We at Smead Capital Management believe in the value of compounded returns. They are the friend of the long-duration common stock investor, especially when considering the intrinsic value of a company. With so much chatter among investors, the media and analysts over when the Federal Reserve will increase interest rates, we would like to share with you how we think about and use prevailing interest rates in security analysis. Together with earnings growth estimates and longevity, the discount interest rate is a cornerstone of calculating the intrinsic value of a company.

In theory, intrinsic value is the net present value of all the future profits of a business. To compute present value, you must first decide what discount rate to use for adjusting future profits into today's dollars. It is the opposite of compounding interest.

Let’s say you want to double your money. How long would it take to double your investment in a 2% interest rate environment versus a 5% interest rate? If we have $0.50 now and earn at a 2% compounded rate, it will take us approximately 35 years for it to become a dollar. If the interest rate is 5%, then it will take approximately 14 years to grow to a dollar. In other words, it takes 21 years for the investor at 2% to catch the investor who earned 5%.

The exact opposite is true in computing the present value of a future dollar. One dollar earned in 35 years is worth $0.50 today at a 2% discount rate. At 5%, a dollar paid to you in 14 years is worth $0.50 today. As a value investor, we prefer the higher intrinsic value at the lower discount interest rate. The discount rate has a massive impact on the intrinsic value of a business. In our opinion, the road to higher riches has been paved in lower discount interest rates.

How do most investors handle valuing the shares of a company’s common stock? They watch quarterly earnings reports looking for every little blip in the life of a solid business and adjust a forward earnings model. An earnings miss can easily knock down the market value of a common stock. We believe much of this is lunacy in today's low interest rate environment because the blip must be repeated for many years to significantly impact intrinsic value.

We don’t think we’re alone in this observation. At the Berkshire Hathaway’s annual meeting, Warren Buffett was asked what he thought of stocks at these current levels. His answer was, "At interest rates around 1%, if they stay low, stocks will go up a lot over the next ten years. If rates go to 5%, the market is slightly over-valued."

While so many investors worry about the noise of short-term earnings, we think a far more important issue in the earnings report is how the moat of a business (defensibility of their market position) is affected by what is going on today. If business was punk, but your competitors are being clobbered harder than you are, your company longevity might be positively impacted by the bad news. Think how miserable the banking industry has been the last five years and how big the moat of JP Morgan (JPM), Wells Fargo (WFC) and Bank of America (BAC) has become. Their market share growth in deposits and loans has been explosive since the financial meltdown.

This leads us to longevity and its impact on intrinsic value. A buyer of Wells Fargo in the 1850s, when it went public, has become incredibly wealthy from 160 years of after-tax profits. A fifty-year life for a public company is a big success story, so just think how much added years of profitability over and above fifty years adds to intrinsic value! At today's low interest rates, a key part of calculating intrinsic value is estimating the life of a business. Long life adds significantly to intrinsic value.

If Company A lasts twenty years longer than Company B, the present value of the extra years of profit are added to Company A's total. At today's low rates, these bonus years can add 50% to the current intrinsic value. Therefore, we place a great deal of importance on company characteristics that we believe lead to longevity.

Longevity in Business

We believe business longevity is most heavily affected by its moat (competitive defensibility), financial strength (balance sheet/free cash flow), branding and long-term re-investment in future growth.

Moat
What stops someone else from competing with you? It can be size, flavor, customer addiction or the fact that nobody else wants to do what you do (think mortician or garbage hauling).

Branding
If you want longevity in a business, put 100 people in a room and name a generic product like gourmet coffee, wholesome family entertainment or tax preparation. If more than 90 of them name one company, the brand has huge longevity potential. The most recent example is the successful re-launch of the Twinkie and other pastries from the failed Hostess company.

Financial Strength
Every business struggles sometimes, and when they do, they must lean on balance sheet strength and free-cash flow. We like to think of free-cash flow like the Bible does about love. It covers a multitude of sins.

Re-investing in Future Growth
If a business wants longevity it must constantly re-invest in its future. This can be R&D for a biotech/pharma company, expanding a new format in retail, or technology investments for a financial service firm. It is giving up current profits to get future profits and in the process, extends longevity.

In conclusion, the interest rate used for discounting future profits and company longevity are immensely important as we calculate the intrinsic value of a company. We use an interest rate higher than current prevailing rates to create a margin of safety in our stock selection. Additionally, we are in favor of focusing on proven factors associated with company longevity to find bigger bargains among quality common stocks. This is another way time could be our friend in security analysis and stock selection.

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

© Smead Capital Management

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