December 6, 2008 · Posted in Business
Shares of common stock are claims to entrepreneurial profits generated by the factors of production employed in a business. How much one should pay for a share depends on the value preference one assigns to it. While consumer goods render various services the valuation of which highly depends upon one’s value preferences, a share in factors of production, only renders one benefit to its owner: It yields specific amounts of money over a specific amount of time at a certain risk, where risk means the uncertainty over the amounts of money to be received.
Thus these three factors need to be incorporated when assessing the price one would be willing to pay for a share.
Within a certain territory, a so called risk free investment is a credit transaction with the government. The interest rate that the government pays shall be considered the risk free rate. It is expedient to apply the interest rate on 10 Year Treasury Notes.
Every investment in factors of production has to be measured against this risk free rate. If one can expect a guaranteed $1100 in 1 year by loaning $1000 to the government, then $1100 in a year returned by a business will certainly be worth less than $1000. Thus this money received has to be discounted by a confidence margin between 0(very uncertain) and 1 (100% certain). As a standard, all calculations are looked at in annual terms, but it is not mandatory.
The price estimation for money received in the future is called present value. A present value for money received in a certain number of years is calculated as follows:
Present Value = (Payment Amount X Confidence Margin) / (1+ Risk Free Annual Rate)(Number of Years)
Since it is very hard to foresee more than what will happen over the next 5 years, the expected money received over those 5 years shall be factored into the valuation, but all future expected money shall be estimated at a very low growth rate. Thus we shall resort to a perpetuity calculation. A perpetuity is an arrangement where one receives a certain amount of money every year at a fixed growth rate for all time. The fair price of an annual perpetual payment is estimated as follows:
Perpetuity Price = Annual Payment / (Risk Free Annual Rate – Fixed Annual Growth Rate)
The profit generated thus far by a business is reported for all publicly traded companies. But the reports might be misleading. What they report under the label “Profit” is a very manipulated figure that is the result of numerous accounting techniques. The closest approximation of what one can expect to be the actual money available to the business is the free cash flow. The free cash flow can be approximated by subtracting capital expenditures from the operating cash flow (Free Cash Flow = Cash Flow from Operations – Capital Expenditures). All these numbers are available on financial websites. Example: NEM
Based on the growth of the free cash flow over the past 5 years plus the overall expectations of whether or not consumers will still have a demand for the company’s goods over the next 5 years, one needs to come up with an estimated annual growth rate for the free cash flow over the next 5 years. After that we shall assume that the free cash flow returned in the 5th year will grow at a perpetual annual rate of 1% for all time.
Thus the formula to approximate a price one should be willing to pay for a share of common stock is the following (where FCF = Free Cash Flow per share over the past 4 quarters):
Price = Present Value (FCF * Annual Growth Rate, 1 year) + Present Value (FCF * Annual Growth Rate2, 2 years) + Present Value (FCF * Annual Growth Rate3, 3 years) + Present Value (FCF * Annual Growth Rate4, 4 years) + Present Value (FCF * Annual Growth Rate5, 5 years) + Present Value of 1% Growth Perpetuity Starting in 6 years