Thursday, August 18, 2011

Stocks Are Cheap

Don't believe me? Consider Dell which currently has a market cap of approximately $25.9 billion (stock price of $13.70 8/18/11 10am). This is effectively the price for Dell; if you buy a share now, you pay a small fraction of this price and gain ownership of an equally small portion of the company. Now, what does this $25.9 billion price tag get you? Well, a lot of cash, for starters. Dell has $14.5 billion in cash and short-term investments. These are assets that are highly liquid and not needed for day-to-day operation of the company. On the other hand, Dell has debt, $7.6 billion of it. Subtract net cash from that price tag and you arrive at an approximate enterprise value of $19 billion. This is the effective value of the business itself. How much money does this business generate? Current trailing-twelve-month income is $3.2 billion after tax. That works out to a yield of 16.8%. If Dell were to simply maintain and pay-out earnings, you'd double your investment in less than five years! (assuming you could reinvest pay-outs at the same yield) Dell will not do this; instead, Dell is likely to use some earnings to grow the company and other earnings to buy back stock. But, these actions aren't all that different from simply paying-out earnings. Buying back stock is roughly equivalent to paying a dividend---it reduces the pool of shares, making your shares worth more. And, though there are no guarantees and earnings/revenue have been flat for a few years, reinvesting earnings is likely to grow the company at a modest clip, increasing the earnings to compare against that enterprise value.

What I don't understand is why bond and stock prices are so out-of-sorts. Dell effectively pays a yield of 16.8%, yet, bond investors are willing to accept a yield of 3.57% on 30-year U.S. treasuries. Of course, the U.S. is guaranteed to pay interest on the bond (worst case they can print more dollars), whereas there is risk that Dell will reinvest earnings unwisely or be bested by other companies. But, 13.2 percentage points is quite a large margin considering the track-record of the U.S. economy and what a strong, prosperous company Dell has proven to be.

P.S. Net mutual fund flows help to explain why stocks are so cheap. $30 billion moved out of equity funds for the week ended 8/10/11. While this is a small fraction of the tens-of-trillions of equity in global stock markets, it is also the largest such negative move since the last major crash. Investors are scared. It's a great time to buy :-)

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