Napa Wealth Management’s
The Sensible Investor
November/ December 2011
Next Newsletter: January 2012
The Case of a Higher Stock Market
By: Tim Ayles, Chief Investment Officer
I want to take a look at the value of 25
Dow components at the end of 1999
compared to the value of the same 25
Dow components today, and show that
even though the Dow has seemed to
move sideways for almost 12 years, the
underlying value of the businesses
have increased by about 168%.
Let's dig in. First I want to make the case for Free
Cash Flow as the way to value a business. If I were to
buy the local widget franchise on my street corner for
a new family business, I would want to know what the
bottom line income I could take out of the business to
live on. Looking at free cash flow of a publicly traded
stock allows this type of comparison. As “Fund Manager of the Decade,” Bruce Berkowitz said in the 6th
Edition of Graham and Dodd's Security Analysis,
"Graham and Dodd referred to that excess cash as
'earnings power' or 'owner earnings.' That's the amount
of cash an owner can pocket after paying all expenses
and making whatever investments are necessary to
maintain the business. This free cash flow is the well
from which all returns are drawn, whether they are
dividends, stock buybacks, or investments capable of
enhancing future returns.”
Assume the local widget franchise on my street corner
is selling for $1,000,000. After paying all my expenses
and investing in new capital equipment to maintain the
business, pretend I can take home $26,600. Before
making the $1,000,000 investment, I would have to
decide if a 2.66% return on my money was worth the
risk of buying that business.
Let's also pretend that back then, if I decide to buy, I
only desire to take home $15,000 and leave the remaining $11,600 in the business to expand or buy a
competitor, pay down debt, or buy out any partners I
may have taken on. I want to look at total owner earnings (free cash flow) rather than just take home pay
(dividend yield), as the determining factor for whether
I should buy the widget store or not. The $15,000 take
home pay is the equivalent of the dividend yield on the
Dow back in Dec 1999. The $26,600 is the equivalent of
the free cash flow of the 25 stocks we will look at today.
This means that these stocks could have paid out all of
their free cash flow in the form of dividends (take home
pay), giving the owners a 2.66% yield. Not bad when
looking at today's low yields from savings accounts, but
back then, the yield on a 10 year "risk-free" treasury bond
held to maturity would have paid the same investor
approximately $65,000 per year for $1 million invested.
So investors on December 31, 1999 that decided to buy
these 25 stocks in equal amounts were willing to take the
risks of the stock market in order to earn $26,600, instead
of investing in the risk free rate from the government
which was $65,000. That equates to 59% less income, for
much more risk. Not a good trade off based on those numbers if you ask me. At year end 1999, investors who were
buying these stocks, were most likely over paying and not
getting a very good risk-reward investment in return.
Fast forward to today. These same 25 stocks are now
showing a free cash flow yield of approximately 7.15%.
That is like buying the widget franchise for $1,000,000
today, but getting owner cash flow of $71,500. If I decide
to buy today, I can take home the entire cash flow and get
a 7.15% return on my money. Let's assume I take home
roughly what the Dow was paying at the start of the year,
which was about $25,000. That is roughly 60% more take
home pay than I would have received in year end 1999.
After the 60% increase in take home pay, I am still left
with $46,500 that I can use to pay down debt, buy out
partners, expand, etc. Did you just see that? The money I
have left over after a 60% pay raise is 75% more than the
entire amount I could have earned back in 1999 year end
and today's left over cash flow is about 400% more than
what was left over back then. A 60% pay raise and 400%
more cash left over. That is huge. Even though the price of
The Case of a Higher Stock Market - Continued From Page One
the Dow has pretty much gone nowhere, by waiting
over 11 years to buy today, I am getting a much better return on my invested money. So much for the
argument that the Dow components have not created
any wealth for investors. Dow companies have done a
great job creating wealth, the problem lies in the fact
that investors over paid by a lot 12 years ago.
Also - the current Dow components are not the same
Dow stocks in 1999. This fact will throw off the yield
numbers above, but for this test, we are assuming
each of these 25 stocks could have been bought at
1999 year end. Another assumption we are making is
that we are investing equal amounts in each of the
stocks, while the Dow itself is price weighted. So the
higher a share price, the more weighting it gets in the
actual Dow.
The list to the right shows the 25 stocks I am analyzing with their free cash flow yield in 1999 year end
compared to 2010 year end. This list of companies is
not to be construed as buy or sell recommendations.
The Dow closed on Dec 31, 1999 at 11,497, and currently is sitting in the 12,000 area (as of this writing).
It seems to be a lost 12 years for investors, which, if
you look at the price, is true. Buying the 25 stocks we
looked at using the Dow price, is the equivalent of
buying the Dow in 1999 at 4,277. I guess you would
do that if you could go back in time and get the Dow
at 4,277. Another way to view it, if these stocks were
to return to a free cash flow yield like that of 1999
around 2.66%, then the Dow today would have to rise
168% from the current 12,000. That puts the Dow at
about 31,920. I am not saying we get there, but want
you to just see the comparison apples to apples. Bottom line, based on 1999 valuations, today's Dow
would need to trade at 31,920 to be a comparable
valuation bubble. Now you can also understand the
absurdity of the prices people were paying for stocks
back in 1999. Today, you get over twice the cash
flow for your money from these 25 Dow stocks, even
though the price has not changed.
1836 Second Street, Napa, CA 94559 ♦ 707.252.1343
In conclusion, while stock prices might have been dead
money for the past 12 years, it is important to realize that
price is not everything. It is important to remember that the
underlying companies are much more valuable today than
they were at these prices in 1999.
Tim
YE 1999
FCF%
3M Company
4.02
Alcoa Inc.
3.39
AT&T
3.20
Bank of America 6.76
Caterpillar Inc.
5.86
Chevron Corp.
1.00
Cisco Systems
0.07
Coca-Cola
2.06
Disney
0.92
Du Pont
3.21
Exxon Mobil Corp 2.08
General Electric
3.02
Hewlett Packard
2.90
Home Depot
1.40
Intel Bus. Mach.
3.89
Intel Corp
2.84
Johnson & Johnson 3.02
McDonald’s
1.91
Merck & Co.
2.85
Microsoft
1.33
Pfizer, Inc.
1.88
Proctor & Gamble 2.31
United Tech.
3.01
Verizon
2.27
Wal– Mart
1.41
YE 2010
FCF%
7.30
2.27
8.00
7.81
4.27
5.86
7.66
4.71
5.41
6.67
4.99
8.74
10.16
6.95
8.72
9.98
8.16
4.62
14.07
8.02
10.27
5.89
7.11
4.33
6.30
Equal Weight Total 2.66%
10 Year Treas. Yld 6.50%
Difference
-3.84%
7.15%
3.83%
3.32%
Stock
Website: www.NapaWealth.com