Credit Trends

Our cash flow/cost of capital model is the most comprehensive that exists, and, as readers know, has proved quite accurate. It was bearish going into the credit crisis and signaled significant under-valuation March 2009, to the extent we put out a special email.

As opposed to every large investment organization, which bases valuation off of accounting concepts (i.e., P/E) or the Capital Asset Pricing Model ( based off of stock volatility), our cost of equity capital (the discount rate we apply to present value free cash flows) is determined through detailed fundamental cash flow and credit information. Our free cash flows undergo a “cleaning” and adjustment which takes out much of the uncertainty of expectations. This process is explained in detail in “Security Valuation and Risk Analysis.”

The table at the bottom, refreshed for all SEC filings as of September 10, affirms the relationship between stock price valuations and cost of capital. While the free cash flow multiple is clearly important and carries significant value, and is a far superior indicator than the P/E multiple, it is change in risk that leads the equity market’s direction. Most pundits would agree, as validated March, 2009 and again this year.  Despite growth in free cash flows, stocks in general are basically flat, reflective of a change in cost of capital.. Keep in mind the free cash flow of the firm is the income to the investor. The same cannot be said with earnings.

Over the past decade and a half (except for the early 2000s) leading up to 2007, as the table notes, risk remained reasonable for the S&P and free cash flows were growing. At that end point, our metrics clearly picked up the change in risk a long time prior to the world-wide financial and credit meltdown.

So where do we stand now. Stocks are about 8% undervalued, resulting from the reduction in cost of equity capital; fair value for the S&P has thusly increased. There are some very undervalued companies in our model portfolio, many of which have risen a multiple of that in the S&P over the most recent period.

Given the re-liquefaction of financial structure for many firms, it would not be unusual to see M&A activity continue to pick up, including some hostile deals. I first spoke about this a few months ago, I regard, however, the step up in share buybacks as a negative development.

HISTORIC COST OF EQUITY, FREE CASH FLOW MULTIPLE AND S&P FAIR VALUE

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