The Best Indicator of Future Stock Prices Over Last 10 Years
Half the book is devoted to risk—credit analysis— and includes my credit model, which is a far superior model from which to derive the discount rate of the free cash flows. I am sure it, or a close approximation of it, will be used by upcoming generations of security analysts. You can have it now.
This leads me to this article’s headline.
By far and away the metric with the closest association with future stock prices-even more so then cash flow, has been the proper estimate of the cost of equity capital. If you have a fair approximation of cost of equity, it will improve your investment results.
For in order to arrive at a fair value estimate for an equity security, the analyst, for a going concern, must discount its free cash flow. We stress going concern as analysts use other measures to arrive at fair value, notably, market value of the individual parts, liquidation value, price/sales, price/earnings, or price/book, most of which are tied into GAAP accounting, but are limited in scope and do not provide what an equity investor is really seeking: the maximum amount of cash that could be returned to them without sacrificing the growth or value of the enterprise. Book value has proven to be an unreliable metric if the book consists of assets where buyers at fair market prices are absent. What is the value of an asset for which there are either no buyers or buyers at unreasonably low prices? It is the free cash flows, which must then be discounted. But at what rate?
Cost of Equity Capital
| Fair Value | Current Free Cash flow Per Share | Growth Rate | Discount Rate (Cost of Equity Capital) |
| $42.00 | $1.20 | 5% | 8% |
| $31.50 | $1.20 | 5% | 9% |
| $18.00 | $1.20 | 5% | 12% |
Causing fair value to change in the table is the cost of equity capital-current free cash flow and its growth rate remain identical. As evidenced, a one percentage point change, from 8% to 9% in the cost of equity equates to a staggering 25% decline in fair value. If the entity’s risk rises further, to a 12% cost of equity, the stock should be expected to fall by 57%. Such is the importance of the discount rate, and the reason it must be precisely established to calculate fair value. If an entity’s cost of capital rises, its share price, must, by definition fall, until it reaches its new lower fair value, as shown in the table.
One might ask: If the current free cash flow and growth rate are known, why would fair value differ? It is because the numerator is only a guess, even if an educated one, supported by appropriate research and investigation. There are risks to any free cash flow or earnings estimate-patent or customer loss, volatility in input costs, foreign government risk, rollover of debt risk, etc, and these are captured by the cost of equity. The fewer and less serious these risks are, the more certain we can feel about the numerator, the free cash flows. For such an enterprise with above average normalized free cash flow and moderate leverage, lower cost of equity will normally place the entity in a position to add value-adding projects with more facility than its competitors.
More on this subject later, as I finish proofreading.
Kenneth S. Hackel, CFA
