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Posts Tagged ‘Expected Returns’

Oracle is Fairly-Valued Following Its Price Correction on 12.21.11

This article presents a financial analysis of Oracle (ORCL), which sold off sharply in the 12.20.11 after-hours session after missing hard on top-line revenue and bottom-line earnings. The analysis shows that this recent price correction has compressed ORCL’s stock to fair value based on a discounted free cash flow model and a slow-growth future trajectory for the company. The stock merits a BUY recommendation at its 12.21.11 closing price of $25.77. Technical analysis indicates negative stock price momentum, however, so even more attractive entry points may lie ahead. ORCL has strong and growing EBITDA/share and NOPAT/share, generates large free cash flows, earns a return on capital well above its cost of capital, and is well-positioned to create value even if future growth downshifts to a new, slower trajectory. I do not expect ORCL’s stock to languish after this revenue/earnings miss like Cisco or Hewlett-Packard. The analysis shows that the company is not broken and can continue creating value in a slow-growth environment. If OCRL follows the MSFT and INTC model, investors will see large dividend increases in the near future, as the company puts more energy into growing dividends to compensate for its slower future growth.

ORCL has a market cap of over $147 billion, posts a return on capital of 15.6% (well above its cost of capital of 9.1%), and had a consensus analysts target price of $36.00 prior to its 12.20.11 price decline.

The stock now yields 0.5%, and its trailing P/E has compressed to a reasonable 14.2 times earnings. As shown below, ORCL creates large and growing economic value-added, and has large and stable free cash flow margins.

ORCL has a beta of 1.19 vs. the Nasdaq-100 index over the past 36 months, a slightly negative annualized alpha due to its higher volatility, respectable institutional ownership, and is one of the most lightly-shorted stocks in the market.

Over the past 2 years ORCL has slightly outperformed the Nasdaq-100 before adjusting for risk:

ORCL’s stock has strongly outperformed peer firms Microsoft (MSFT) and Google over the past 2 years:

ORCL posts strong revenue per share, comparable to a giant revenue producer like MSFT:

ORCL’s trend in EBITDA and EBIT is impressive, growing every year for the past 6 years:

EBITDA per share displays a similar trend, once again comparable with MSFT:

MSFT pulls slightly ahead in terms of EPS, however:

For a dividend-focused investor, MSFT makes more sense:

MSFT now has a respectable yield of 2.6%, vs. ORCL’s yield of 0.5%:

Both companies gross margins have contracted slightly in recent years:

MSFT’s operating margins are also in a slight downtrend, while ORCL’s are more stable in the mid-30% range:

Both firms have strong, stable net margins:

Our process favors stocks whose prices are strongly supported by fundamentals such as Net Operating Profit After Tax. Each companies’ NOPAT/share is shown below. Note the rising trend:

ORCL has invested more in recent years than MSFT, thus their lower FCF/share until the most recent fiscal year (both companies are now in their 2012 fiscal year):

ORCL has a strong ROIC, which only looks small compared with MSFT’s. The spread of each stock’s ROIC over their cost of capital is huge, which is a necessary condition for shareholder value creation:

Both companies create large and growing economic value-added per share.

ORCL has grown its market value-added per share recently due to its stronger stock price performance:

We projected ORCL’s financial statements using a slow-growth scenario that takes growth from 2013-2017 on a declining trajectory, beginning at 4.0% and slumping towards a 2.0% perpetual growth rate. Margins were held at their historical averages in the forecast:

Based on a 5-year beta of 1.09, the current 10-year yield of 1.96%, and a market risk premium of 7.0%, we estimate ORCL’s cost of capital at 9.1%:

A detailed valuation analysis is shown in the table below.

ORCL’s 12.21.11 pre-market price of $26.25 indicates slight undervaluation, based on a DCF fair value price of $27.74:

Technically, the MACD indicates ORCL’s price may drift even lower:

Conclusion: ORCL’s 12.21.11 closing stock price of $25.77  is well-supported by fundamentals and most likely represents a good entry point for the long-term buy-and-hold investor who does NOT require high dividends. Technical analysis indicates negative stock price momentum, however, so even more attractive entry points may lie ahead. The stock has strong and growing EBITDA/share and NOPAT/share, generates large free cash flows, earns a return on capital well above its cost of capital, and is well-positioned to create value even if future growth downshifts to a new, slower trajectory. I do not expect ORCL’s stock to languish after this revenue/earnings miss like Cisco or Hewlett-Packard. The company is not broken and can continue creating value in a slow-growth environment. If OCRL follows the MSFT and INTC model, investors will see large dividend increases in the near future, as the company puts more energy into growing dividends to compensate for its slower future growth.

Datasource: Capital IQ

Thinking Long Term About the Equity Premium

Posted by Rob Weigand.

One of my favorite blogs, Abnormal Returns, recently linked to a post at the blog Zero Beta regarding the Equity Premium “Puzzle.” I’ve published a few papers on this topic recently (Journal of Portfolio Management, Journal of Investing and Journal of Financial Planning — forthcoming in October), so the literature remains fresh in my mind. Here’s the perspective I’ve cultivated after reading over 100 papers on the Equity Premium:

The only way to properly conceptualize risk premia is from a very long term perspective (as in Siegel’s Stocks for the Long Run). US equity markets have set the long term real return on equities at just under 7%. But egg-headed professors look back on the data — with the benefit of perfect hindsight — and say 7% was too large, AS IF EVERYONE KNEW STOCKS WOULD EARN 7% REAL RETURNS. Duh! The equity premium has been that large because people were extremely unsure how compelling global events would play out — at the time those events were occurring.

Try to appreciate the incredible uncertainty associated with two World Wars, the Great Depression and the Cold War. All of these events eventually worked out for the best — and thank goodness for that — but investors didn’t KNOW they would when those events were playing out. Moreover, the US economy was closer in time to regularly-recurring bank panics than we are today (I would assert that we currently suffer from a false sense of security that regulation and Fed monetary policy is better than it used to be).

As if in response to all this contrived thinking about the equity premium being too large historically, the equity premium is smaller today — any way you measure it. Yet, as we’ve seen with the subprime banking crisis, the world is just as uncertain as it used to be. Russia and the Middle East have most of the oil — and we’re no closer to independence from foreign oil than we were under Jimmy Carter. The Chinese have a work ethic that would make the average American faint — just THINKING about it. And we have witnessed a pronounced decline in the value of the US dollar in recent years (the recent rally notwithstanding). Residential real estate is in a protracted bear market and the credit creation system is gummed up beyond all recognition (GUBAR). We’re as up against it as we’ve ever been. And we may very well prevail, just as we always have — but we don’t know that with the type of perfect certainty that warrants real expected returns on stocks of 3-5% (or lower).

When you look at the P/E ratios (use 10-year smoothed earnings as suggested by Graham & Dodd, Shiller and others) and dividend yields on the major indexes, however, these metrics don’t reflect the expected returns necessary to fully compensate for the real risks going forward — at least as those risks appear to a rational person TODAY. (That’s why the super-rich are hoarding cash and cash equivalents and, as the Forbes crowd always loves to do, hoarding gold.)

One of the major factors holding up equity values in the current bear market (and keeping relative valuation high compared to this point in bear markets historically) are all the “jocks” that have migrated into professional money management. You know who they are — they’re lined up a mile deep to get their 5 minutes on CNBC and say things like “Stocks have always paid off and I’m really bullish on America,” or “Stocks look really cheap to me right now,” etc. Of course, they never back up their forecasts with any metrics — they just spout pro-market “feelings.”

Now, all this doesn’t mean that equity values can’t rise from current levels as soon as the news turns more positive than negative, but if they do, we’ll just be perpetuating the rolling global asset bubble that’s been hanging over markets since the latter 1990s (read Jeremy Grantham’s Barron’s interview on the global bubble and credit crisis from February, or his more recent post on the global competence meltdown). Therefore, after reading 100+ papers and publishing 3 myself, my perspective is that markets have set the LONG TERM equity premium just right historically, and this premium remains too low today when considered alongside the financial, economic and political risks that prevail in the current environment.

You can email Rob Weigand at profweigand@yahoo.com or find him on the web at Rob Weigand’s Home Page.