In general, risk is measured by the uncertainty of the firm’s future free cash flows. Free cash flows are, in essence, the income to the investor; they represent the maximum amount of cash the firm could distribute without impairing its growth.
Sure, analysts use other measures to arrive at fair value, including market value of the individual parts, liquidation value, price/sales, price/earnings, or price/book. Book value has proven to be an unreliable metric if the book consists of assets where buyers at fair market prices are absent. What is the value of an asset for which there are either no buyers or buyers at unreasonably low prices?
It is the free cash flows, which must then be discounted. But at what rate?
In order to arrive at a fair value estimate for an equity security, an analyst or investor must discount the firm’s free cash flow by a rate equal to the perceived risk. And the risk is a reflection of the uncertainly of the free cash flows. Treasuries will be discounted at the risk free rate plus a small mark up for the loss of its investment grade status. The amount of the markup is up to the analyst.
That’s why estimates of free cash flow and earnings are called estimates! And because they’re estimates, there at the whim of such risks as the loss of patents or customers, volatility in input costs, litigation, inadequate insurance (ie, BP was self-insured), foreign government-related issues and rollover of debt, whatever. These risks must be captured by the cost of equity. The fewer and less serious these risks are, the more certain we can feel about the free cash flows. For such an enterprise with above average normalized free cash flow and moderate leverage, lower cost of equity will normally place the entity in a position to add value-adding projects with more facility than its competitors.
The ability to assess risk to the free cash flows through the adjustment of the cost of equity (discount rate) will provide you with a tool which will place you head and tails over just about every securities analyst you see on CNBC or elsewhere. I can also assure you that over the coming years you will be hearing and reading a lot about the appropriate setting of the cost of capital.
So where do things stand now?
According to the CT Capital LLC comprehensive credit model, and, as outlined in my text, “Security Valuation and Risk Analysis,” (McGraw-Hill), the fall in yield spreads, sovereign risk, improvement in credit strength, and rise in free cash flows, have reduced the cost of equity capital to 7.9% for the S&P Industrials from 8.3% a year earlier. Thus, one should expect a 7.9% return for the S&P over the next year, based on the current level of risk.
So, next time your hear during a company presentation or read in an analyst’s report a cash flow estimate, make sure you understand all of the potential risks to the forecast, made possible through a thorough reading of all SEC filings, for in so doing, your expected return will not only shift, but be more realistic.
Kenneth S. Hackel is president of CT Capital LLC, an investment advisory firm. An internationally recognized expert in security analysis, he has managed the nation's leading mutual fund, a large investment advisory firm, and has consulted and written on mergers and acquisitions and fairness opinions. He is the author of the leading textbook on cash flow based security analysis, “Security Valuation and Risk Analysis.” To read more visit his blog,www.credittrends.com