Hewlett-Packard (HPQ) and Lexmark (LXK)—Cost of Capital Key to Forecasting Stock Price

September 7th, 2010 by hackel Leave a reply »

I was looking at some of this years’ winners and losers and couldn’t help but notice the discrepancy in returns of Hewlett-Packard (HPQ) versus Lexmark (LXK) going back 3 years. For this year, Lexmark is up 35% and Hewlett-Packard down 25%.

I ran a comprehensive series of diagnostics, including the most common ratios looked upon by security analysts and investors. In this assessment of profitability, credit and cash flow, one metric stood head and shoulders above the others, in its forecasting ability.  CT Capital’s free cash flow data was enhanced via adjustments to cash flows from operating activities to reflect events that should have been included.

For Lexmark, its net income and revenues have been much more volatile than that of HPQ. For HPQ, free cash flow, when adjusted, has also been more stable and has increased over the period studied. At LXK, free cash flow declined.

Yet, LXK’s stock has outperformed that of HPQ?

The answer to the discrepancy in performance, despite apparent superior financial measures at HPQ, is the cost of equity capital, which for LXK has been declining. During the period (compare charts below) when HPQ exhibited stable cost of capital, its stock significantly outperformed that of LXK. HPQ has eliminated much of its financial flexibility due to historic and announced share buybacks. LXK has not repurchased shares since its December, 2008 quarter, and has outperformed HPQ, which has been a very large acquirer during this span.

As we have long maintained, estimation of free cash flow is only half the fair value equation—the other half relates to the uncertainty of those cash flows and must encompass everything from stability of operations, hedging strategy to taxes to litigation risk, pensions and health care, insurance, sovereign risk, loss of a key executive, and over 60 other important metrics. This “last frontier” of security analysis often provides an important investor edge which has not been carefully studied by even the largest of investors and enterprises. Investors may implicitly take cost of equity capital into account without a clear and definable method to quantify its importance and role in the investment process.

How do I know this is so? Just read through 20 10Ks, searching for cost of capital, and see what you come up with—it’s all about the capital asset pricing model (CAPM), and not fundamental characteristics. My upcoming text, to be out next month, “Security Valuation and Risk Analysis” will fully explain how an investor should define cost of equity and free cash flow. 

For information on how cost of capital can provide you with an important competitive edge, or just if you’d like to learn more about it, please contact us at CT Capital, and be sure to visit www.creditrends.com. We have plenty of literature to back up our leading edge strategies.

Figure 1: Three-year Relative Stock Performance of Hewlett-Packard and Lexmark

Figure 2:  Cost of Equity Capital—Hewlett-Packard

 

Figure 3:  Cost of Equity Capital—Lexmark

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Disclosure: No positions

Kenneth S. Hackel, CFA
President
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

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