Tuesday, May 12, 2009

Price Targets and Valuations

At AlphaNinja our favorite valuation measure is a company’s “FCFY,” or free-cash-flow yield. And that yield is based on the price it would take to purchase a company, net of cash. The reason this measure is so useful is because it avoids the pitfalls of picking a PE ratio out of thin air, based on a "historic" multiple, etc. Many people purchased stocks last year with the idea that PE's were low versus the ten year (or 15 year or 20year) PE ratio, and suffered serious losses as stocks become even cheaper. We also find FCFY better than using a Discounted Cash Flow model, partly because of the myriad of assumptions (the problems with CAPM are a topic for another day) that go into calculating the cost of capital. FCFY allows for a clearer comparison between asset classes.

Instead of hoping for the market to agree with you about a company's PE ratio being too low, you can be comfortable that a company's FCF yield is a good return on your investment(or for a potential acquirer), and certainly higher than its cost of capital. Dell For instance:

Market Capitalization = $21.8billion
Cash = $9.09billion
“Net MCAP” = $12.71 billion

Approximate FCF = $2billion
FreeCashFlowYield = 16%

I don't care WHAT your cost of capital for DELL is, a 16% FCFY is well above it -expect that to come way down, i.e. the stock to go way up. (I exclude debt in the calculation of purchase price because operating income would average about 36times it's interest expense - not a moot point, but an extremely healthy margin.)

Apple might look expensive with a FCF yield of 6.5% on it's net MCAP, but in early March it could be bought yielding over 10%. At Apple's nosebleed mid-2008 levels equity investors were getting maybe 2-3% FCF yield while sitting at the bottom of the capital structure, a risky bet. But either way, FCFY is a great way to evaluate an investment in these companies - is the lower yield (to the tune of 20 points!) on Apple's shares a decent trade-off for it's better growth profile compared to Dell? Maybe, maybe not.

(Disclosure - long DELL)

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