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A Share Is Not Just For Easter

By James Carlisle
March 27, 2002

I was reading Stuart Watson's excellent Fool's Eye View from yesterday, An ISA Is For Life, Not Just For Easter, and it got me thinking that exactly the same thing applies to shares. Whenever you come across news and commentary about shares, it inevitably seems to involve what's going to happen in the next couple of years, months or sometimes even days.

With a company like ARM Holdings (LSE: ARM) for example, you'll hear that someone thinks that the state of the semiconductor market is set to deteriorate over the coming months. So, it might and it might not, but assuming you don't think the semiconductor market is actually going to disappear, its near-term state really has very little to do with ARM's valuation.

ARM is valued on a price to earnings (P/E) ratio of 64 for this financial year, giving it an earnings yield of 1.6%. Since (at least) 100% of ARM's earnings come through in free cash, we'll say that the 'free cash flow yield' is also 1.6%. Let's also guess that the free cash is growing at 30% per year, so that next year it will be 2.1% of the current price, then 2.7%, then 3.5% and, in five years' time, 4.6%.

If we set up a discounted cash flow model, with a discount rate of 10%, then these first five terms would become 1.6, 1.9, 2.2, 2.6 and 3.1. This implies that just 11% of ARM's long-term valuation is contributed by the anticipated cash flows over the next five years.

The other 89% of ARM's value has to do with what the company can achieve beyond five years' hence. If all goes well (at 30% growth per year and a discount rate of 10%), and of course it's a very big if, then the thirteenth year from now would be producing a greater contribution to the company's valuation than the next five years put together.

ARM makes a mess of discounted cash flow valuations because it's currently growing more quickly than the discount rate you'd use. So each year's earnings gets more and more valuable, exponentially, until you arbitrarily decide that the growth has to slow to below the discount rate. The point at which you do that will make a massive difference to the valuation.

You can see a slightly different effect when you look at a dull 'value' share. Let's take an imaginary company, Ruddersfield Forge, and start it off on a PE of 8. We'll also say that about half of that comes through in free cash, producing a cash flow yield of 6.25%. We'll also credit it with growth of 5% per year and use the same 10% discount rate. So, this year, we're collecting 6.25% of the company's value. Then, next year, we collect 6.0% (6.25x1.05/1.1) and so on.

This time, we find that about a quarter of the company's valuation is set to come through in the next five years, about half in the next ten years, and we should expect to recoup our total outlay after about 28 years. After that, we're just getting free money, so you'd call the share a bargain.

Ruddersfield Forge's valuation is more sensitive to the cash it can make in the next few years than ARM's, but in both cases, the valuation is far more dependent on what happens further into the future. You'll often hear people say that looking far into the future is too difficult and therefore pointless but, as far as the valuation is concerned, there's far more point to it than there is to worrying about the next couple of years.

So when assessing an investment, you need to think about its 'rating' and how much growth you're relying on in the future. You then need to think about whether the business has the fundamental qualities to be generating that growth in five, ten or fifteen years' time. But don't get too obsessed with the short-term dynamics of the next couple of years' profits. The Wise analysts in the City will be desperate for you to care that they've downgraded Techowidget's 2002 earnings by 10% but, of itself, it hardly makes the slightest difference.