Saturday, April 27, 2013

Example – Intrinsic Value of Microsoft Part I

Now that we outlined the intrinsic value of a stock in general terms let’s focus on a real life example: Microsoft. From GlobeInvestor Gold or from the Canadian Shareowner Database you can download the financial data over the last 5 to 10 years. We need to know the company’s stock price history, net earnings, EBIT and information about its debt. In the figure below you see some of this data from June 30, 2008 (right) until June 30, 2012 (left).

 Figure 1 Part of Microsoft’s Income statements over last 5 years, as is available on GlobeInvestor Gold. Other databases you could use are those of Canadian Shareowner or Yahoo-Finance. Click on this figure to magnify.

Our first goal is to create an investment cash flow and price appreciation forecast. To do so, we need not only to know earnings growth, dividend payments and share buybacks in the past, but we also need to estimate how this data extends into the future, say over the coming five years. From our earlier discussions it should be clear that the wider Microsoft’s moat around its business is, the more predictable and reliable this forecast will become.
About Microsoft’s moat you can all learn into today’s media commentaries. As said on this blog many times, you will have to be critical of what you’re being told and separate the hype from reality. Ask yourself, 'do you see Microsoft being in business 100 years from now,?'; similar to companies like GE or Proctor & Gamble have done? That really is the type of company we’re looking for in our Dividend Portfolio (one of our four portfolio strategies).

Here is a screen shot from Excel that shows how you could arrange our 5 year data and our five year forecast.
Figure 2. Earnings  forecast - click on this figure to magnify.

Column A3 to A12 shows the years from 5 years ago (years1-5) to 5 years into the future (years 6-10). Column B shows the fiscal year end date of the company who’s data we’re analyzing; Column C holds the EBIT and Column D the Net Earnings data for the corresponding years. So in our Microsoft example, Year 1-5 rows contain EBIT and Net Earnings from 2008 to 2012 as released by Microsoft. They are plotted in the adjacent graph versus time. Trend line analysis was used to determine slope and intercept for this earnings data shown in columns C and D, rows 15 and 16. The slope and intercept were used to extrapolate these earnings into the next 5 years (2013-2017) as shown in column A (years 6 to 10). The extrapolated earnings are shown in the earnings graph for 2013-2017 and are reported in Columns C and D, rows 8 to 10 (colored orange).

To estimate the stock price in year 10 (June 30, 2017) I make the assumption that market emotions regarding Microsoft five years from now are not really that different from today. So the P/E should be the same as it averaged over the past 5 years. To calculate the average P/E over the last five years determine from historic stock price data what Microsoft’s common share price was on June 30 for each of the past 5 years (Column E) and determine the P/E for these dates (Column F) by dividing this price by the corresponding net earnings in Column D. Next these P/Es are averaged in cell F13.
Using our earnings forecast for 2017 multiplied with the average P/E, we can estimate that Microsoft’s share 2017 price will be around $39.09 (cell J7). The dividends combined with this estimate of the potential share price 5 years from now will let us construct the cash flow stream of our Microsoft investment for the coming five years and thus estimate its intrinsic value. This we’ll do in one of our near future blog posts.

Sunday, April 14, 2013

What happened to Peak Oil? – The new energy revolution.

I am writing this stepping onto the bus using my new Surface Pro tablet computer while being connected to the cloud using my Windows phone as wireless network. Yes we’re living in truly revolutionary times. Not only are we experiencing a technology revolution, we’re also living in an energy revolution and that is the theme of this posting: What happened to Peak Oil?
As a geologist with over 30 years experience in the oil patch, I realize that although  economics rule the day in terms of where we putting our efforts, technology, social trends and many other factors determine the final direction of our collective lives.
Peak oil made the correct assumption that our resources are limited. Yes, we have run out of oil by now – that is oil to be found in, what today we consider, highly permeable reservoirs. Because, with the technologies of the 1970s it were only those reservoirs that allowed us to produce oil and gas economically.
How much has live changed in terms of hybrid cars, hydrogen driven cars or electric cars in the fight to conserve energy. The way we look at the environment and a sustainable economy has resulted in enormous shifts of thinking. But in the end, I think that economics will determine that we have vehicles powered somehow by natural gas and oil for some decades to come.
I would like to digress for a moment (don’t I always?). Although I feel that green activists, leftist journalism and for that matter, journalism on the right, all have their place in the ongoing discussion about the direction we as a society take. However, I do not like the ideological fanaticism that these activist groups espouse and their ‘adjustments’ of facts.
It is so ironic; with the 'green' opposition to new pipelines as an unintended consequence they have driven oil companies to much riskier rail transport. The same is true for the greens’ war on carbons and their push to alternative energy under the guise of fighting global warming or climate change in the most futile and hysterical way possible. Their audacious and arrogant views that humans can significantly affect and control climate is beyond believe.
As I have said in earlier posts, it is important to keep our earth clean and sustainable but not to the fanatical degree of anti-human behavior as displayed by those activists. Another irony in their opposition to hydrocarbon powered vehicles is the so-called hydrogen engine as developed with mixed success by companies such as Ballard and Plug. Imagine a world filled with hydrogen powered cars that spout… 'poisonous' water and water vapor; the latter being an even more powerful greenhouse gas than CO2! Well let’s go back to our original discussion.
So our conservation of energy has resulted in delaying 'Peak Oil'. But it is technology on the other side of the hydrocarbon equation that has really rendered the 'Peak Oil' concept obsolete. The new horizontal wells penetrating sometimes up to 4 miles of reservoir combined with multistage fracking has opened up a whole new type of reservoir - non-conventional low permeable reservoir.
First we applied these technologies in ‘tight gas reservoirs’ and we were thus successful that we created an oversupply of natural gas. Our pipelines and markets were filled to the rim and with North America not being well connected to the global natural gas infrastructure, gas prices collapsed to below the cost of production.
Many North American industries took advantage of the situation such as electric utilities and car manufacturers that build engines running on natural gas. Transportation is in the process of quickly converting a lot of trucks to natural gas-powered. With more natural gas than we can handle, we have actually started to export it. However, our current export facilities are so far behind in capacity that for the immediate future we’re drowning in our own gas. Finally, after five years, our gas production has stabilized and a local supply/demand equilibrium is starting to form. In response, gas prices have started to revert to a more normal level(close to the cost of production). It will take several years before we can export this gas and before we will have true global gas pricing.
The same is now true for oil as well. Pipeline constrictions have cost industry and society billions. But, in spite of reactionary green, left activism (and the Xenophobic Tea Party), export facilities will be build and antiquated oil and gas export policies in the U.S. will be defeated, allowing us to reduce our trade imbalances and government deficits. Nothing is as economically stimulating as affordable energy and in-spite of Obama’s dithering and damaging politics, his administration is likely to preside over the beginning of an extremely prosperous period in North American history.
Let China and other BRICS take care of themselves – I am sure they will do well upon reaching a critical mass of economic self-sufficiency. The new energy revolution has the potential to take care of the trade imbalances and debt levels that we all worry so much about (well... some more than others).
If there is one thing I have learned then it is humanity's unlimited potential. You just have to dare to lookout into the future far enough. There is no shortage of energy around us, whether hydrocarbon based, or solar, or geothermal. The real issue is to achieve the right balance of energy sources at reasonable prices. For that, our collective wisdom as expressed in the markets – the invisible hand – is ideal. It may be a bit slow and it may be indifferent to the ups and downs in the lives of individuals and that is where neighbor, community, province, country and possibly a global government have a role to play.
How much this role is to be, seems the perpetual topic of discussion between left, right and the center. But in all of this, we should never forget about individual accountability and the right of reward when we’re doing good.
I think, the term ‘Peak Oil’ will fade in history. It has proven to be very useful in making us aware of our resources and how to manage those resources in a responsible fashion. I also hope that we will never forget its lessons.


Wednesday, April 3, 2013

What is the INTRINSIC or TRUE VALUE of an investment asset? Part III

Spreadsheet stuff – Intrinsic Value

So let’s put in practice what we have learned. Say an investment’s purchase price is $28.04. To buy it, you have to pay out of cash flow $28.04, in other words you have at time 0 a negative cash flow of $28.04.

Figure 1. Cash flow from investment including purchase in year 0 and sale in year 5 is shown in column 2. Cumulative Cash Flow shows when you have received back your investment funds. Investment Value is the potential market value of the investment in Years 0 through 5. The last column is the Cash flow expressed in Today's Dollars (i.e. Year 0).
A year later you receive dividends equal to 5% of the purchase price. Investors say then that the dividend yield is 5%. Thus you receive at the end of you first year $0.93, i.e. you have a positive cash flow of $0.93. If you had bought additional shares that year, say $10 worth of shares, then the cash flow for year 1 would have been $0.93-$10= $-9.07.
Taking additional share purchases or other expenditures such as brokerage charges or interest on money borrowed to purchase the shares into account would make our example too complex and that defeats the purpose of this exercise. So in our case, we only receive dividends - $0.93 in year 1.

Dividends tend to rise with rising corporate profits and our investment is made in an excellent company that increases its dividend every year. So in year 2 we’re having a positive cash flow of $0.96 and the year there after $0.99, and so on.

Let’s assume that we sell our investment at the end of year 5. The share price has increased to $37.00 (see investment value column) at the time of sale. Thus cash flow in Year 5 is: dividend plus sales proceeds: $1.05 + $37.00 = $38.05. Now we have constructed the cash flow stream over the 5 year life of our investment (Figure 1).

In the third column of our spreadsheet you see the cumulative cash flow; the total cash flow received up to a particular year (row). E.g. in year 3, we had a total cash flow of negative $25.17. In year 4 we received dividends of $1.02 which created for that year positive cash flow of $1.02. Thus the total or cumulative cash flow received between Year 0 and Year 4 was negative $25.17 plus $1.02 which equals negative $24.15.

The term Net Present Value means “what is $1.00 in Year 4 worth in Year 0.” Think inflation. What can $1.00 that you receive four years from now buy you today?

What if you borrowed money and you paid 6% interest and you get four years from now $1.00, how much would you pay for that dollar today? Correct, you would pay $1.00 minus the interest paid over those four years (assuming there is no inflation). The interest rate you paid is called the ‘Discount Rate’ it is a measurement of how much you have to pay to borrow the money, i.e. the Cost of Money.

If you could invest your money risk free for 6% and you get the chance to invest in a riskier opportunity, then to  invest in this riskier investment you would want to get a better return than 6%. In fact, the higher the risk the higher a return you would require.

You can express Net Present Value in terms of today’s purchasing power, in other words correct it (or in accounting lingo, discount it) at today’s inflation rate. However, many corporations and investors look at either the cost of borrowing the money or the costs of forgoing investing in a risk free opportunity compared to a riskier one.

Thus many corporation set the discount rate for calculating NPV at the rate of return they can get on a ‘risk free’ investment – typically somewhere between 10 and 20%.

What rate of return can you get on a risk free investment today? GICs are often guaranteed by the government and over five years you may get interest at a rate of 2.7% This is probably the best ‘risk free’ return you can get as a small investor and this maybe a suitable discount rate for you to see how much more you will make when investing in the shares of a riskier stock purchase.

Fig 2. At the top we calculate in the red boxed column the Net Present Value of the entire investment including purchase price in Year 0 dollars. Note since we assume that typically investment income is received at year's end, Year 0 is basically the start (i.e. January 1) of Year 1. Thus $0.93 received on December 31 of Year 1 is worth $0.84 the the start of Year 1 which we call: Year 0. This is one of the quirks of a NPV calculation. Figure 2 shows the INTRINSIC VALUE of the investment, i.e. the proper purchase price, which is the Net Present Value of all dividends and sales proceeds received over the five year live of our investment. If the market price is below intrinsic value you will make a return better than the required 10% (discount rate), while if you buy at a higher market price then you return will be less than the discount rate.
In our example we pretend to be a big business that requires a 10% discount rate. Thus we can now ask, what is $0.94 in dividends a year from now worth today discounted at 10%? In other words, what is the Net Present Value of $0.93 using a discount rate of 10%?
The answer is: $0.84 because at a rate of return of 10%, we’ll have $0.84 + $0.084 = $0.93 (rounded off) by year’s end. If we received two years from now $0.96 in dividends that would be worth $0.79 in today’s dollars:

$0.79+ $0.079 = $0.87 in year 1 plus $0.87*10% = $0.087 in year 2 or 0.79 + 0.079 + 0.087 = 0.96. In other words $0.96 dividends in year 2 is worth $0.79 today (year 0).

In the column ‘NPV of Cash Flow', I have converted the cash flow for each year into ‘Year 0’ dollars or NPV. When you add up the yearly NPV from year 0 to year 5, we’re calculating the Net Present Value of the entire cash flow stream of the investment including the initial purchase price and the final sales price.  It shows a negative NPV of $1.34. Apparently, this investment will not return the 10% that we want from our investments.

In fact, if we want a NPV = 0 for this particular investment we would need a discount value of 8.9%. The discount rate that would give an investment a NPV of $0 is often called the Internal Rate of Return or IRR. So our investment’s IRR is 8.9%

Now we’re finally ready to ask the question: Given that we receive dividends in five successive years of $0.93, $0.96, $0.99, $1.02 and $1.05 plus final sale proceeds of $37.00 and given that we require a 10% annual rate of return would you pay today $28.04 for this investment?

Your answer should be no, because the intrinsic value of this investment is less than $28.04. For us to earn 10% per year, I would pay only the net present value of this income stream discounted at 10% which is: $26.70 or the sum of the NPV of years 1 through 5. The Intrinsic Value of our stock investment is $26.70.
Calculating the intrinsic value to determine how much we are willing to pay for an investment takes a lot of emotions out of our investment decision. Two important questions remain. The first question is: How confident are we that the dividend payments are as forecasted? In other words: How wide is your moat?  This issue we discussed in the previous post.

The second question is how do we make a reliable prediction as to what the final sales price will be? In order to do that, we will have to look at the earnings yield, i.e. earnings/purchase price (E/P) rather than the dividend yield. If we could forecast what the earnings by our investment would be five years from now and assuming the earnings yield will not change, then the stock's end value would equal the forecasted earnings divided by the earnings yield. We’ll discuss this in the next post.

 A final point: When does this investment payout? Let me rephrase the question: When have we received dividends equal to the original purchase price? The answer is: when Cumulative Cash Flow equals 0 (Figures 1 and 2 - column 3). Or… assuming the dividend yield of 5% does not change over the next five years, we calculate that in year 20 (=1/dividend yield) we will have received dividends totalling the initial purchase price.

For those amongst us who really like math: