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Morningstar.com's Interactive Classroom Course 309 SteadyState ValueIntroduction When you buy a stock, you become part owner in a business. What you're really getting is a stream of future profits. So how do you know if you're paying a fair price now for future profits? One way to find out is to isolate what the company would be worth if profits were to continue just as they are now. Once you've determined that "steadystate" value, then you know that all other expected profits would have to come from growth, and thus what you're paying for that growth. The company's steadystate value represents the company just as it is now, generating the same level of cash year after year. The second elementthe growth componentis what's left over. The growth is the difference between the market value of the company and its steadystate value. Value of growth = market value – steadystate value Determining SteadyState Value To determine a company's steadystate value, we start with free cash flow, or the cash left over after all of a company's expenses have been paid. (Find a company's free cash flow figure on its Quicktake Report.) It also represents the amount of money a company could distribute to shareholders each year and still keep the business running. Once we have determined a company's free cash flow, we assume that the company will generate that same amount of cash every year forever. Next, we want to find out what that future stream of cash is worth today. To determine the present value of the future cash, we need to take the free cash flow and divide it by a discount rate. Steadystate value = free cash flow / discount rate A discount rate is an interest rate used to determine the present value of future cash flows. In the following examples, we'll use a discount rate of 10%, which is loosely based on the yield of the 30year Treasury bond. The yield at the end of 1999 was about 6%. Then we'll add an even 4 percentage points, since we expect a company's cash to appreciate in value more quickly than a bond's value would. That gives us 10%. Let's consider Ford F as an example. The auto giant's free cash flow was $14 billion in 1998, so assume Ford will be able to continue to generate $14 billion in free cash flow each yearno more, no less. Then the business would be worth $14 billion divided by the 10% discount rate. The steadystate value ends up being $140 billion (that's $14 billion/0.10). The Value of Growth To go the final step and determine how much today's stock price reflects expectations of future growth, you need to know the market value of the company, which is also known as market capitalization or "market cap." To calculate market value, take the total number of outstanding shares and multiply it by the current stock price. Market value = total number of outstanding shares x stock price Morningstar calculates market cap, which changes every time a stock's price changes, in each stock's Quicktake Report. Ford's market value in late December 1999 was $60 billion. You can determine the value of growth by subtracting the steadystate value from market value. In Ford's case, the steadystate value of $140 billion exceeds the market value of $60 billion, giving you a value of growth of negative $80 billion. Since Ford's steadystate value is greater than the market value, Ford would not have to grow at all to justify its current share price. Does that make this stock a bargain? Not necessarily. When a company's steadystate value exceeds its market cap, it just means the market expects free cash flows to decline. Given the cyclical nature of the auto industry, the market's pessimistic view of Ford is probably right on target. Contrast Ford with Amazon.com AMZN, the online bookseller. Amazon's free cash flow is minimal right now because it's too busy investing every available dollar in the business. Going through the same calculation we did with Ford, we get a steadystate value for Amazon of $30 million. That's tiny compared with Amazon's market value of $32 billion at the end of 1999. Since Amazon's steadystate value is negligible compared to its market value, growth represents 100% of the stock's price. That means even if Amazon maintains its current level of profitability, it's still literally worthless. All its worth and then some hinges on future growth. Most companies lie between these two extremes. For largecap companies that generate positive free cash flow, for example, the average mix was about 38% steadystate profits and 62% growth for 1999. (That figure has historically been closer to 50/50.) A company like CocaCola KO will land on the growth side of the average. If CocaCola generates $2.5 billion in free cash flow each year from now on, its business is worth $25 billion, or 17% of its stock price. The other 83% is growth. Rocket science it isn't, but this method does provide a quick way to gauge the growth assumptions built into a stock price. If you stumble onto a company whose future growth represents all, or nearly all, of its market value, then before buying the stock you'd better be darned sure the company's really going to grow rapidly for a long time. Otherwise you won't get enough future profits to justify the price tag. 

Quiz 309 

1  Steadystate value shows:  
a.  Whether a company is able to grow in the future.  
b.  What portion of a business each shareholder owns.  
c.  The value of a company based on its current free cash flow.  
2  The free cash flow divided by the discount rate shows:  
a.  The rate of growth.  
b.  How the stock market expects the company to grow.  
c.  The value of future profits given today's cash flows.  
3  The growth value increases if:  
a.  Market value increases and steadystate value stays the same.  
b.  Steadystate value increases and market value stays the same.  
c.  Free cash flow increases and market value stays the same.  
4  If Ford's stock price doubled but its number of outstanding shares and steadystate value stayed the same:  
a.  The stock would be expensive based on future growth expectations.  
b.  The company's steadystate value would still exceed its market value.  
c.  The company would now be expected to grow beyond its current level of profitability.  
5  If a large company's growth represents 80% of its market value, the stock market expects the company to:  
a.  Grow faster than the average largecap stock.  
b.  Grow slower than the average largecap stock.  
c.  Grow at the same rate as the average largecap stock. 
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