Financial Freedom Is Merely Organized Common Sense

Joachim Klement published a useful piece today. What drives valuation? An interesting question and one too few of us ever address. Warren Buffet has said investors need two well taught courses. One on stock valuation and one on how the market prices stocks.

As you can appreciate, the money is to be found when you are right on stock valuation and the market is wrong on pricing it.

Value or growth has tpically been a smart place for people to invest. If I could buy dollars for pennies, then I would do well as a value investor. If I could buy businesses with products whose sales are sure to grow over the long term, I would do better with growth.

Joachim points out that over the last 15 years you would be the big winner with growth. He draws on several scholarly papers to support the observation. It is interesting to notice that his philosophical bent is toward value. He appreciates how things may be different and thus the underperformance.

It appears to be that the market method for valuation has changed some.

As you would expect. Right?

If ultimately the value of a stock is its ability to produce cash income for the owner, then stock valuation says the stock should sell for the present value of that stream of future cash flow. That calculation is immensely affected by the rate one uses to discount that cash flow. In times of high interest rates and high inflation, the discount rate must be quite large, even if we assume the cash flow amount keeps pace with inflation. It seldom does.

Suppose a stock produces $1.00 per year in cash to its owner. Assume the corporation earns $2.50 and pays 40% of it to owners. That cash flow increases at 2% annually. Suppose further the owner demands 7% as the discount factor. Assume further still the holding period is forever. That keeps us from worrying about the value of the stock when we sell. The discount makes its present value close to zero.

In that calculation, the net present value of the cash flow is **$19.44.**

But what if inflation is 5% and the discount rate is 10%. Now the value is **$19.85** so no real difference. That’s what happens when more of the same is expected. A value investor could be quite interested in this stock at $14.00, but not at $20.00.

But, if the corporate earnings grow very quickly, the present value grows very quickly too. The distribution rate remains at 40% of earnings, remember. If earnings can grow at 4% instead of 2% then the stock valuation using the same 7% discount rate, (inflation has not changed) becomes** $27.06. **You get really interesting numbers at 10% growth. $106.47

Doubling the growth rate of earnings from 2% to 4% results in a vlauation increase of 40% compared to $19.44

The trick of course will be to find the Facebooks of the world instead of the Proctor & Gambles of the world.

That is no easy task. There are far more that fail than succeeed.

Only potentially good stocks can fail big. One of the rules of life is you cannot lose much money with a bad idea because you cannot get much to lose. Only good ideas can cost big.

Larry Swedroe’s paper referred to in the “What Drives Valuation” article is helpful, too. The Simple Explantion of Value’s Underperformance.

His argument is that this has happened before and there is no forever change. It is about the migration from one approach to another.

I think people want the most money back for the least trouble and risk on their part. They should learn what to look for. We saw earlier that changing the expected earnings, pre-dividend, in a business has a large effect. What if we can discover how that works?

One factor I have noticed changing over the decades is the amount of fixed capital it takes to produce a dollar of sales. Businesses like Microsoft or Facebook or Google can scale up without a proportional amount of capital spending. Outsourcing production helps too. Ones like GM, any manufacturer, and any retail operation cannot.

If the cost of capital as a percentage of sales is lower as the business grows, then earnings and distributable cash flow grow more quickly and you get the growth value. That happens whether interest rates stay low or rise. It is likely even a more pronounced advantage for growth if they rise.

Look for companies with cash flow growing faster than inflation and small internal needs for it.

Use your crystal ball to decide if its sustainable and if it isn’t, be the first to bail out. Growth tends to be more volatile.

*I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages. The result: more security, more efficient income, larger and more liquid estates.*

*Please be in touch if I can help you. don@moneyfyi.com 705-927-4770*

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