- William McChesney Martin
Early in his career, a relatively well-known behaviorist was watching students coming to class (many were late as usual) by taking the stairs at two – or even three – at a time without ever looking down. Mulling over a seminar he recently gave on “expecting the unexpected”, he decided to give in to his inner Sherlock Holmes and asked maintenance to add a ½” thick plank on to the top stair. After roughly three out of four students tripped and fell (these were days before OSHA and uncontrolled civil litigation!), he told the class how remarkably large a half inch can be when people aren’t looking at where they are going and complacent in their inner thinking. His message: small things can lead to big events, especially when you aren’t aware of your surroundings.
A Valuation Dilemma
I bring this up because I was recently talking with my colleague John Dorfman at Dorfman Value Investments about an interesting problem facing those of us who use a discounted cash flow method for calculating intrinsic value. In my recent review of several portfolio holdings, each had several of the same attributes: free cash flow growing at a reasonable rate, earnings increasing at high single digit rates, and management purchasing back shares. A last attribute came as a surprise. Each company saw its valuation drop over the past 6-month period. At first glance, I checked to see where I had misplaced a digit or entered an incorrect figure. Like the students left rubbing their knees and scratching their heads, my immediate reaction was that there was a problem based on my calculations or process.
The problem lay of course in the same way our speeding scholars missed that top step. Looking back at each calculation, it was clear the increase in the 10-year Treasury note yield was decreasing intrinsic value greater than the free cash flow growth was increasing intrinsic value. Much like our brilliant future scholars racing up the stairs, it’s amazing how much a difference a half point (or more) in the Federal Reserve discount rate can make in your valuations. This dilemma can frequently be seen near the end of bull markets and robust economies. As the Federal Reserve takes away Mr. Martin’s aforementioned punch bowl, increases in the federal funds rate can create enormous drag on your intrinsic valuation calculations.
How This Works: Calculating Intrinsic Value
Last year I outlined the main criteria I use in calculating a discount rate to use in my valuation tool set. There are 7 main criteria that create a discount rate range of 5 – 14%. These are the company specific attributes that impact my estimated total discount rate (or weighted average cost of capital). After these criteria are scored, I then add in the current yield of the 10-year Treasury note. This reflects the market conditions driven by the Federal Reserve. The total of these two give me the total discount rate I will apply to future cash flow used to generate the company’s intrinsic value.
Company Size: Range 1-3 (1 = smallest 3 = largest)
Financial Leverage: Range 1-3 (1 = none 3 = heavily leveraged)
Cyclicality: Range 0.5-1 (0.5 = none 1 = highly cyclical)
Management/Corporate Governance: Range 1-3 (1 = outstanding 3 = poor)
Economic Moat: Range 1-3 (1 = wide moat 3 = no moat)
Complexity: Range 0.5-1 (0.5 easy to Understand 1 = rocket science)
10 Year Treasury Rate: (Insert Number)
I should point out that my discounted free cash flow (DCF) model and rising rates will have a greater impact on two groups of companies. The first are those at the higher end of the quality spectrum. For a company with outstanding attributes that score 5 - 6% on the company specific factors, increases in the 10-year Treasury rate can have a far greater impact than a company with a poor score. The second group are companies with high levels of debt on the balance sheet. As rates go up, this will disproportionately affect companies with higher debt servicing requirements. Since I focus only on the former, I will leave issues related to the latter for another discussion.
Let’s take a look at a current portfolio holding and a rising rate environment’s impact on its discount rate calculations and valuation.
A Working Example: Masimo
I wanted to use a holding here at Dorfman Value Investments to discuss the frustration of seeing a great company increase its free cash flow, maintain high returns on capital and equity, and keep a hawk’s eye on costs only to see its valuation drop. Masimo (MASI) is a mid-sized medical device company with no debt, little market cyclicality, outstanding corporate governance, and a deep competitive moat. Its company specific scores on the discount rate calculation spreadsheet is 7.00%.
With the 10 Year Treasury yielding 2.97% on June 12, 2018, the total discount rate would be 9.97% for Masimo. The 10 Year rate makes up roughly 30% of Masimo’s total discount rate. It may not seem like much, but the impact after a 1, 2, or 3% increase in the 10 Year rate can do truly horrible things to your calculated valuation.
At the current discount rate of 9.97%, I have Masimo valued at $105/share. Raise the 10 Year rate from 2.97% to 3.97% (increasing the total discount rate from 9.97% to 10.97%) and the valuation drops to $91/share. Raise it to 4.97% and my valuation drops to $80/share. With each full point increase in the 10 Year Treasury rate, Masimo’s valuation drops by roughly 10-12%. It’s important to remember that this is for a company with zero debt. For companies with extremely high debt loads valuation decreases can be greater and far steeper in nature.
To make up for this lost dollar valuation, Masimo would need to increase my estimated 8% growth in free cash flow over the next 10 years to nearly 11% annually – an increase of nearly 27%. These are numbers I find highly unlikely to occur. The drop in valuation can’t be made up by tweaking the growth numbers. In reality, I am left holding a company in the portfolio worth less today than it was 6 months ago. Realized loss or not, this is a painful exercise for any investment manager.
Rising federal fund rates as exhibited by the 10 Year Treasury yield can have an enormous impact on corporate valuations. Even with improving fundamentals such as increased revenue, earnings, or free cash can be offset by the smallest increase in interest rates. These same rates act as a gravitational pull on market valuations – and ultimately – on market returns. While many argue whether the Fed’s decision to end quantitative easing and increase rates is too late or too early, investors should worry less about the punch bowl and more about market value and corporate valuations. Much like those graduate students running up the stairs, it doesn’t take much of an increase to force investors and markets to stumble.
 This quote comes from a speech given on October 19, 1955, by William McChesney Martin, who served as Chairman of the Federal Reserve from 1951 through 1970, to the New York Group of the Investment Bankers Association of America. For those who are investing in a growing economy where the Fed is tightening rates and ending quantitative easing, there really isn’t a better read to influence your thinking.
 This is from the classic case of Holmes asking Dr. Watson how many stairs there were on the way up to their flat. His retort was the classic “you see, but you do not observe”.
DISCLOSURE: Masimo is held in several individual accounts managed by the author.