Saturday, May 4, 2013

You see, these metrics are all part of the same beast? Microsoft Part II

To construct future cash flow, we’ll have to start with the purchase price of $28.04 per share, (this includes commission). As pointed out, the NPV calculations for years 1 through 5 are done at year’s end. The purchase the share is done at the start of year 1. The closest approximation of this would be a purchase at the end (Dec 31) of year 0.
Since the purchase is a negative cash flow event, Year 0 is set at minus $28.04. Dividend payments add to cash flow and are consequently positive. At $28.04 current dividend yield is 3.3%. Just like the P/E we assume that the yield does not change over the coming 5 years (a bit simplistic, but alas!). So dividends will increase with the share price. By multiplying the forecasted share price (column D) with the dividend yield we’re estimating our positive cash flows for years 1 through 5.
Apart from collecting dividends in year five (5), we also assume that we will sell our share for the forecasted share price of $39.09. For year 5 we then have a positive cash flow of $1.20 dividends plus $39.09 sales proceeds totaling $40.38. Voila! Our cash flow forecast!
Now we’re ready to calculate the NPV of the cash flow stream for each year. By adding up the NPV for all 5 years plus Year 0, we arrive at the investment’s NPV ($0.19). If the NPV is slightly positive, our investment will likely provide us a return that is slightly better than the Discount rate required by us (10%). If the NPV is negative, the ROI will be below the discount rate. If NPV is 0 then the forecasted cash flow will provide a return equal to the discount rate.
Fig 1. 5 year Cash flow forecast. Click image to magnify.

Well, you may ask, if a NPV of 0.19 indicates a return slightly better than the discount rate, could you tell me how much better? Yes, I could fiddle around with the discount rate until I have a NPV=0. This return is also called the Internal Rate of Return and it is 10.2% according to Excel’s IRR() function.
Yeah, and the intrinsic value? Well the intrinsic value is nothing more than the NPV plus the initial purchase price. In other words, the NPV of all cash flows without the investment capital that you, the investor, has to put up (i.e. the purchase price). Microsoft’s intrinsic value according to our spread sheet is $28.23. Guess what, if you subtract our $28.04 initial investment from the intrinsic value of $29.07 you’ll get the NPV=$0.19.
You see that these metrics are all part of the same beast? - Going around and around.
Now we’re doing one last metric: Pay-out time. This is the number of years it takes for your cash flow to break-even, i.e. when the total amount of cash flow (dividends) received equals your share purchase. For that you can extend our cash flow forecast to, say, 25 years. By calculating the cumulative cash flow in the column adjacent to the annual cash flow (Column C) you can observe that after 18 years you will have received a total of dividends that equal’s the initial purchase price of $28.04. In other words, pay-out is 18 years.

If you divide 1 by the dividend yield, you would learn that if the dividend did not change you pay-out time would have been 30.3 years, however, the continuous stream of dividend increases that are associated with earnings growth will accelerate your payout to around 18 years.

Fig. 2. Extended (25 years) Cash flow and Cumulative cash flow forecast. Note that cumulate cash flow is greater than zero (0) or turns positive in year 12, The investment's payout time is thus 18 years. Click on the image to magnify.

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