With both a new year and a new millennium upon us, this is about as good an opportunity investors will ever have to reassess their investment strategy. With hindsight being perfect, it is obvious all of us should have invested our entire net worth for the last decade into Microsoft. For the few of us who did not, what do we do for 2000?
This is a major problem with all investment strategies. For the most part they are predicated on looking at the past and then extrapolating out to the future. As humans, we will have to live with the fact that we cannot predict the future, but there are some tools we can use to get a glimmer of the future.
As stated in previous articles, when you buy a stock you are actually buying a business. The cash flows you receive over the years and how management reinvests excess capital will ultimately determine your return on investment. When discounting future cash flows most analysts rely, to a degree, on the Capital Asset Pricing Model (CAPM). CAPM uses a risk-free proxy such as T-bills and then attaches a risk premium for owning the business. This risk premium, or beta, is calculated by comparing the price fluctuations of the stock in question to that of the overall market. In other words, you are looking at past volatility to arrive at a number for discounting future cash flows. Some people have compared this to driving a car while looking in the rear view mirror.
A recent new approach that attempts to look through the windshield as opposed to the mirror is Cash Flow Return on Investment (CFROI). CFROI uses a current market derived discount rate as opposed to an historical rate. The logic goes something like this: If you assume the market is reasonably efficient, then the current stock price of any business is an aggregate of investors’ expected cash flow returns, discount rate, inflation expectations and tax rates. To then determine how much volatility investors expect as opposed to how much there was in the past, one needs to do the reverse math to measure the implied discount rate in the current stock price.
To calculate a more meaningful number CFROI advocates first create an aggregate of similar firms. For this particular group of companies their total market value, including both debt and equity, is calculated. Then the expected net cash receipts of these firms are summed. Finally, a discount rate is selected and a net present value of the cash receipts is calculated. It then becomes a trial and error procedure until the appropriate discount rate is selected where the net present value of the expected cash flows per share equals the current stock price. In other words, at this particular moment in time the market, which is forward looking, is dictating the appropriate discount rate to use when valuing the business.
As an investor, this is a very important concept to understand. As the saying goes: garbage in, garbage out. If you believe that discounting cash flows is an appropriate metric for valuing a business (stock), then the discount rate used can dramatically influence the value. Perhaps this year, in an attempt to get a glimmer of the future and discover that next Microsoft, consider using a forward-looking discount rate as opposed to one based on the past.