Wednesday, April 26, 2006

The Finance Wonk makes a stock call on LECO

I frequently write my views about the overall economy and the particulars of economic numbers, but people always want to know: "what stock do I buy."

So here we go: stock buying the Finance Wonk Way

First of all let me tell you that I am very conservative and loss averse. I don't like to gamble on a "greater fool" being available to purchase my high priced dot-com shares and I usually have a fondness for stocks that have dividends.

I like to look at cash flow: I don't like using Price/Earnings ratios (although I do look at them), because the earnings number can be modified in a lot of different ways. Cash flow is the sum of the cash receipts and cash payments a company makes. If the company is stuffing it's supply line by booking sales before the customer has accepted goods it doctors the earnings numbers, but not the cash flow numbers. Cash flow is far more resistant to manipulation. Positive cash flow is where the actual money comes from that the company puts into dividends, research and development, and growing th business. The cash flow numbers I use are arrived at by taking the net income and adding back in depreciation expenses (because that is not actual cash outlayed) and subtracting out preffered dividends (which I consider to be a form of debt in many cases). You will find many people use this definition of cash flow. For those of you who wish to be a hard core finance whiz look into the Z-score theory of predicting corporate bankruptcy (for a 50 page paper on Z-scores and predicting bankruptcy go here). Cash flow (compared with debt) is statistically one of the strongest measures of probability of corporate success or failure.

From the cash flow I calculate the price/cash flow by dividing the cash flow by the market value of the stock.

If you were to think of the stock as loaning someone money the market value would be the amount of the loan and the cash flow would be the amount they pay you for it yearly. In the stock market the amount they pay you is divided into dividends (which you get) and continued operations (which presumably grows the company and thus your stock value). I look for a price/cash flow less that 15 for a large company that can't grow rapidly. For smaller companies you have to look at things in more detail because many small companies can go from a dramatic loss to excellent cash flow in one year of growth if they are adding customers without raising costs too badly.

Lets apply this to an example: The Lincoln Electric Company Inc. [symbol: LECO]
I bought this stock in July of 2005 based on a price to free cash flow ratio of 12.75, a dividend of 2%, and background reading that found no significant surprises and showed that this company seems to have a good handle on competing overseas. Lincoln is the worlds leading suppier of welding supplies and equipment, which may sound boring to some but I love a boring company with good growth and solid fundamentals. Since I bought it the stock is up 46%, and they just reported earnings this morning, which means it's time to evaluate the stock anew and see if I would buy it again. If not, I should sell (and will). Be ruthless, and sell any stock you wouldn't buy today!

Since the report just came out I can't get all the data I would want but we can get close. The net income for the Q1 reporting period is easily findable in the companies 10-Q as $36.7 million. The tricky part is that I've chosen an example where not all the data is out yet so we don't have the depreciation numbers to calculate cash flow, but looking at the previous data and since nothing big has changed in the capital picture it looks like 12 million is a good number for the depreciation, giving a cash flow of $48.7million for the first quarter (versus $32m Q1 of 05, for a very impressive cash flow growth rate which explains the stock price run up). Adding in the three previous quarters of cash flow I get $180.8m for cash flow in the last 12 months. The market capitalization has risen from 1.53B when I bought it to $2.24Billion now so when we divide that by the 180.8 million cash flow we get a price to cash flow ratio of 12.4, just below where it was when I bought it despite the 46% share increase and in a great territory for a strongly growing stock with a good divided.

Having passed this test I continue looking at the stock.

The analyst average 5 year growth prediction is 11%. If we assume an 11% growth rate on the stock for 10 years and then assume it matures and slows to 6% for the indefinite future and take all of that cash flow and discount it back to the present using net present value analysis we find that a 16% per year discount rate is indicated by the current price. That is to say that assuming rational pricing and stable growth this stock would return 16% per year (total dividends plus capital gains) at its current price. While that sounds amazingly good please keep in mind that stocks are not bonds and that stocks vary in price for market reasons and also undergo bumpy rides as their business ebbs and flows. I don't like to buy a stock with an implied discount rate lower than 15%. 16% clears that hurdle though, so by my technical standards this stock is a buy.

Note that some people are used to thinking of the net discount rate the other way around: as a target price. I hate target prices because they hide what's really going on but let me tell you how to get one. We take that same future cash flow for this stock and, instead of solving for the discount rate using the current price, apply a fixed discount rate of 11% and solve for price. Target Price: $76.47. Why do I dislike the target price? Because that 11% number is a wobbly and changing number that most people don't understand. I'm using 11% because it is the 5 year bond rate (5%) plus the "common" equity risk premium of 6% that people use to estimate how much extra return people demand from stocks to make up for the risk they have over bonds. But if I use a risk premium of 5% instead of 6% I get a target price of $82.82 and if I use 7% I get a target price of $70.69. If you saw analysts with targets at $70, $76, and $82 you might think they disagree, although in reality they could just be thinking about different invetors and their different risk tolerance. The truth is that people will get in and out at all of these values based on their desire for risk and their belief in the market.

So does looking for a 15% discount rate while bonds are returning 5% mean I require an 10% risk premium? Maybe that's one way of looking at it, but I did tell you up front I was very conservative. More to the point I know that the analysts projected earnings is likely to be wrong and the stock market does crazy things. A 15% discount rate says you're buying at a reasonable enough price that some things can go wrong and the investment still work out.

Digging more into the quarterly report I see that the cost of goods sold and personnel based expenses have both decreased from last year as a percent of sales and profit margins are increasing. This is that fantastic point in the business where doubling shipments doesn't require twice as many people and materials, which is exactly what we look for in a good business to buy (which is how you should think about buying stock). Digging even deeper shows that the net sales increase (at least in North America) was a little less than half due to raised selling prices. This is great because it shows pricing power and means the company will be more resistant to inflation or blips in sales.

Final conclusion: LECO is still a BUY with a current net discount rate of 16% (or you can think target price $76.47 if you really must). I will be keeping my shares of this stock.

And that is how the Finance Wonk decides to buy or sell a stock.

Later posts are going to have some more buys and sells and why...
Click back to the main page!

2 Comments:

Blogger FinanceWonk said...

Some questions came in via my email:
====================
1. I'm just a newby in investment and I have barely managed to learn DCF in calculating stock value. I thought one needs , FV, time in yr, and the generally used 11% discount rate to work out the PV. With your method would you need the FV to work out the discount rate (sic. growth rate of plus capital gains). Then how do you figure out the FV say in 10yr.
=========================
FW replies: I have a tool which allows me to assume a growth rate X for the first 10 years, then Y for all years after that. I can apply an X and Y and solve for the discount rate or apply a discount rate and solve for X (right now Y is fixed). Y is the presumed "long term growth rate" after the company leaves it's current growth phase and I tend to use 6% for that although it hardly matters mathematically because with 10 years of growth at X and a target discount rate of 15% the growth more than 10 years out is not a strong contributor to the result.

For LECO I start by applying the projected growth (11%) as X and solve for the discount rate and get 16%, which makes me interested in buying it. For a target price at 11% discount rate I leave X at 11%, Y at 6%, set the discount rate to 11%, and solve for price. Let me know if that isn't clear enough, maybe I should write a full column on this topic

-FW

9:24 AM  
Blogger FinanceWonk said...

Another question that came in by email:
========================
2) You assume a growth rate of 11% for10yr. Welding equipment, I suppose, also belongs to the cyclical business and subjected to the ups and downs of the business cycle. Is the growth rate a reasonable assumption?
=======================

An excellent point. The assumed growth is an average growth rate, just like the 5 year or 10year historical growth rates one might see on a mutual fund. I would expect the actual numbers to have a distribution as the industrial cycle continues. These cycles are actually why I use a ten year average instead of the 5 year typical number used on wall street - 5 years might only capture a downturn but 10 years should cover both ups and downs in the market and in present value analysis a long initial timeframe pushes down the numerical impact of the aftereffects.

Cheers, FW

9:27 AM  

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