Until recently, market optimism presented us with wonderful opportunities . . . to catch up on sleep. Indeed, we found few compelling investment opportunities as the stock prices of top quality companies appeared irrationally high. Current market pessimism has jolted us awake. Although stock prices are still high on a historical basis, the recent pessimism, though tragic in its origin, has resulted in relatively more rational stock pricing and, consequently, presented fruitful options for the wise allocation of capital.
We must acknowledge that we do not know whether the coronavirus outbreak in China will expand into a global pandemic, and we do not know how the outbreak will ultimately affect the global economy or individual companies. Nor does anyone else. However, those factors do not influence our investment decisions. Importantly, we believe that attempting to predict those outcomes and how they will affect the movement of markets and stock prices is sheer folly. The speculator who experiences some great success is condemned to even greater failure - a fool and his money are soon parted (perhaps Gordon Gekko was more accurate - a fool and his money are lucky enough to get together in the first place). We remove the guess work. Our decisions are anchored instead by the concept of intrinsic value.
We distill the Durable Stocks approach down to two simple concepts: 1) buy wonderful businesses to own for the long term, and 2) buy them at rational prices relative to their intrinsic values. Once we have identified a wonderful business, we determine its intrinsic value by conservatively estimating the present value of its future earnings (as illustrated below).
There are a small number of wonderful companies (companies with strong competitive moats that offer products or services for which there will be long term demand) that we would want to buy at the right price. One such company is Boeing. Here we will dispense with the corporate portraiture. Boeing clearly lost its way and the results were tragic and unacceptable. Thus, we would not even consider Boeing if new management had not been installed. In view of its new management, we consider Boeing to be a wonderful company. As a member of a duopoly, it faces limited competition. Its customer relationships are sticky because airline crews are trained for specific equipment. It earns high returns on capital. There is reasonably foreseeable long-term demand for its products though the journey may be bumpy.
To succeed, Boeing needs to regain the public's trust. It will deservedly be under intense scrutiny for quite some time. We are encouraged by Horace: "Many shall be restored that now are fallen and many shall fall that now are in honor."
Current market conditions and the company's specific problems have driven the market capitalization down to about $171 Billion. We estimate that the intrinsic value is somewhat higher at about $191 Billion. The basis for the intrinsic value estimate is as follows:
First, we determine a reasonable growth rate. The free cash flow rose from $1,94B in 2003 to $13.6B in 2018, an increase of 12.23% compounded annually. If measured from 2007 when free cash flow was $7.85B, the increase was 5% compounded annually. To be conservative, we will use a 5% growth rate.
Next, we conservatively average the last three years' free case flow as shown below:
2016: $7.88B
2017: $11.61B
2018: $13.6B
Avg: $11.16B
Then, we apply the growth rate to that average free cash flow of $11.16B to determine an estimated free cash flow for each year of the following 10 year period, divide each year by a discount rate (we used 5% which appears conservative in view of the current 30 year bond rate under 2%), and sum the results for the 10 year period. The sum of estimated free cash flows for the 10 year period is $106.13B.
Finally, we add to the 10 year free cash flow a residual value determined by applying a long term growth rate of 2% after the 10 year period to be conservative. Using that rate, the original growth rate of 5% and the discount rate of 5%, we obtain the residual value of $85.12B. We add the residual value to the 10 year estimated free cash flows to arrive at an estimated intrinsic value of $191.26B. This result could change significantly depending on the growth rates and discount rates used in this approach. Nonetheless, it compares favorably with the market capitalization of $171B, apparently offering a small margin of safety.
Disclosure: The author owns shares of Boeing. This article does not represent a recommendation to buy or sell shares or engage in any other transaction.
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