DCF analysis

 We blend Options trading with Universal Art and share the profits.

Wall Street has a way to tell. It’s called discounted cash flow, or DCF analysis, and it’s the basis for analyst price targets and Buy, Hold, and Sell ratings.

Step 1: Predict precise free cash flows far into the future, say 10 years, even though Wall Street routinely guesses wrong on much easier measures like revenue for the current quarter.

Step 2: Choose what’s called a discount rate, which is based in part on risk, which no one has figured out how to accurately measure for stocks in their four-century history.

Step 3 onward: Use this made-up rate to calculate how much to pay today for those unknowable future cash flows. I’m leaving out some important steps, like calculating a terminal value, which involves conjecture beyond year 10, and adjusting for distant, entirely theoretical debt levels. Don’t forget to express your answer in the form of absolute certainty.

Here’s an alternative that’s less mathy and more appropriately iffy. It doesn’t have a high-finance-sounding name. I’m considering “disgruntled crash-flop electrolysis,” but I have to check the trademark status. DCFE involves starting with things we already know, like today’s price, or can safely assume, like that an investor buying shares of one of these Big Tech companies would want to be decently rewarded—say, with 12% yearly returns over the next five years. Ballpark how much free cash the company would have to be generating after those five years to be worth that price. And then sniff deeply at recent cash flow trends to decide whether such a thing is plausible, resulting in a rating of Yeah, Meh, or Nah. Think of it as a sanity check, not a market timing tool.

Take Apple, the biggest of the bunch. A 12% yearly compounded return would take its recent $175 share price to just over $300 in five years. Based on today’s market value and how the share count has been steadily declining, figure a future value of $4 trillion. At minimum, an investor might expect to see a 4% free-cash-flow yield on a mature business like that, or $160 billion a year. Not even oil monopoly Saudi Aramco is hitting those levels.

Every weekday evening we highlight the consequential market news of the day and explain what's likely to matter tomorrow.

But Apple is already over $100 billion in yearly free cash. And its capital spending isn’t growing much. So even moderate revenue increases could leave it with a Brewster’s Millions situation where it’s difficult to spend the cash. (Richard Pryor, John Candy, 1985, in which a minor league baseball player has to blow $30 million in 30 days to inherit $300 million.) I rate the stock a solid Meh, bordering on a Yeah.

Microsoft, Alphabet, and Amazon are three more companies with a path to joining the $100 billion free-cash-flow club at some point within the next several years, giving the U.S. the financial equivalent of four Aramcos. Amazon has much further to climb than the others, and all carry regulatory risk, but the idea is the same: Puttering around with the numbers, today’s prices don’t look ludicrous in light of the plausible path for free cash flow. Ditto for Meta, but on a smaller scale. Its management has stopped yammering about the metaverse, started yammering about artificial intelligence, and most important, slashed spending. Free cash flow could top $30 billion this year and approach $50 billion in several years.

Nvidia and Tesla are more difficult. Before the pandemic, Nvidia was generating free cash like a prosperous chip maker—a few billion dollars a year. Its current value implies that within several years it will turn out a Meta-like $50 billion, or remain an incredibly fast grower, or both. It could happen—the company has one of the strongest positions in AI—but the assumptions are bold. And Tesla stock this past week skidded 9% in a day, after third-quarter results showed elevated discounting to sell vehicles. That makes the free-cash multiplication needed to justify the current price a leap. Nah for both.

On the whole, prices look elevated but not nuts. As for the equity risk premium, it’s theoretical and ultimately unknowable, but I recently gave it an imaginary squeeze and it felt modestly positive. Which is good.