Archive for the ‘Cash Flow and Cost of Capital in Investment Decision Making’ category

What Part of Market Volatility Don’t You Understand?

February 4th, 2010

We’ve been saying for years investors DO NOT understand risk. The numerator (cash flow) has not shifted much over the past quarter-it’s the denominator, cost of capital, as only can be measured by our comprehensive credit model, factoring everything from tax rate and revenue stability, free and operating cash flows, yield spreads, and 50 other metrics, all carefully defined.

The problem is, in a nutshell, investors are setting risk thru the Capital Asset Pricing Model, which is terribly flawed. They look towards EDITDA, which is terribly flawed.

COMING THIS FALL: Cash Flow, Cost of Capital, and Security Valuation, McGraw-Hill

Central Tenet: The risk premium should not be set by stock volatility, as implied by the capital asset pricing model, but by the cash flows and credit worthiness of the entity.

Altera, Cost of Capital and Return on Invested Capital

January 30th, 2010

Altera - Cost of Capital and ROICOnly CT Capital LLC has the proprietary free cash flow-based return on invested capital (ROIC) and very detailed cost of capital credit-based models to properly evaluate these most important yardsticks.  All other approaches fall short as they do not accurately reflect the underlying financial profitability and stability of a firm, its growth potential and value enhancement level

No wonder Altera is far outpacing its peer group. Continuing to invest in value enhancing projects, whose cash based return in invested capital exceeds its cost of capital is a value creating management strategy sure to reward equity holders.  Altera’s free cash flow yield, like all the companies in our portfolio, is far in excess of the 10-year Treasury yield, while their debt measures are much higher than the median S&P company.

What Cramer doesn’t understand can hurt his viewers …

January 28th, 2010

Switching stations, I heard the first minute of his show this evening, saying “ investors are looking for a reason to sell.”

Someone please tell Mr. Cramer, large investors look to make money, and will sell if they have information not reflected in the current price of the security. If someone sells, someone who holds the opposite opinion buys.

But what he doesn’t really understand, and something I have been pointing out the past three months, is that current financial risk is greater than stocks are pricing in. When we called the market bottom in March, we did so as free cash flow increased, discretionary expenses were being reigned in, and valuations were low.

Over the past quarter, we are finding cash flows, adjusted for discretionary spending growing very modestly, credit health, as measured by our credit model (which incorporates everything from revenue and tax rate stability to yield spreads and off balance sheet debt, and everything in between), showing just minor improvement over the prior quarter. Yet, stocks were rising such that the free cash flow yield was approaching 4%.

And that is why stocks have, in general, declined. Not because “investors are looking for a reason to sell.”

We stated three months ago that although stocks almost never sell precisely at fair value, they were about 10% overvalued. Today, they are about 4% overvalued, based on a 3.6% 10-year Treasury bond, and a 8.4% cost of equity capital.

Ford Motor Company – Cost of Capital Improves, but …

January 28th, 2010

Investors should not get carried away with Ford just yet. Despite market improvement, its cost of capital is still some 70% higher than the median S&P 500 company, reflecting its credit and financial health are still tenuous.

The cost of capital, which is a function of the risk free rate and the firm’s credit health, suggests Ford stock should only be considered by speculative investors, willing to lose a substantial portion of their investment. Ford will be facing strong competition from China and possibly a resurgent GM over the years ahead, and with their long-term free cash flows in doubt, and reliance on debt ( $ $4 bil cash covenant requirement), Ford’s stock appears fully valued.

Ford - Cost of Capital