On Tuesday, November 24, the Dow Jones Industrial Average crossed 30,000, marking a high for the index and generating a high for investors. President Trump spoke with journalists about the event and characterized 30,000 as “sacred.”
For investors who prayed for this day, perhaps achieving 30,000, especially in the midst of a pandemic, might well be sacred. However, I want to use this event to ask investors to reflect on the degree to which stock prices accurately reflect fundamentals.
For the purpose of illustration, consider a single stock, Facebook FB . Now Facebook’s stock was actually 10% below its all-time high when the Dow first crossed 30,000. But that is less important than the fact that Facebook is one of six technology stocks whose performance have propelled U.S. stock indexes over the last three years. The six technology stocks are often called FAANG plus Microsoft MSFT , with the F referring to Facebook. In future posts, I will discuss the other five technology stocks. However, for this post, I will focus only on Facebook, and consider a single analyst report on Facebook that was authored by a group of analysts from Morgan Stanley MS .
At the close of trade on November 24, Facebook’s stock price was $276.92. On January 21, 2020, the Morgan Stanley analysts established a target price of $270 for the stock, a number reached for the first time in late August 2020. Notably, the Morgan Stanley analysts used discounted free cash flow analysis to arrive at their target price. What makes this important is that in January 2020, the Morgan Stanley team was effectively implying that if Facebook’s stock price reached $270 in early 2021, then the stock would effectively be fairly priced on fundamental grounds.
On January 17, 2020, Facebook’s stock closed at $222.14. An investor who purchased Facebook stock at the close of trade on January 17 and held it until it reached the target price of $270 would have earned a 21.5% rate of return. Think about this question: Was the Morgan Stanley team actually suggesting that 21.5% is a fair return for holding Facebook’s stock over the period?
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The answer to this last question is no. Based on the contents of the report, it is possible to infer that the Morgan Stanley analysts thought that a fair return to holding Facebook’s stock was just above 8%. Notably, the 8% corresponds to Morgan Stanley analysts’ estimate of Facebook’s cost of capital. The upshot is that the Morgan Stanley analysts viewed Facebook’s stock has having been undervalued on fundamentals back in January 2020, but predicted that the stock price would move to fundamental value on or before January 2021.
Incidentally, on November 24, when the Dow was crossing 30,000, the consensus target price for all the sell side analysts following Facebook was $314.96. Given that Facebook closed at $276.92 that day, the implied rate of return to holding the stock for the next year is 13.7%, a number considerably greater than 8%.
If you look back at Facebook’s historical performance, you will see that the company’s average ROE and ROIC both lie in the range 15-to-16%. Is that sustainable with a cost of capital of 8%? Typically not. Competitive pressures make it very difficult for most companies to earn more than their cost of capital in the long-run. For this reason, it would be worthwhile for investors to check analysts’ work to see if they incorporated this feature into their target price valuations.
There is a straightforward way to check analysts’ work on this last point, and it involves computing the percentage of net unlevered cash flow that the company reinvests for growth. Net unlevered cash flow is simply unlevered cash flow minus depreciation and amortization. What the company reinvests for growth is capital expenditures minus depreciation. The rate at which the company reinvests for growth is the ratio of its net capital expenditures to its net unlevered cash flow.
Over the last decade, Facebook reinvested just over 24% of its net unlevered cash flow to grow its free cash flow stream.1 With that number in mind, it is important for investors using valuations such as those produced by Morgan Stanley to ask how the reinvestment rate is forecast to change in the future.
As it happens, the Morgan Stanley team forecasts that after 2030, Facebook’s free cash flow stream will grow at a rate of 2% per year. According to textbook financial theory, if Morgan Stanley were to forecast that Facebook would earn its cost of capital exactly after 2030, then its reinvestment rate for growth would be 25%, the ratio of the growth rate to the cost of capital. In other words, if Morgan Stanley were forecasting that Facebook would earn its cost of capital exactly after 2030, then its reinvestment rate after 2030 would be just a bit higher than the rate from the last decade.
The thing is that the Morgan Stanley analysts assume that after 2030, Facebook will only reinvest 18% of its net unlevered cash flow for growth, not 25%. This means that if Facebook reinvests less than 25%, but its free cash flows grow at 2%, then the company must be earning more than its cost of capital.
For readers who doubt the importance of what happens after the year 2030, just consider that over 65% of the enterprise value which the Morgan Stanley analysts attribute to Facebook derives from the free cash flows that arrive after 2030.
It is possible that Facebook will earn more than its cost of capital in the long run. However, just remember that few firms are able to do so, and those which come to dominate their industries encounter regulatory pressures even if they manage to deal successfully with competitive pressures.
The upshot of all this number crunching is that high performing stocks like Facebook, which carry so much weight in the overall market, might be overvalued. This possibility should give investors pause as to whether Dow 30,000 accurately reflects fundamentals.
Source: Forbes – Money