Since I graduated college I’ve taken quite a bit of interest in the stock market. I’ve done so primarily because I felt I owed it to myself to be financially educated. I’ve gone through a number of hair-brained and hackneyed theories about how to cash-in on the market during this time. For awhile I was enamored with the idea of quick money in the currency markets and loved using Excel to back test every technical indicator one could imagine.
Eventually, however, you fall back to earth. And when you do, names like Benjamin Graham and Warren Buffett start to float around with greater frequency. What is the intrinsic value of a company? How is the market valuing the company differently from it’s intrinsic value. Well, it turns out that this is calculated by a little method called discounted cash flow analysis. Basically this involves plugging in a few known (and unknown) company variables into an equation to produce the fair value that the company ought to be trading for.
Discounted cash flows are based on a principle called the “time value of money.” It’s the notion that the value of something now is higher than the value of that something in the future. So, for instance, (most rationally self-interested) people would prefer to have $1000 now than $1000 a year from now. So, if we are going to loan that $1000 now, we expect to be compensated by more than that amount a year from now. Depending on how badly the owner of the money wants to give it up and how badly the borrower needs it, they will eventually come to an agreed upon amount of future repayment a year from now. Let’s say this is $1050. We therefore now have what’s popularly called an interest rate of 5%.
Companies, according to discounted cash flow analysis, are worth the present value of the stream of future income that the company will produce. How you know what this future stream will be, of course, is a good question. This is why discounted cash flow analysis is necessarily an imprecise matter. However, it is possible to lock in certain assumptions in the equation to yield a fair value for the company identical to the prevailing market price. In other words, we can ask ourselves, “if the market price was decided by a consensus on discounted cash flow, what variables would the market be plugging in?” In other words, if market price was always identical to intrinsic value, how would the market be determining intrinsic value right now? We can then ask the more important question, “were those assumptions correct?”
Moneychimp.com has a discounted cash flow calculator. There are five variables one needs to plug in to produce intrinsic value: annual earnings, annual growth rate for the forecast period, length of forecast period, perpetuity growth rate, and the discount rate. Let’s break these down. Earnings are simple. It is how much the company profited the last year. It is generally recommended to use cash flows instead of earnings in the equation, but generally they converge over the long run. Company growth is divided amongst a forecast period and a perpetuity period (in other words, the entire time after the forecast period). If you wanted, you could plug projected earnings for each individual upcoming year into the equation. This particular calculator simplifies matters by asking for an average growth over a certain period of time, followed by a general prediction of the growth thereafter. Typically, this perpetuity growth will be assumed to be very modest.
The last component is the discount rate. This is the minimum required rate of return. A good way to think about how the discount rate works is by assuming 0% growth and running the calculations. You find that for a constant earnings stream of $10, a discount rate of 10% will produce a value of $100. $10 being 10% of $100, the discount rate indicates a baseline for what earnings should be in relation to value. If you were dealing with 5% interest on treasury bonds, you would expect that that $10 “earnings” to produce a bond worth $200 ($10/$200 = 0.05 = 5%). You expect stock to produce at least the same return (if not greater) as a bond, which is presumably risk free.
As a matter of fact, you should expect more than that. You should expect a company to return at least the same as its Weighted Average Cost of Capital (WACC). This is the amount it costs to finance the company through debt and equity. Cost of debt is the rate the company can borrow at. Cost of equity is more complex. It includes not only dividends, but also expected appreciation on share values. Because of this, cost of equity is generally higher than cost of debt. The higher the WACC (and by extent, the higher the discount rate), the more conservatively you are valuing the company. A 10% WACC on $10 earnings means a $100 company. 20% WACC means a $50 company.
At this point, it is safe to start introducing some of the assumptions I am going to put into the equation. For forecast period, I chose 10 years. Basically this is the period for which one would desire to hold the stock. Perpetuity growth rates are assumed to be 3%, roughly the rate that GDP expands. The discount rate I am using is 15%. I arrived at this figure by basing it totally on the higher cost of equity, which was calculated according to the Capital Asset Pricing Model. The primary company specific variable involved is the Beta coefficient, a measure of share volatility. The equation is R = Rf + B( Rm – Rf ). R is rate of return (cost of equity), Rf is the risk-free rate of return (treasury bond yield), Rm is the market rate of return (historic S&P500 growth rates), and B is the Beta Coefficient. So R= 5% + B (11%-5%). For R=15%, B is roughly 1.67, which is a fairly high amount, resulting in a conservative value estimate. According to Yahoo’s stock screener, only about one fifth of the securities in the S&P500 have a Beta higher than 1.5.
This leaves forecast period growth and earnings. Earnings have been normalized to $1. The reason for this is that ultimately I am looking to compare price/earnings ratios. The major concern is not so much to gauge company value directly as it is to estimate how much company value there is for each dollar of earnings, whatever actual earnings figure may be. Therefore, earnings have been put at $1 so as to produce a price/earnings ratio in the final value solution.
This leaves growth rate as the only remaining independent variable. Zero growth in the forecast period means a P/E of 7.14. There is an upward limit on acceptable P/E, governed by maximum sustainable growth. Return on equity (ROE) caps the growth rate, since growth higher than that requires borrowing more money or floating new shares. Because ROE is affected by leverage, and because we want to look at companies will lower debt, we will cap the debt/equity ratio at 1, so at most ROE can be twice Return on Assets (ROA.) Only 1% of the S&P500 has a reported ROA higher than 25% (hypothetical ROE of 50%).This would yield a P/E of over 179! A more reasonable upper limit seems like 30% ROE, which yields just over 50 P/E. Anyhow, we can produce a table correlating various P/E ratios to expected growth rates:
Growth P/E
0 7.14
1 7.59
2 8.07
3 8.58
4 9.14
5 9.73
6 10.36
7 11.05
8 11.78
9 12.56
10 13.40
11 14.30
12 15.26
13 16.29
14 17.40
15 18.58
16 19.85
17 21.21
18 22.66
19 24.21
20 25.87
21 27.64
22 29.54
23 31.56
24 33.73
25 36.04
26 38.50
27 41.13
28 43.94
29 46.93
30 50.12
Then there’s the final question: is the market right? I screened for companies with P/Es below 7 but had historical growth rates above 10%, the assumption being that there will likely not be a steep drop in growth over the coming period, and it produced a few results. There are other factors to consider of course, but this seems like an interesting and promising angle on P/E ratios. Perhaps more on that to come.
Tuesday, November 13, 2007
Wednesday, November 7, 2007
Unitarianism Redux
I've written on Unitarianism in a previous blog, but sometimes you have a flight of inspiration to make a few more comments.
The biggest problem with Unitarianism is that it takes liberal social values and turns them into a matter of theological certainty. That is not something Unitarians themselves would like to hear, as they pride themselves on forsaking any claims to absolute knowledge in matters of theology. The problem, however, is that often times dogmas exist not primarily due to contrived indoctrination of this or that orthodoxy, but because of the prejudices developed in the course of familiarity to a particular community. That is, the church organization itself has a tendency to inculcate dogma via groupthink. As a matter of fact, this is actually worse than traditionally conceived overt dogma as it is not even out in the open and available for scrutiny.
Unitarianism is geographically strongest in Massachusetts (approx. 35,000 members), and with Episcopalism shares the distinction of being a religion of Blue Bloods and Boston Brahmins. The Unitarian population is also somewhat larger in the Seattle metro area, but outside of those areas the Unitarian community does not extend beyond a few thousand per state, usually varying with how liberal that particular state is. At least in America, it grew out of the influence of Enlightenment ideas in the already notoriously independent Congregational churches of New England.
In other words, it is primarily a northeastern WASP religion with enclaves of social liberals elsewhere that move in and out of the church in revolving-door fashion. According to one study, it has a higher percentage of members with incomes over $100,000 (21%) than any other historic American religion except Judaism (with 29%). It is fair to characterize UUs as bourgeois liberals.
This is important because there is a sort of faux magnanimity that pervades Unitarian culture. Any multicultural gesture or nod to social progressivity is welcomed with praise. And there are even a few middle-class posterchildren for such causes that are warmly embraced by the church. It is rare, however, to find tolerance that which falls outside the tacit morality of the privileged environment in which UUs operate.
For instance, Unitarians have been strongly associated with the civil rights movement in the past. They appear, however, to be unsympathetic to both the social conservatism of the black community and to its more extreme expressions of militant radicalism, favoring instead cool-headed reformism. Both black conservatism and radicalism come from the same necessity of negotiating underprivileged status, the first in desiring what little social cohesion can come through moral uprightness alone, the second in sheer desperate reaction to the conditions of urban poverty. In either case, it goes beyond the scope of UU respectability.
It's easy enough to point these things out to UUs and allow them to go through a bout of critical self-reflection. At the end of the day, however, there is only a new strategy developed to attempt to make the church appear more accessible to this demographic or to be more deferential to that alien attitude. Nothing can ever fundamentally question the Unitarian disposition in the first instance. There is a cozy yet superficially thoughtful and earnest sense of superiority.
This is the kind of thing to which I refer when speaking of Unitarian dogmatism. It is especially grotesque when examing cultural trends. Any leftward shift in popular sentiment is not perceived on the terms in which the average American experienced it, but rather as a groping towards the prior existing wisdom possessed by the small vanguard of enlightened religious liberals.
It can almost be likened to the gay-dar gone berserk of some in the gay community that sees homosexuality or the seeds of it in anyone and everyone. Which makes me think, can we speak of "U-dar"? Hmm, perhaps it could stick...
The biggest problem with Unitarianism is that it takes liberal social values and turns them into a matter of theological certainty. That is not something Unitarians themselves would like to hear, as they pride themselves on forsaking any claims to absolute knowledge in matters of theology. The problem, however, is that often times dogmas exist not primarily due to contrived indoctrination of this or that orthodoxy, but because of the prejudices developed in the course of familiarity to a particular community. That is, the church organization itself has a tendency to inculcate dogma via groupthink. As a matter of fact, this is actually worse than traditionally conceived overt dogma as it is not even out in the open and available for scrutiny.
Unitarianism is geographically strongest in Massachusetts (approx. 35,000 members), and with Episcopalism shares the distinction of being a religion of Blue Bloods and Boston Brahmins. The Unitarian population is also somewhat larger in the Seattle metro area, but outside of those areas the Unitarian community does not extend beyond a few thousand per state, usually varying with how liberal that particular state is. At least in America, it grew out of the influence of Enlightenment ideas in the already notoriously independent Congregational churches of New England.
In other words, it is primarily a northeastern WASP religion with enclaves of social liberals elsewhere that move in and out of the church in revolving-door fashion. According to one study, it has a higher percentage of members with incomes over $100,000 (21%) than any other historic American religion except Judaism (with 29%). It is fair to characterize UUs as bourgeois liberals.
This is important because there is a sort of faux magnanimity that pervades Unitarian culture. Any multicultural gesture or nod to social progressivity is welcomed with praise. And there are even a few middle-class posterchildren for such causes that are warmly embraced by the church. It is rare, however, to find tolerance that which falls outside the tacit morality of the privileged environment in which UUs operate.
For instance, Unitarians have been strongly associated with the civil rights movement in the past. They appear, however, to be unsympathetic to both the social conservatism of the black community and to its more extreme expressions of militant radicalism, favoring instead cool-headed reformism. Both black conservatism and radicalism come from the same necessity of negotiating underprivileged status, the first in desiring what little social cohesion can come through moral uprightness alone, the second in sheer desperate reaction to the conditions of urban poverty. In either case, it goes beyond the scope of UU respectability.
It's easy enough to point these things out to UUs and allow them to go through a bout of critical self-reflection. At the end of the day, however, there is only a new strategy developed to attempt to make the church appear more accessible to this demographic or to be more deferential to that alien attitude. Nothing can ever fundamentally question the Unitarian disposition in the first instance. There is a cozy yet superficially thoughtful and earnest sense of superiority.
This is the kind of thing to which I refer when speaking of Unitarian dogmatism. It is especially grotesque when examing cultural trends. Any leftward shift in popular sentiment is not perceived on the terms in which the average American experienced it, but rather as a groping towards the prior existing wisdom possessed by the small vanguard of enlightened religious liberals.
It can almost be likened to the gay-dar gone berserk of some in the gay community that sees homosexuality or the seeds of it in anyone and everyone. Which makes me think, can we speak of "U-dar"? Hmm, perhaps it could stick...
Monday, November 5, 2007
Wait a Gersh-Darn Minute...
As a fresh-faced and gullible student at the University of Pittsburgh, I was drawn into the campus leftist milieu, an environment that seemed to valorize my indignation about my youthful economic insecurity and the general lack of respect I received from the adult world. In the process, I learned quite a bit about both domestic and foreign affairs, which helped to sustain the illusion that there wasn't real debate or disagreement in politics, just misunderstanding between the enlightened left-leaning community and the prejudicially ignorant patriotic jingoists of America that could be overcome with enough education. Unfortunately, it made sense especially since most of the professors were some stripe of left-liberal and the only conservative voices you typically heard were from that barely articulate segment of the student body that had yet to fully assimilate itself.
I've been living in Washington DC for a little over 2 years currently, and I realize a lot more about the nuance required to have a serious political discussion. I am roundly convinced that on most campuses, one simply cannot have such a discussion. The culture of most do not exist to cultivate a sense of civic virtue so much as to outdo one another with how self-righteously radical one can be. And no one was better at that at Pitt than John Lacny.
Lacny gained a reputation as a leader of the student left for the work he did in founding the labor solidarity organization Students in Solidarity. (Its initials were SIS, but many people thought they were resurrecting the spirit of another student leftist organization with three-letter initials, two of which were also 'S.') It is difficult to recall in one sitting the full breadth of the cacophony of distorted, paranoid conceptions of the world that this man could bark. Perhaps it was his utterly unironic, pompous demeaner that attracted so much respect in individuals who were separated from the serious moral authority of their parents for the first time in their lives. No one ever seemed to speak with John as an equal, he was always in the role of mentor.
On one occasion, he was going on that in the 1980s foreigners looked at workers in the United States as simply victims of capitalist fat cats, but in the early 21st century workers are perceived as just as culpable for American crimes as the ruling class. I casually asked, "what would you attribute that to?" His only response was an impatient grimace.
So, a few years out of college and with a different perspective on the world, I decided (just for kicks) to revisit Mr. Lacny's cognitive processes at work. He currently runs a blog entitled "It's No Accident," in which he makes Marxist commentary on a variety of current affairs. Most recently, he posted a letter to the editor of the Pittsburgh Post-Gazette concerning the public reception of Michael Vick's dog-fighting charges. He alleges that there is a racist double standard in the public mind, constasting the "vituperation" of Post-Gazette readers to the apparent lack of condemnation of Florida boot camp guards for the death of Martin Lee Anderson or the dearth of sympathy for the Jena Six. He ends the letter asking rhetorically, "could it be that some of white America puts a higher value on the lives of dogs than on the lives of young black men?"
My question in all of this is, how would it have been possible to express any legitimate revulsion at Vick's acts, according to Lacny? Would it have been possible at all? There appears to be no such thing as simply condemning Vick's actions in isolation. They immediately have to be compared and contrasted to other events that have no particular relation to what Michael Vick did to construct the image of "some of white America" (who may or may not have even been following those other events) as vile dehumanizers of blacks. Does anyone really believe that the readers condemning Vick wrote their denunciations calculatingly ignoring this or that offense against American blacks? Are we really expected to accept the implied conclusion that those readers value the lives of dogs over human beings? Do we even know how many of said readers were white?
Lacny received one comment on his post that points out that the comparison cases he mentions are not quite as morally unambiguous as he presents them, but adds afterwards that, "it is sick and undeniable though that in the media pets are more important than people, and whites are more important than blacks." This may or may not be true of the media, but Lacny points the finger at a section of white America, not the media. I'm sure some of white America does think that blacks are subhuman. There are in fact hard-right racist organizations functioning the United States. But, in essence, accusing a random slice of the white public of tacitly subscribing to those ideas because some of the Post-Gazette's readership felt comfortable roundly condemning a clear case of cruelty towards animals is absurdly grasping at straws.
The saddest part of the entire thing is that Lacny, having spun these implications out of thin air, will walk way believing the story he's told himself about the attitudes of white Americans and take the lessons learned to the next event that he can show as being an egregious instance racism, sexism, homophobia or whatever other sinful rabbit can be pulled out of the magic rhetorical hat.
I've been living in Washington DC for a little over 2 years currently, and I realize a lot more about the nuance required to have a serious political discussion. I am roundly convinced that on most campuses, one simply cannot have such a discussion. The culture of most do not exist to cultivate a sense of civic virtue so much as to outdo one another with how self-righteously radical one can be. And no one was better at that at Pitt than John Lacny.
Lacny gained a reputation as a leader of the student left for the work he did in founding the labor solidarity organization Students in Solidarity. (Its initials were SIS, but many people thought they were resurrecting the spirit of another student leftist organization with three-letter initials, two of which were also 'S.') It is difficult to recall in one sitting the full breadth of the cacophony of distorted, paranoid conceptions of the world that this man could bark. Perhaps it was his utterly unironic, pompous demeaner that attracted so much respect in individuals who were separated from the serious moral authority of their parents for the first time in their lives. No one ever seemed to speak with John as an equal, he was always in the role of mentor.
On one occasion, he was going on that in the 1980s foreigners looked at workers in the United States as simply victims of capitalist fat cats, but in the early 21st century workers are perceived as just as culpable for American crimes as the ruling class. I casually asked, "what would you attribute that to?" His only response was an impatient grimace.
So, a few years out of college and with a different perspective on the world, I decided (just for kicks) to revisit Mr. Lacny's cognitive processes at work. He currently runs a blog entitled "It's No Accident," in which he makes Marxist commentary on a variety of current affairs. Most recently, he posted a letter to the editor of the Pittsburgh Post-Gazette concerning the public reception of Michael Vick's dog-fighting charges. He alleges that there is a racist double standard in the public mind, constasting the "vituperation" of Post-Gazette readers to the apparent lack of condemnation of Florida boot camp guards for the death of Martin Lee Anderson or the dearth of sympathy for the Jena Six. He ends the letter asking rhetorically, "could it be that some of white America puts a higher value on the lives of dogs than on the lives of young black men?"
My question in all of this is, how would it have been possible to express any legitimate revulsion at Vick's acts, according to Lacny? Would it have been possible at all? There appears to be no such thing as simply condemning Vick's actions in isolation. They immediately have to be compared and contrasted to other events that have no particular relation to what Michael Vick did to construct the image of "some of white America" (who may or may not have even been following those other events) as vile dehumanizers of blacks. Does anyone really believe that the readers condemning Vick wrote their denunciations calculatingly ignoring this or that offense against American blacks? Are we really expected to accept the implied conclusion that those readers value the lives of dogs over human beings? Do we even know how many of said readers were white?
Lacny received one comment on his post that points out that the comparison cases he mentions are not quite as morally unambiguous as he presents them, but adds afterwards that, "it is sick and undeniable though that in the media pets are more important than people, and whites are more important than blacks." This may or may not be true of the media, but Lacny points the finger at a section of white America, not the media. I'm sure some of white America does think that blacks are subhuman. There are in fact hard-right racist organizations functioning the United States. But, in essence, accusing a random slice of the white public of tacitly subscribing to those ideas because some of the Post-Gazette's readership felt comfortable roundly condemning a clear case of cruelty towards animals is absurdly grasping at straws.
The saddest part of the entire thing is that Lacny, having spun these implications out of thin air, will walk way believing the story he's told himself about the attitudes of white Americans and take the lessons learned to the next event that he can show as being an egregious instance racism, sexism, homophobia or whatever other sinful rabbit can be pulled out of the magic rhetorical hat.
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