Investing is all about predicting the future. When you buy a stock, you trade your hard-earned cash today for those shares in the hope that sometime in the future, you’ll get back more cash than you handed over in the first place. Whether or not you do get more back than you paid will depend in large part on how much the company behind that stock earns during the time you own it.
Compensate for your broken crystal ball
Nobody really knows what a company will report as its earnings in future quarters, The best any of us can really do is estimate. Because you’re estimating, the farther out in the future you go, the worse your estimates are. Also, because of inflation, risk, and the loss of use of your cash while it’s out of your hands, a dollar potentially earned in the future is worth less than that same dollar held for certain in your hand today.
As a result, valuing a company takes more than just adding up the cash it’s expected to earn in the future. It also takes reducing those future earnings back to a lower value today, to compensate for those factors.
That sort of valuation model is known as a “discount model,” and it’s one of the most common ways to estimate an intrinsic value for a company. It’s not perfect — no projection system is. The main advantage of the model is that it’s based on risk-adjusted financial flows over time. The main disadvantage? Well, as with any forward-looking projection, it’s based on assumptions, and those assumptions may be wrong.
What counts
To build a discounted earnings model, there are several key questions you need to answer. Three of the most important are:
- What is the company earning now?
- How are those earnings expected to change over time?
- What return do you need to be adequately compensated for the risks you’re taking?
That return level is an important consideration, as it provides the discount rate you use in your analysis. There are several different ways to arrive at a discount rate; my personal preference is to start at 12% and then move up from there based on risk factors.
Why 12%? Well, over the long haul, the total return on the S&P 500 with dividends reinvested has been in the neighborhood of 10%. Investing in a 500-stock-strong index is inherently less risky than investing in an individual company. After all, the odds of 500 of the largest companies around going bankrupt is a lot lower than the odds of any one of them failing.
Assuming that long-run historic trend holds true for the future, investing in an ETF like the S&P Depository Receipt that tracks the S&P 500 would provide 10% total returns. That extra 2 percentage points starts to compensate for the additional risk of buying an individual stock. If a company or an industry is particularly risky, I’ll dial that discount rate up even higher.
For instance, when I went bank-stock shopping for the real-money Inflation-Protected Income Growth portfolio, I used a 15% discount rate. After all, banking crises aren’t exactly rare, and nearly all the banks were affected by the recent financial crisis. Indeed, even some large banks, like Bank of America Corp (NYSE:BAC) and Citigroup Inc (NYSE:C) haven’t recovered well enough from that most recent crisis to begin restoring their dividends. Your money may be safe in a bank, but it’s at risk in the bank’s stock.
For Bank of America Corp (NYSE:BAC), a big part of the issue seems to be lack of consistent earnings. In spite of the recent economic stabilization, Bank of America Corp (NYSE:BAC) reported a quarterly loss as recently as last September’s quarter. It looks like the bank’s ill-timed purchase of mortgage giant Countrywide during the financial crisis is still haunting it.
Citigroup Inc (NYSE:C), on the other hand, has been a laggard throughout the recovery, only recently passing the Federal Reserve’s stress test, and still in need of some balance-sheet repair to be fully back up to snuff.
What’s it worth today?
The bank that fit that real-money portfolio’s criteria was Wells Fargo & Co (NYSE:WFC), which I estimated at the time as being worth about $226 billion. Solid earnings and stock market gains since then have propelled Wells Fargo & Co (NYSE:WFC)’s market cap to around $235 billion, above that initial estimate. Given that the market cap now exceeds my original fair value estimate, it makes sense to review it again to see whether that gain makes the company a candidate to sell.
Since the most recent banking crisis is fading, the economy seems to be stabilizing, and Wells Fargo & Co (NYSE:WFC) continues to perform solidly, I’m willing to dial back that discount rate to 14%. From an earnings perspective, over the past four quarters, Wells Fargo & Co (NYSE:WFC) has earned $19.777 billion in income applicable to common shares. That leaves the question of its growth, which analysts estimate will be around 7.22% annualized over the next five years.
