What Return Can Stock Investors Reasonably Expect?

July 11th, 2010 by hackel Leave a reply »

The table at the bottom affirms the relationship between stock price valuations and cost of capital. While the free cash flow multiple is also clearly important and carries significant value, and is a far superior indicator than the P/E multiple, it is change in risk that leads the equity market’s direction. Most pundits would agree, as last validated March, 2009. Keep in mind the free cash flow of the firm is the income to the investor. The same cannot be said with earnings!

During bull markets expansion in multiple valuations is commensurate with like growth in free cash flows, pushing those multiples even higher.

During bear markets, even though firms are more managed for risk, the cost of capital rises, as investors demand additional compensation for the increase in exposures. This comes even though valuation multiples are being suppressed.

As the table shows, during June, 1987 (which doesn’t seem that long ago to me) I was warning of impending risk, and finally shortly before the October crash, was quoted in the New York Times: “ The bull market is dead , it’s over.”  This quote was repeated the following day.

Several months after the crash, as many firms needlessly fell to ridiculous levels, four stocks in my clients portfolios were bought out. Because of that, I was featured in an Inside Wall Street column in Business Week titled “A Divining Rod for Deal Stocks is Striking Gold” and from that article, correctly predicted no less than 4 additional companies than were eventually bought out. It was just a matter of cash flow, risk and valuation. Nothing, as Warren Buffet would surely note, has changed in how the valuation of financial securities should be performed today. There are new instruments, to be sure, but how one goes about such valuation of risk and reward, will barely change.

Over the past decade and a half ( except for the early 2000s) leading up to 2007, as the table notes, risk remained reasonable for the S&P and free cash flows were growing. At that end point, our metrics clearly picked up the change, a long time prior to the world-wide financial and credit meltdown.

To see our worksheet, please pre-order “Security Valuation and Risk Analysis.” at any online bookstore.

As for where we stand now, and what investors can reasonably expect, the table, our other data and history, point to sub-par (below 8%), yet positive returns over the coming year. The cost of capital, at 9.1% is sufficiently high such that any increase in risk would surely result in a magnified effect on stocks.

True, the free cash flow multiple is in the bottom quartile of its historic range, but the cost of capital is in the top half. This combination of higher risk and lower valuation is almost always a recipe for out-sized volatility. Normally it takes years to see the type of reduction in risk necessary for a prolonged expansion. If that seems excessive, recall stocks have declined over the past decade. This, however, should not preclude investors being exposed to stocks. With 10-year Treasury’s under 3%, investments in firms with a clear spread between their cost of capital and their return on that capital should bring superior returns to their stockholders, given a below-market multiple for those assets. This has always been the case and always will, in a free society (sovereign risk is one of our cost of capital metrics).

We will attempt to bring you some of those firms in this space. We will also point out firms which are selling at inexpensive valuations, but behind the financial curtain, are really risky securities to be avoided.

HISTORIC COST OF EQUITY, FREE CASH FLOW MULTIPLE AND S&P FAIR VALUE

FCF MULT COST OF EQUITY S&P APPX F.Value YEAR
16.9 9.2 1090 Mar 2010
16.5 9.1 1156 July 2010
16.5 9.2 1124 May 2010
17.0 8.5 953 1995
17.8 8.7 982 1996
18.0 8.8 1125 1997
20 8.8 989 2002
20.5 8.7 1118 2004
24 8.8 1223 2006
27 9.6 1209 2007
24 9.5 304 June, 1987
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