The Will Robinson Moment continues part 2


The technical picture is one of extremes or approaching extremes that indicate a market reversal/decline is highly likely in order to bring about a more balanced pace of change, a pace of change that is more in line with the historic patterns of the way in which the stock market typically behaves. Extreme states are exceptions, not the norm, and these occurrences resolve themselves through corrections, for as the saying goes, “nothing grows to the sky”, and this current market advance has surely tried to do just that.

The next question is one of magnitude. If we are at extreme levels of technical market behavior which point to a need for a price correction lower, then how large will that correction potentially be? The answer is most likely found within the comparison of current stock valuations vs what may be considered normal market valuations. For this, the assessment is based on the historic relationships of fundamental market factors such as earnings, cash flows, debt levels, interest rates, dividend levels, and overall market return metrics that encourage or discourage further changes in stock prices. The fundamental data that follows indicate we are at an extreme level of valuation indicating the magnitude of the correction when it comes will have the potential to be dramatic in size. Consider the following:

1. Price of equities compared to the cash flow they generate: The historic relationship of stock prices to cash flow produced, which is simply dividing the stock price by the per share cash flow a company earns, averages 17.2 times based on the current year’s cash flow performance, and assuming growth in cash flow in the following year, averages 15.2 times on what the company is projected to generate in cash flow for the following year. Given the rise in stock prices, it would be expected that the growth in cash flow supports the price change thereby maintaining the historic relationship of price to cash flow. Based on the 2016 cash flow results and the 2017 cash flow forecast for stocks, the current price to cash flow relationship now resides at a price to cash flow of 22.29 times for 2016 and 19.59 times for 2017. Clearly we have stock prices that are priced at a premium to the cash they generate. What is the degree of this premium pricing in the current market? It is the highest premium since 2007, in fact it is higher than 2007, and would require an approximate 25% stock price decline to bring the price to cash flow relationship back in line with history.

2. Given the importance of growth in cash flow and earnings to stock prices, what do analysts currently project for cash flow and earnings in this year and for next year? For cash flow, the growth rate for 2017 is 14.03% higher than projected 2016 cash flows. For 2016, the cash flows are actually lower than 2015 by minus 1.95%, so the forecast for 2017 is coming off of a negative growth year (BTW, in December 2015 the cash flow growth projection for 2016 was 12.53%, and that turned into actual negative 1.95% growth). Given the double digit rise in the major stock market indices in the United States for 2016, clearly the poor 2016 cash flow results are not what is driving stock prices. It must be that the projected growth for 2017 far surpasses prior expectations. As noted above, that growth is projected at 14.03%. That growth rate is slightly above the historic projections of growth one year out that has averaged 12.9% over time. Yet even with that above-trend growth rate, stock prices are values at 19.59 times forward cash flow, a very high premium. What about earnings on the S&P 500? For 2016, earnings look like they will only be .6% above 2015, so this has not been a very good year for earnings either. The difficulties in the oil market were a serious depressant on 2016 earnings. What about the forecast for 2017? Currently that forecast is for 12.25% growth over 2016. Healthy, but again not enough when we see this earning growth translated into a price to earnings ratio. If we assume no further appreciation in stock prices, then based on projected 2017 earnings, stocks are priced at 19.35 times. That is a very rich multiple based on history.

Speaking of history, what do we see in terms of projections made and results obtained? In the case of cash flows, the projections have been much higher than the actual results obtained. Since 2009, the actual cash flow generated was 6% below the projection. In fact, for the seven-year span from 2009 through 2016, the actual results have been below the projections in five of those years, and those shortfalls have averaged 9.5% below the projections. Given the track record and the robust 14% cash flow growth projected for 2017, it is hard to see the current stock price environment as reflecting a buying opportunity.

3. Staying on the cash flow theme for one additional point, it is important when valuing companies to look to the cash they generate. Cash flow and cash flow growth over time are critical in assessing investment opportunities; After all, the purchase price of a stock is based on the buyer’s decision to buy an asset with the expectation that the cash the company generates will enable the company to return to the purchaser sufficient cash and/or appreciated business opportunities through re-investing cash to justify the current price paid for an ownership interest. As such, the value of a share today is directly linked to the future cash it will generate. The discounted cash flow model incorporates the expected future cash flows, the growth in those cash flows, and a discount factor to adjust the cumulative value of the future cash for the risks inherent in the uncertainty of tomorrow and for the years (time) it will take to produce the cash. One of the measurements of a given portfolio of stocks is to assess the composition of the portfolio by determining the number of the companies represented within the portfolio that are presently priced below, at or above their discounted future cash flows. Utilizing a pre-existing portfolio of 187 companies as a barometer of the overall market, the historic average of the number of companies that are priced above their DCF computed value lies within the 60 to 61 range. So, at any point in time one can expect that roughly a third of the portfolio is over-valued, while two thirds are fairly-valued or under-valued. This assessment enables buying and selling decisions to be made with the goal always of buying low and selling high. The question today in order to assess whether we are in a normal market or a market that is priced away from the norm is “How much of the portfolio, given current prices and projections of future cash flows, is valued above the historic one third of the portfolio?” The answer is troubling for it indicates we are at extremes that have not existed in the ten years that this portfolio of 187 companies has been tracked. As of Friday, December 9, 2016, 53.5% of the companies tracked are priced above their Discounted Cash Flow price. That level has never been reached (over the past ten year). Further, as a combined portfolio, how does the price of the overall portfolio compare to the overall DCF price? The DCF price of the portfolio is currently $5.99 BELOW the current aggregated price of the portfolio. Historically, the DCF price has, on average, been higher than the current price by $11.29. This indicates a gap of $17.28 ($5.99 plus $11.29) exists, a gap that is larger than any difference seen over the past ten years. To bring the relationship back to normal, current prices would have to decline by 21%, or cash flow would have to increase by 19% above the current projection for 2016 and the cash flow growth rate for future years that was previously projected at 14.03% would have to increase by 20%. The risk in realizing these growth rate improvements is high, and the more likely outcome will be a deep overall market correction to bring values back into balance with realistic company cash flow and earnings growth prospects.

4. Two final points on cash flow need to be included as part of the discussion. The first is a comparison of each year between 2007 and 2015 against 2016. This analysis compares the change in price and the change in cash flow for each year against the current year’s data. For example, there is an expectation that the changes will be correlated such that increases in price will be directly connected to increases in cash flow. This exercise yields results that fit the expectation of a high degree of correlation between the two sets of data. At least it did through December 2015. At year-end 2015, the change in price from 2007 thru 2015 was an increase of 56.98% while cash flow increased by 65.31%. If we also look at 2009 vs 2015, we see a price increase of 80.63% and a cash flow increase of 88.53%. With that as the backdrop, how do the comparisons look when we replace the 2015 data with 2016 data? Here we see the breaking down of the correlation. The comparison of 2007 to 2016 shows a price increase of 81.88%, but only a 62.09% increase in cash flow. For 2009 vs 2016 we see a price increase of 109.29%, but only an 84.86% increase in cash flow. Price expansion is outstripping the growth in operating performance and that would appear to be problematic for sustaining the price increase. While there is an expected growth in cash flow for future periods, the growth estimates would need to be materially higher to bring the long-term price and cash flow change relationship back to their historic correlation. Absent this, the sustainability of the current price increase and the potential for additional price increases in equities is doubtful.

The second point is one of comparing the average compound annual growth rate of price and cash flow. The reason for including this is to assess the impact of the current year’s changes in price and cash flow in the context of history. The expectation is that there should not be a material divergence from year to year in trajectory of these two measures. The average CAGR in price and cash flow for the combined periods 2007 thru 2016, 2008 thru 2016, 2009 thru 2016, up to and including 2014 through 2016, when contrasted with the same calculation that also includes the additional period of 2015 through 2016, reveals a troubling divergence that is not likely to remain unresolved. Through 2014 there is an average CAGR in price of 12.0% and in cash flow of 5.2%. When 2015 through 2016 results are added, the average price CAGR rises to 12.4% but the average cash flow CAGR falls to 4.4%. It is hard to accept that this observation which is being driven by the rise in equity prices in 2016 without a corresponding increase in cash flow is not a warning of a market that is being valued above what a rational buyer should pay for the risk that is inherent in achieving an adequate return on invested capital.

More to come……………….

Author: Thomas Connolly

Tom possesses a rich and diverse background that includes deep investing experience, senior corporate executive positions, and roles as a Regional Managing Partner and Global Industry Leader within Ernst & Young. He has advised executives on some of the largest acquisitions and dispositions in the Media and Entertainment industry, including clients such as Comcast, Citibank, Sony, Dalian Wanda and Publicis. Tom is a Certified Public Accountant with a Masters Degree from Columbia University. His skills are further accompanied by a personal passion for the study of economic trends and evolving market dynamics.

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