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Cash Flow, Present Value, and Discount Rates
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The big drawback of the ratios we discussed in the previous chapter is that they're all based on price —they compare what investors are currently paying for one stock to what they're paying for another stock. Ratios do not, however, tell you anything about value, which is what a stock is actually worth.

Without knowing what a stock is worth, how can you know how much you should pay for it? At Morningstar, we're firm believers that stocks should be purchased because they're trading at some discount to their Intrinsic value, not simply because they're priced at a higher or lower point than similar companies. Comparing ratios across companies and across time can help us un­derstand whether our valuation estimate is close to or far from the mark, but estimating the intrinsic value of a company gives us a better target.

Having an intrinsic value estimate keeps you focused on the value of the business, rather than the price of the stock—and that's what you want because, as an investor, you're buying a small piece of a business. Intrinsic valuation also forces you to think about the cash flows that a business is generating today and the cash it could generate in the future, as well as the returns on capital that the firm creates. It makes you ask yourself: If I could buy the whole company, what would I pay? Second, having an intrinsic value gives you a stronger basis for making investment decisions. Without looking at the true determinants of value, such as cash flow and return on capital, we have no way of assessing whether a P/E of, for example, 15 or 2O is too low, too high, or right on target. After all, the company with the P/E of 2O might have much lower capital needs and a less risky business than the company with the P/E of 15, in which case it might actually be the better investment.

In this chapter, I'm going to walk you through a simplified version of howwe estimate intrinsic values at Morningstar. Even if you choose not to go through the entire exercise yourself for every stock you think about buying— and you very well may not—knowing the basic principles will help you make better investment decisions.

A warning: This can be some difficult stuff, so don't be discouraged if you're a bit confused. It does get easier with practice, though—I promise!

Cash Flow, Present Value, and Discount Rates

Our first step is answering a basic question—what's a stock worth? Luckily, we can stand on the shoulders of giants such as economists Irving Fisher and John Burr Williams, who answered this question for us more than 60 years ago: The value of a stock is equal to the present value of its future cash flows. No more and no less.

Let's take this idea apart carefully, because understanding it is crucial to properly valuing stocks. Companies create economic value by investing capi­tal and generating a return. Some of that return pays operating expenses, some gets reinvested in the business, and the rest is free cash flow.

Remember, we care about free cash flow because that's the amount of money that could be taken out of the business each year without harming its operations. A firm can use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, "which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and rein­vest it in the business.

These free cash flows are what give the firm its investment value. Apres-ent value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today.

Why are future cash flows worth less than current ones? First, money that "we receive today can be invested to generate some kind of return, "whereas "we can't invest future cash flows until we receive them. This is the time value of money. Second, there's a chance we may never receive those future cash flows, and we need to be compensated for that risk, called the "risk premium."

The time value of money is essentially the opportunity cost of receiving money in the future versus receiving it today, and it's often represented by the interest rates being paid on government bonds. It's pretty certain that the U.S. government will be around to pay us our interest in a few years.

Of course, not many cash flows are as certain as those from the feds, so "we need to tack on an additional premium to compensate us for the risk that we may never receive the money that we've been promised. Add the government bond rate to the risk premium, and you have what's known as ^discount rate.

The oddly named discount rate makes more sense when you think about it in these terms: What rate of return would you need to make you indifferent between receiving some quantity of money right now versus at some time in the future? The old saying that a bird in the hand is "worth two in the bush ex­presses the same concept in a different way: We know we have the bird in the hand, so "we need two birds in the bush to make us indifferent between the two options. In a similar vein, money to be received in the future is worth less to us because we don't know if we'll get it, and if we get it today, we could invest it to earn a return.

For example, if you were about to take a one-week vacation, but your boss asked you at the last minute to postpone it for a year, you might ask your boss for an extra day off to compensate for the delay. In other words, six days off next year is equivalent to five days off right now, because you'd rather take the trip now and because something else could crop up over the next year that would force you to delay the trip again.

So, your mental discount rate for vacation time is 20 percent. That's the rate at which five days becomes six days in a year (6 days — 5 days/5 days). And if you thought your boss might get fired—which "would make it less certain that her promise of an extra day would be honored—you might ask for two extra days off next year. In that case, your mental discount rate would be 40 percent, which is the rate at which five days becomes seven days in a year (7 days — 5 days/5 days).

Now you can start to see why stocks with stable, predictable earnings often have such high valuations—investors discount their future cash flows at a lower rate, because they believe that there's a lower risk attached to the likelihood that those future cash flows will actually show up. Conversely, a business with an extremely uncertain future should logically have a lower valuation be­cause there's a substantial risk that the potential future cash flows will never materialize.

You can see why a rational investor should be willing to pay more for a company that's profitable now relative to one that promises profitability only at some point in the future. Not only does the latter carry higher risk (and thus a higher discount rate), but the promised cash flows won't arrive until some years in the future, diminishing their value still further.

This can be a tough concept, so let's look at an example with some real numbers. Figure 10.1 illustrates the difference that changing discount rates and

However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about $2,700 less than StableCorp. That's because StableCorp is more predictable, which means that investors' discount rate isn't as high. CychCorp's cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they're valuing its shares. As a result, the present value of the discounted cash flows is lower.

The difference in the present value of the cash flows is even more acute "when you look at RiskCorp, "which is "worth almost $8,300 less than StableCorp. Not only arc the bulk of RlskCorp's cash flows far off in the future, but also, we're less certain that they'll come to pass, so we assign an even higher discount rate.

Believe it or not, you now know the basic principles behind a discounted cash flow model. Value is determined by the amount, timing, and riskiness of a firm's future cash flows, and these are the three items you should always be thinking about "when deciding how much to pay for a stock. That's all it really boils down to.

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