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Overestimating Future Cash Flow?


Persistent Intervention could chronically impair judgment, returns on capital.


Revvin' up your engine
Listen to her howlin' roar
Metal under tension
Beggin' you to touch and go
--Kenny Loggins

Many astute investors are offering cogent arguments as to why stocks offer long-term value at these levels. My personal analysis also detects stock-market value not seen in some time, although perhaps not as across-the-board as others suggest.

That said, a big risk to the "stocks are good value at these levels" assessment is that investors (me included) may be overestimating future cash flows.

As an example, consider a name that I'm involved with, Merck & Company (MRK). Currently, I'm estimating that Merck can generate $6 billion in annual free cash flow (FCF) over the long term (this is at the low end of Merck's annual FCF generation over the past few years).

The value of that cash flow as a perpetuity discounted at 10% is $60 billion. A ratio of Merck's current market cap of $59 billion (based on Monday's closing stock price of $27.91 per share) to this FCF perpetuity value equals 59/60, or about .98. As such, Merck is selling for about a 2% discount, using these assumptions and methodology. If we replace market value with enterprise value of about $53 billion, then this discount increases to about 12% (53/60 = .88).

The big "if" here is our assumption of future free cash flow. What if Merck doesn't approach this FCF level? If, for instance, Merck's long-term FCF-generating power turns out to be only $3 billion annually, then Merck stock is currently overpriced, selling for about 2 times fair value.

How might such a situation come about? Well, Merck could run into business- or industry-specific problems that drastically reduce its earning power, such as an unproductive drug pipeline, increased bargaining power of buyers, legal actions, etc.

While such events are certainly within the spectrum of possibilities, I'm more concerned about changes to overall market structure that could chronically impair capital returns at firms across the board - not just at Merck.

Specifically, I'm worried about the long-term consequences of pervasive bureaucratic intervention in markets that we've experienced - and may continue to experience moving forward. Persistent government meddling dramatically increases the probability of capital misallocation over time. Future returns on that capital and resulting free cash flows will almost certainly be weakened.

This is important because, as noted by John Hussman, among others, stock valuations depend more on cash flow far into the future than on cash flows in the near term.

If returns on capital will indeed be chronically impaired, then those who are valuing stocks under the assumption that equities will ultimately revert toward historical cash-generation patterns may produce overly optimistic forecasts.

The boilerplate warning that "past performance may not be indicative of future returns'" seems particularly appropriate when governments are assuming more control over markets.

Position in MRK

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