Friday, November 27, 2015

A Warning

       It is easy to lose perspective when things are going well and for stock things have been going well for quite some time.  The chart table below gives the total returns on the S&P 500 for the years 2008 through the current point in 2015.  Since the collapse in 2008, it has been up, up and away.  From the end of 2008 onward, the S&P 500 has average a compound return of over 15% in an environment of little inflation and with short-term interest rates close to zero.  But the continued rise stretches valuation thinner and thinner.  Stocks clearly cannot go on performing as they have relative to interest rates and inflation forever.  The question is when will stop, or even reverse.  If I had a good idea I would be trading rather than writing this blog.  (Well to be fair I am trading, but cautiously.)  Although I can't predict the future with any accuracy, in my view a warning is in order.

S&P 500 Total Return
2008 -37.00%
2009 26.46%
2010 15.06%
2011 2.11%
2012 16.00%
2013 32.39%
2014 13.69%
2015 2.65%

Friday, November 20, 2015

Don't Be Square

     I hate to be boring but here we go again.  Square has jumped to nearly $14 after its IPO.  To justify that valuation you have to assume significant future value creation (what financial economists call growth options).  Exploiting growth options requires barriers to entry and in the payments world the barriers may be less than in the wearable devices market discussed here earlier.  Apple and Samsung, among others, may use payments as a free feature to sell their devices.  Of course, Square may say that it is going to become some type of financial service provider for small business.  But at this point that is pie in the sky and that business is highly competitive too.  In short, buying Square for about $14 means bearing a great deal of risk for what appears to me to be little expected return at such a high valuation.  The good news is incorporated in the price but that market has not given enough weight to the down side.  Bottom line - keep you money elsewhere and don't be square.

Wednesday, November 18, 2015

Market Sentiment

      For long-term fundamental investors the path to superior returns is via market sentiment - both when it is high and it is low.  Gpro has been a constant topic in this blog due to the fact that I long argued that it was vastly overvalued due to market sentiment.  Well things go both ways.  Now, at about $19 dollars per share, I actually think that Gpro is undervalued.  The sentiment has turned so dramatically that its P/E ratio is below the average for the S&P 500.  While it may not have the growth options implied by a $90 dollar price, it does have some.  Ironically, my models suggest a fair value around the IPO price of $24.  Stay tuned as the saga continues.

Monday, November 9, 2015

Google vs. Amazon: A Valuation Faceoff

            Google (now Alphabet) and Amazon are two of the giants of the internet.  As of the close on Friday, November 6, Google had a stock market capitalization of $541 billion while Amazon weighed in at $309 billion.  The two companies are often lumped together, but from a valuation perspective, at least to date, they could not be more distinct.  To see why we say this, remember that the source of all value is free cash flow and take a look at the Table below.  No surprise in the case of Google.  It generated $24 billion of free cash flow in 2014 even after deducting the company’s “other investments” that are not part of its core business.  Add back those other investments and the free cash flow for 2014 was $34 billion.

            In the case of Amazon, the free cash flow is, like the operating income, essentially zero.  At a minimum, this puts to rest the assertion that the market is short-sighted and focuses too heavily on quarterly earnings.  Amazon is one of the most valuable companies in the world and it has never had any quarterly earnings to speak of.  The market clearly believes that someday Mr. Bezos will pull the switch and earnings and free cash flow will start pouring in, but that day has yet to arrive.

            But the point here is not to analyze Amazon in isolation, but relative to Google.  Based on 2014 results, Google is winning the free cash flow race by more than $23 billion, more than $34 billion if you add back the other investments.  Amazon’s free cash flow is less than 4% of Google’s.

            To compare the operating values of the two companies, net cash (cash minus debt) must be deducted from the stock market values.  In the case of Google, net cash is almost $60 billion (the free cash flow has to go somewhere) while at Amazon it is less than $5 billion (because it has been generating much less free cash flow).  Therefore, the operating values are $482 billion for Google and $304 for Amazon.  For the operating values to be this similar, it must be case that the market expects Amazon’s free cash flow to “catch up” to Google’s in the not too distant future given the impact of discounting.

            To be more specific, assume that a fair discount rate for both companies is 9% and that Google’s free cash flow grows initially at 10% falling to 4% in the long run.  These assumptions are basically consistent with Google operating value.  To rationalize the relative valuations, it turns out the Amazon’s free cash flow must grow at about 175% per year for the next twenty years (at which point it catches Google) to rationalize the relative valuation!  Does that seem unlikely to you?  If so, you are effectively saying that Google is underpriced relative to Amazon.  If you were to buy one of the two stocks, Google would be the wiser choice.  More generally, relative valuation often provides useful investment insight because one company can serve as a benchmark for the other.

GOOGLE 2014 2013 2012 2011
Stock market capitalization    541,150
  - Net cash     (59,158)
Market enterprise value    481,992
Operating Income (EBIT)       49,505       40,116       32,505       26,273
  -  Corp Tax at 20%       (9,901)       (8,023)       (6,501)       (5,255)
  +  Depreciation         3,523         2,781         1,988         1,396
  + Amortization         1,456         1,158            974            455
  -  Increase in working cap            364            (31)            898            630
  -  Capital expenditures     (10,959)       (7,358)       (3,273)       (3,438)
  -  Other investments     (10,096)       (6,321)       (9,783)     (15,603)
Free Cash Flow       23,892       22,322       16,808         4,458
Stock market capitalization    309,090
  - Net cash       (4,927)
Market enterprise value    304,163
Operating Income (EBIT)            178            745            676            862
  -  Corp Tax at 20%            (36)          (149)          (135)          (172)
  +  Depreciation         4,746         3,253         2,159         1,083
  + Amortization               -                 -                 -                 -  
  -  Increase in working cap            974            767         1,523         1,464
  -  Capital expenditures       (4,893)       (3,444)       (3,785)       (1,811)
  -  Other investments          (172)          (832)            190          (119)
Free Cash Flow            797            340            628         1,307