Political Math

I was recently asked why I rarely discuss politics and the possible implications of a Trump presidency. The answer is I don’t have a strong opinion on how new policies and legislation will impact the valuations of the businesses I follow. While reductions in regulation, higher spending, and lower taxes may increase earnings, will higher fiscal deficits, rising interest rates, and possible trade disputes offset these benefits? I really don’t know. Adjusting my valuations at this time seems premature and would be speculation on my part – as an absolute return investor attempting to limit mistakes, guessing is something I always try to avoid.

Politicians and policies come and go. Some influence corporate cash flows more than others, but over time I view them as cyclical trends that tend to normalize (see tax rates over the past twenty years – they’ve fluctuated, but not far from the average). This is similar to how I view the impact and movements in currencies. I try avoiding knee-jerk reactions to every election or legislation proposal. Instead, I take a longer-term view and attempt to take political and policy uncertainties into consideration in my required rate of return and normalized free cash flow assumptions.

There are many reasons to take a long-term view when considering political and policy uncertainties. Unlike viable businesses that should be around for decades, most politicians and their policies are shorter-term in nature. For example, the majority of value of a business occurs well beyond one presidential term. Similar to a long-term bond, most of the value of an established business is accumulated over many years, not the next four.

Below is a simple cash flow valuation of a business growing at 4% and generating $100 million per year in normalized free cash flow. I discounted these cash flows at 10%. On a multiple basis, this valuation equates to a 16.6x normalized free cash flow valuation, or similar to the average long-term CAPE (so not an out of the ordinary valuation).

Free Cash Flow Business Valuation ($100 million free cash flow; 10% discount rate; 4% growth rate):

Year 1: $90.1 million

Year 2: $86.0 million

Year 3: $81.3 million

Year 4: $76.8 million

Terminal value: $1.33 billion

Total Business Valuation (Years 1-4 + terminal value): $1.66 billion

While investors have driven up stocks considerably since the election, valuation math clearly illustrates that only a small portion of a business’s value is derived over one presidential term. In the example above, years 1 through 4 contribute $334 million, or only 20% of the total $1.66 billion valuation. Considering the sharp rise in equity values and the contribution the next four years have on business valuations, investors appear to be discounting well beyond the current presidency.