Sunday, August 8, 2010

An easy and novel way to value stocks

Stock valuation is typically based on book value, earnings, and expected earnings.  It's the best we can do.  An intriguing variation of the efficient market hypothesis would be that every stock is expected by the market to be worth double todays value in 10 years (dividend adjusted).  If buy and hold is a legitimate investment strategy (and it happens to be the foundation of financial advice industry **cough**) , then picking stocks based on confidence of value in 10 years would seem like the best approach.

The expected value of a stock in 10 years though,  isn't based on book value, earnings, and expected earnings.  Instead it is based on what the book value, earnings and expected earnings outlook will be in 10 years.  It's relatively easy to predict if a stock's book value will be double in 10 years.  But if earnings are gone, and earnings outlook weak, then a market to book value of 2 today, could turn into a market value below book in 10 years, and so price might have gone down after 10 years.  Earnings and earnings outlook 10 years from now are extremely difficult to predict, but still better a better basis for expected market value in 10 years than cashflow analysis using today's more tangible numbers, because you're unlikely to be paid any of the cashflow growth.  The valuation assumption that you will eventually is simplifying but wrong.


 Apple at 21 PE 6x book and $260  today has great earnings and earnings outlook.  10 years from now (or 20), will it have hit products, and will Jobs still be with the company?  Probably not.  The high P/E implies near term growth, which the market may be correct in anticipating, but a $520 stock price probably would need 4x current earnings (10 P/E).  Its hard to have confidence in that outcome.



Microsoft at PE of 12 and $25 (and 2% yield) has decent earnings outlook.  It has product franchises on PC and console, and could get growth from web strategies, and its not impossible that it comes up with a successful phone/tablet.  Microsoft doing about the same or better seems more probable than Apple.

 A different  but relevant question than which company is most likely to be worth double is which company is more likely to be still alive in 20-30 years.

While both these companies could convert to natural finance, Apple especially would never consider buying out its shareholders at current prices, because it would be too expensive to.  Converting shares into loans is only attractive when those shares feel undervalued to the company.  On the other hand, even if Apple is one of the least well suited companies for natural finance share conversion, it could still benefit from converting the relatively little debt it has to natural finance soft loans:  There is more certainty that Apple will make $10B more in profit before it collapses than the US government will be solvent in 10 years.  So investors should be willing to buy up to $10B in Apple soft loans at rates lower than US bonds (currently under 3%).

One of the main advantages of natural finance to investors over common share ownership,  is that it is much easier to estimate the likelihood that a company will make $10B or $50B before dying, than it is guesstimating whether it will have a positive earnings environment in 10 or 20 years.  The advantage of natural finance over bonds for investors is that there are no substantial obstacles to prevent the company from issuing substantial debt at the same credit priority as your bond.  A natural finance investor can never have his secured priority subjugated by corporate dilution or new debt.

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