20 October 2005

Vacation Reading

I'm back from a wonderful vacation in Scotland (plus a whirlwind weekend in Paris). I brought one book with me for the flight, since we were trying to keep our bags light. Our jaunt to the Continent on Ryanair, the bargain European airliner, required us to keep our luggage under approximately 35 lbs, or we would have been charged hefty fees depending on how much heft we brought with us from the States. So I left the hardcover Potter books at home, and took with me The Five Rules for Successful Stock Investing by Pat Dorsey at Morningstar. I thank John Coumarianos for the excellent recommendation.

The investing philosophy espoused by Dorsey is prudent, long-term, value-based, and research-intensive. It's not a book on trading, nor will its lessons help me discern wonderful speculative plays. The first half examines how to evaluate companies and stocks, culminating in applying a valuation method. The second half (which I have left mostly unread) analyzes individual industries. I will be using Dorsey's book as a reference onward in this blog, specifically on figuring out core long-term portfolio positions.

So let's see what I may have learned over my vacation.

The remainder of this post is a straightforward nerd-o-rama focusing on stock valuation. My next post will get into some of the really fun things I did in Scotland and how those experiences may have triggered some pursuable investment ideas. So unless your name is Louis, Gilbert, or Booger, you should have stopped reading already.

I tried out the Discounted Cash Flow model described in chapter ten on Wal-Mart, since that's the stock with which I started down this slippery slope. I'll try to be as clear as possible, in case you want to play along.

My starting assumptions for WMT were culled from data at Morningstar.com and Marketwatch.com:

Current stock price: $45.60
Shares outstanding: 4160 million
This year's free cash flow (millions): $2151
Next year's free cash flow (millions): $2688.75
Perpetuity growth rate (g): 3%
Discount rate (R): 9%

I arrived at next year's free cash flow figure of $2688.75 by multiplying this year's free cash flow of $2151 by 25% and adding to $2151. Why 25%? I looked at WMT's free cash flow figures for the past five years and calculated how much they changed year to year. The average change was +26.6% ('01-'02 = 20.2%; '02-'03 = 69.3%; '03-'04 = 79.0%; '04-'05 = -62.2%). 25% is just an easier number to use than 26.6%, and it's only a model.

Taking these numbers, I calculated the free cash flow (FCF) forecast for the next ten years assuming the 25% growth rate:

Year 1 = 2688.75
Year 2 = 3360.94
Year 3 = 4201.17
Year 4 = 5251.46
Year 5 = 6564.33
Year 6 = 8205.41
Year 7 = 10256.76
Year 8 = 12820.95
Year 9 = 16026.19
Year 10 = 20032.74

Still with me? I then calculated the discounted free cash flow (DFCF) by taking the above free cash flow numbers and dividing them by the discount factor of (1+R)^N, where N = year being discounted. For example the discount factor in year 2 is (1 + .09)^2 = (1.09)(1.09) = 1.19. In year 4, the discount factor is (1.09)^4 = (1.09)(1.09)(1.09)(1.09) = 1.41.

Year 1 = 2266.74
Year 2 = 2824.32
Year 3 = 3231.67
Year 4 = 3724.44
Year 5 = 4262.55
Year 6 = 4884.17
Year 7 = 5604.79
Year 8 = 6442.69
Year 9 = 7385.34
Year 10 = 8452.63

Next, I calculated the perpetuity value and discounted it to the present: Year 10 FCF x (1+g)/(R-g)

(20032.74 x 1.03)/(.09-.03) = 343895.37
Discounting the perpetuity value = 343895.37/1.09^10 = 145103.53

The total equity value is the sum of the ten DFCFs and the discounted perpetuity value:
89408.70 + 145103.53 = 234512.23

The per share value is total equity value divided by shares outstanding:
234512.23/4160 = $56.37

So according to this model, applying my somewhat-informed assumptions, WMT is worth $56.37. So WMT is $10.77 or 19.1% undervalued according to its current price of $45.60. My earlier attempt at a valuation of WMT came to $76.98, making WMT look like the 50-cent dollar. This model adapted from my vacation reading makes WMT an 80-cent dollar.

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