008	2007	2006	2005	2004
Average Mkt Cap	$ 16,650	$ 16,550	$ 15,600	$ 9,200	$ 6,500
ST Debt	$ 200	$ 25	$ -	$ -	$ -
LT Debt	$ 3,000	$ 2,250	$ 900	$ 1,600	$ 900
Total Debt	$ 3,200	$ 2,275	$ 900	$ 1,600	$ 900
Total Equity	$ 7,900	$ 5,000	$ 4,800	$ 4,300	$ 3,500
Total Capital	$ 11,100.0	$ 9,550.0	$ 6,600.0	$ 7,500.0	$ 5,300.0
Interest Expense	$ 135	$ 50	$ 40	$ 35	$ 25
Net Earnings	$ 1,800	$ 1,500	$ 1,800	$ 1,300	$ 1,100
						Mean
Interest Rate	4%	2%	4%	2%	3%	3%
Earnings Yield	11%	9%	12%	14%	17%	12%
WACC	9%	5%	9%	9%	12%	9%

In the above example, I have calculated a WACC of 9% to which I add the previously assumed inflation rate and the risk free return rate, yielding a final discount rate of 15%. Now off to the forecasting races!

Income please, hold the risk.

As an individual investor focused on income producing equities, and someone who manages similar investments for others, one of the most important analyses I perform is an assessment of risk. I have come to live by the following… “Is it safe? Is it cheap?” Full credit for this mantra goes to Marty Whitman at Third Avenue Funds. Much has been written over time about “margin of safety” and the fact is that the best company in the world can be a lousy investment if you pay too much for it.

For my purposes, RISK is defined as the potential for permanent loss of capital and/or a long-term impairment in the value of the investment, and/or a significant impairment in the income production of the investment.
One of the portfolios I run belongs to a lovely woman in her mid-eighties (I’ll call her “Mom”). When he passed away a few years ago, her husband (I’ll call him “Dad”) left Mom pretty well off, and completely clueless regarding her financial situation. I took over management of her assets upon Dads’ death.

Needless to say, this one is a bit “different.” This is not just any client. As “Mom” says, I’ll never be too big or too old to keep her from swatting me on the back of the head if I screw up. Trust me... it’s not an experience you want to have.

“Mom” lives fairly frugally. She owns her home outright and is able to live comfortably off her Social Security and the RMD from her IRA. She has not had to touch any funds in her taxable investment accounts. The problem that I saw with her portfolio was that there was inadequate growth. Each year the RMD increased and portfolio income was not keeping pace, thereby causing a need to sell a portion of her investments each year in order to fund the RMD.

The recent massive decline in the stock market has presented a fabulous opportunity. A huge degree of risk has been removed from specific individual equity investments precisely because 1) prices are low because like a rising tide raises all boats, a falling tide does the opposite without regard for the seaworthiness of the ship, and 2) the outgoing tide has revealed many naked swimmers in the sea of the stock market. Please note that I do not know or care whether the “market” is over or under valued. Having bought and sold a couple of businesses in my career, I am comfortable valuing a business, not a market.

In the case of Mom, this ebb tide has allowed me to reallocate her retirement portfolio in such a way as to meet all of the following requirements:

1. Generate sufficient income to fund her RMD entirely out of income for several years
2. Provide for sufficient income growth to maintain portfolio income in line with required increases in her RMD
3. Provide the potential for (hopefully substantial) capital appreciation over time
4. Minimize the risks outlined in the second paragraph while achieving the above goals.

A final, secondary goal is the preservation and maximization of the value of Moms’ estate for her heirs (of which I am one, unless she changes the will) when the inevitable date arrives and she joins Dad in the great hereafter.

In trying to achieve these goals, I use individual dividend paying stocks for income, income growth and capital appreciation and I analyze each company I purchase for Moms’ portfolio from the following perspectives.

1. Is the company safe? Downturns come and go and I am not so much interested in current results as I am interested in the company’s’ ability to weather the downturns and continue forward without permanent impairment. The daily/weekly/monthly fluctuations in a company’s stock price are largely irrelevant. I look for companies with strong balance sheets and strong cash flows. Judging management has also become a bit easier when judging the safety of a particular company. While there is truth in the “rising tide" saying, the current economic situation has thrown a bright light on managements’ ability to navigate rough waters. In the words of Syrus Pubilius, “Anyone can hold the helm when the sea is calm." I want pilots who can handle the storms.
2. Is the dividend safe? Is it adequately funded out of cash flows and available cash on hand? Is it likely to remain so?
3. Will the dividend grow? Here there are two elements of concern. First is the long-term prognosis for the business. Can the company grow and increase its’ earnings and cash flows? Second is a demonstrated willingness on the part of the company’s board to increase the dividend more or less in line with the growth in the company’s earnings and cash flows.
4. What are the alternatives? Coke versus Pepsi as it were.
5. Is the price cheap and more importantly, is it cheap enough? Valuing a company will, if you are doing it correctly, produce a range of values, not an absolute number. Buying below this range provides a warm and fuzzy margin of safety to nestle in. I personally feel that the harder this analysis is to do and wider the range of values that are derived from the analysis, the less likely the answer to the above question is to be “YES.”

For any investment, I have a long-term target rate of return, which combines yield on cost, with anticipated growth and varies based upon my perceived risk that the investment carries. Another cliché (from Moms’ deep well of such things) is “Better safe than sorry.”

Finally, a word on DRIPs. I do NOT use DRIPs. I do not believe in “set-it-and-forget-it” investing. I whole-heartedly endorse reinvesting dividends but I would rather deploy excess cash based on my current analysis of investment alternatives. Frankly, all else being equal, my willingness to reinvest in a company is inversely proportional to the change in the price of the company’s stock price.

Where There's a Will... There's a Way

Since the release of their quarterly earnings on April 21, and given managements’ statements regarding their full year outlook, there has been some speculation regarding whether Caterpillar, Inc. (CAT) will cut their dividend.

While a cut is always a possibility, a quick glance at their financials would seem to indicate that if they have the will, there is no need for a dividend cut at this juncture. Here is why:

1. CAT had over $3.5 billion in cash on their balance sheet at the end of Q1-09, an increase of $830 million from the end of 2008. In Q1-09 they paid out $253 million in dividends. This translates to roughly 14 quarters of dividend coverage at current levels.
2. Both Operating Cash Flow and Free Cash Flow were positive and were higher in Q1-09 than in Q1-08. The Dividend Payout Ratio on these two metrics was 28% and 38% respectively versus 32% and 61% in Q1-08.
3. CATs’ current ratio improved from 1.21 at the end of Q4-2008 to 1.34 at the end of Q1-2009

So while CATs’ current outlook for a full year profit of $1.25 before redundancy costs throws up the red flag of earnings being less than their annual dividend (currently at $1.68), their financial condition would seem to indicate that they have enough headroom to weather the current economic cycle without reducing the dividend… if they have the will.