Who or what is going to be the face of the 2020 Covid-19 Pandemic? Will it be the Doctors and Nurses on the front lines? Will it be the kids who are spending a quarter of their school year learning online? Will it be the parents teaching those kids? Will it be the empty baseball fields or quiet swimming pools of summer? One of the faces I worry about is the College Seniors who have lost their Spring Semester of their final year at University. A few months ago, they were planning on their graduation and looking for jobs. Now they are facing no graduation celebration, a fight for a job, and uncertainty of what is next.
Today's guest post is Emily Meehan.
Emily is currently a Senior at Creighton University where she is pursuing a BSBA in Financial Planning and Marketing. While attending school, she has had the pleasure in being involved in campus organizations such as Financial Planning Association, as well as participating within the community through helping prepare tax returns via Volunteer Income Tax Assistance (VITA) and tutoring individuals to pass their citizenship tests with Omaha Public Schools. Upon graduation, she has accepted an offer from Charles Schwab in the Financial Consultant Academy located in Indianapolis.
Brandon's comments: This is a simplified version of what investment managers are doing when they look at the value of a company based on a lot of variables. There are the financial numbers that we make estimations on; inflation rate, deficit, taxes, unemployment, etc. and even if you knew all those a year from now it would still be hard to predict what the stock price was going to be. As Warren Buffett has said, "Price is what you pay, Value is what you get," the price of a stock is less important to us than the value of the company, and that is what we want the focus of our fund managers to be as well.
What Do Earnings Now Mean Towards the Long-Term Valuation of a Business?
By: Emily Meehan
Note: LPL Financial has no affiliation to Emily Meehan and the comments and/or opinions mentioned are those of Ms. Meehan, not LPL Financial.
It has now been over a month since the nation was first placed on shutdown, and the economy has seen its impacts. Companies in every industry have faced challenges in the new environment. This has resulted in companies needing to change their strategy, which has caused companies to layoff workers, shut off production, etc. In this time of uncertainty, many investors are concerned about the current investing environment. While current conditions are worrisome to think about, maybe it is time we consider the future of a company.
A common analysis done in the world of finance is called the “Discount Cash Flow” analysis. Essentially, this model looks at what the future cash flows of a company and “discounts” them at a rate that allows investors to look at cash flows in present-day dollars. In doing this, an investor can determine the current value of an investment. So, while a company may currently not make any profits, this may not affect the long-term valuation of a given business.
Let us look at an example. On December 31st, you are investigating what companies to invest in during the new year. In your research, you find information on the future cash flows of Company X for the next two years. Company X has an expected steady cash flow of $1,000,000 for the next two years, as shown below. The discount rate is the percentage used to “discount” the future cash flow to its present value. In this example, 5% expresses the time value of money in determining if a company is worth the investment. From this analysis, you conclude that Company X is a good stock to invest in because the fair market value of the stock is higher than the current cost for a share. If one share costs $50 (based on the current supply and demand for one share) to invest in a company and there are currently 100,000 outstanding shares, you should highly consider investing in Company X. Based on the discounted cash flow analysis, a share of Company X is valued at $85.
But what happens to the fair market value of the stock if all of a sudden Company X experiences $0 in cash flow? Let us look at an example where Company X does not have a cash flow for two quarters. As shown, the fair market value at $67 is still greater than the cost per share at $50. In this case, even with the fair market value down 20%, it would still be considered a good purchase.
Of course, this is assuming that the company will completely rebound after two quarters and go back to the same steady cash flows. What if in quarter four, when the company does start to experience cash flows again, it is only half of what it originally was and will grow each quarter at 15%? Even when a company has a slow recovery in gaining original cash flow, the fair market valued at $55 is still greater than the cost of the share at $50.
In the current environment, there is still speculation as to when some businesses will fully re-open. What if Company X experiences no cash flow for a whole year? What does that do to the fair market value of the stock? Let us look:
As seen, if Company X were to experience no cash flow for an entire year and return to the same level after a period of zero cash flow, the fair market value of the stock at $51 will be greater than the actual cost of the stock at $50.
As we did with only missing two quarters, what if the cash flow does not return to its normal levels right away? What would that mean for Company X if they miss a full year of no cash flow? Let us assume again assume that when Company X re-opens and starts generating cash flow again that they first only generate half of what they used to, but that it will grow at 15%. As shown in this example, the fair market value of the stock at $42 will be less than the cost of the share at $50. It is important to note, however, that the cash flow level increases every quarter.
So, while a company may experience of a period of $0 in cash flow, the overall value of the company will bounce back from the small periods of not having income. In most cases shown, the actual value of the stock is still greater than the actual cost to buy one share in Company X. As this is a hypothetical example, a disadvantage of using the discounted cash flow model is that one would have to correctly estimate a variety of future external factors that would influence a business. It is important to note that the analysis of a company in times like these should be value-driven and not stock price-driven. Businesses that are good at allocation of capital will be rewarded as they understand the long term value of a company is based on their protection of future cash flows not the stock price quoted daily.
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This is meant for educational purposes only. The information is based on data gathered from what we believe are reliable sources. It is not guaranteed by LPL Financial as to the accuracy and is not intended to be used as the basis for any investment decisions. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.