{"id":1796,"date":"2010-09-07T12:16:32","date_gmt":"2010-09-07T16:16:32","guid":{"rendered":"http:\/\/www.credittrends.com\/blog\/?p=1796"},"modified":"2010-09-07T12:16:32","modified_gmt":"2010-09-07T16:16:32","slug":"hewlett-packard-hpq-and-lexmark-lxk%e2%80%94cost-of-capital-key-to-forecasting-stock-price","status":"publish","type":"post","link":"https:\/\/www.credittrends.com\/blog\/2010\/09\/07\/hewlett-packard-hpq-and-lexmark-lxk%e2%80%94cost-of-capital-key-to-forecasting-stock-price\/","title":{"rendered":"Hewlett-Packard (HPQ) and Lexmark (LXK)\u2014Cost of Capital Key to Forecasting Stock Price"},"content":{"rendered":"

I was looking at some of this years\u2019 winners and losers and couldn\u2019t help but notice the discrepancy in returns of Hewlett-Packard (HPQ<\/a>) versus Lexmark (LXK<\/a>) going back 3 years. For this year, Lexmark is up 35% and Hewlett-Packard down 25%.<\/p>\n

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. \u00a0CT Capital\u2019s <\/a>free cash flow data was enhanced via adjustments to cash flows from operating activities to reflect events that should have been included.<\/p>\n

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.<\/p>\n

Yet, LXK\u2019s stock has outperformed that of HPQ?<\/strong><\/p>\n

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.<\/p>\n

As we have long maintained, estimation of free cash flow is only half the fair value equation\u2014the 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 \u201clast frontier\u201d 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.<\/p>\n

How do I know this is so? Just read through 20 10Ks, searching for cost of capital, and see what you come up with\u2014it\u2019s all about the capital asset pricing model (CAPM), and not fundamental characteristics.<\/strong> My upcoming text, to be out next month, \u201cSecurity Valuation and Risk Analysis<\/a>\u201d will fully explain how an investor should define cost of equity and free cash flow.\u00a0<\/strong><\/p>\n

For information on how cost of capital can provide you with an important competitive edge, or just if you\u2019d like to learn more about it, please contact us at CT Capital<\/a>, and be sure to visit www.creditrends.com<\/a>. We have plenty of literature to back up our leading edge strategies.<\/p>\n

Figure 1: Three-year Relative Stock Performance of Hewlett-Packard and Lexmark<\/p>\n

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Figure 2:\u00a0 Cost of Equity Capital\u2014Hewlett-Packard<\/p>\n

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Figure 3:\u00a0 Cost of Equity Capital\u2014Lexmark<\/p>\n

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