Our columnist takes on reader issues in this month's installment of fundamental questions.
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We're back again for our monthly installment of

Fundamental Questions

. Please keep those questions coming in, with your full name, to

agreta@thestreet.com. It's the readers who really make this column fly. For a refresher course in fundy analysis, check out our

five-part basics series. Now, on to today's action.

### The Golden Nugget of the Dividend Discount Model

From education and various readings, I have always seen the method of estimating a price of a stock to be: dividends divided by (required rate of return minus growth rate). I, for one, have never been able to figure out how to do this problem in a "real-world" scenario because a required rate of return is never just given to you. -- Chrystal Evans

Chrystal,

You're giving me painful flashbacks to corporate-finance class where I regularly butted my real-world head against Professor McConnel's stonewall defense of the mystical "dividend discount model" -- the common term for the formula that you describe. The truth is that, while the DDM may have been

Newton's

apple to the evolution of stock valuation, its practical value is pretty limited in today's complex quantum world. Nevertheless, one component -- the idea of a required rate of return -- is a critical drop of insight for investors and corporate chieftains alike. So let's focus on that.

The concept goes something like this. Investment capital costs money, either through an explicit interest payment on a loan, or through the return a company is expected to provide to equity holders. In order for a company to build shareholder wealth, it's not enough to simply be profitable. The firm needs to earn a rate of return on its invested capital greater than what it costs the firm to use it.

Intuitively, this makes sense. If a \$100,000 bamboozle machine costs you 10% a year just sitting on the shop floor doing nothing, it had better bam at least \$10,001 boozles for you to create shareholder wealth. If your firm ends up even a few bucks shy of the benchmark, although seemingly "profitable" in that it's generating positive value, the firm actually destroys shareholder wealth if that value doesn't outweigh the cost of the capital.

So how do you calculate this magical required rate of return -- the benchmark? In financial terms, it's the weighted average cost of capital, or the WACC. WACC is an average that reflects the blend of both debt levels and the historic riskiness of the stock.

Figuring out the cost of debt financing is easy. It's simply the interest rate on the loan. An 8% bond costs the company 8% (ignoring any tax benefits). There's no brain surgery here. Figuring the required rate of return on pure equity, however, takes some real number crunching. The theory is that the higher the risk of the stock, the more investors need to be compensated for that risk with higher returns. As such, the required rate of return for equity is a function of the stock's "beta."

Rather than taking an entire semester of college-level finance, you can look up a table of WACCs for the biggest 1,000 stocks on the

Stern-Stewart

Web site. Just add the report and ranking to your "info kit" on the site by clicking on the link, then entering some basic registration information for the free download. (But don't blame me if you start getting spammed with financial algorithms!) You'll get the WACCs, as well as the ROC, or return on capital. Basically, these provide a comparison of where the company should be, WACC, vs. where it actually is, ROC. The comparison table shows you which companies are clearing the value hurdle and are creating instead of destroying wealth for shareholders. (For more on this, see my

EVA article.)

You can also ballpark a stock's WACC directly from its historic beta, but the approach only works for stocks with no debt (thankfully not a problem when dealing with your average debt-free Net stock start-up). Just take the stock's beta times the historic market risk premium of about 7% (basically the difference between the historic rate of return for stocks and the risk-free return on Treasuries) and add the current 30-year bond rate (around 6% these days) to get a rough estimate. Following the formula, a debt-free stock with a 1.50 beta has a back-of-the-envelope WACC of around 16.5%. (You'll find a stock's beta at

rapidresearch.com.)

So why does the required rate of return matter? For backroom quant jocks, the rate represents the cornerstone of their

labyrinthine

-discounted cash-flow models. For you as a long-term investor, the theory says you're well advised to invest in wealth creators such as

Coke

(KO) - Get Report

and

GE

(GE) - Get Report

, which routinely beat their WACC hurdle and steer clear of the wealth destroyers such as

GM

(GM) - Get Report

and

Loews

(LTR)

-- the dead losers in the value creation track-and-field meet, according to the latest Stern-Stewart rankings.

### Spotting Deadbeat Tenants With Fundy Analysis

When I am reviewing the financial statements of a company that is a prospective tenant for an office real estate holding, what do you feel are the highlights for determining the company's ability to meet its rental obligations? -- Clay Carlton

Clay,

While real estate may be all about location, location, location, as a landlord, you're concerned with the rent, rent, rent. The best way to make sure the tenant can meet its rent obligations is by checking a few critical financial indicators: liquid assets, free cash flow and liquidity.

First off, how much cash and other liquid assets does the firm have on hand right now? Is it enough to cover at least several months of rent -- or even better, the entire lease obligation? Next, how's the free cash flow been over the last few years? (For the formula, see my

Getting a Grip on Cash Flow piece.) You want this number to be high and positive, indicating lots of discretionary income available to pay off the landlord.

Finally, look at the current ratio, or the ratio of current assets to current liabilities. (See

Balance Sheet Basics.) Ideally, you want a ratio above 2.0 showing good liquidity and the ability of the firm to meet its short-term obligations even in a business downturn.

If the firm is marginal in some of these areas, consider structuring the deal to minimize your risk (high-security deposits or guaranteed letters of credit spring to mind). If the numbers look downright shaky, find another renter. In most states, tenants are like a bad case of crab grass -- once they take root, they're hard to remove. Do yourself a favor and do the homework up front.

### Aligning Assets Post Merger

If XYZ Company decides to buy ABC Partnership for cash, how will this new asset appear on the shareholder equity side of the balance sheet, and how will it be carried forward (provided that all else stays the same for the sake of simplicity)? -- Andras Fancsik

Andras,

The simple answer is that the transaction (as you've described it in ideal-world terms) doesn't impact the acquirer's shareholder equity one iota. XYZ's cash (an asset) is merely exchanged for ABC's assets (and liabilities if any). Any amount paid above market value is carried as goodwill (another asset) on XYZ's balance sheet.

You can think of goodwill as the price paid for intangible assets such as a brand name, customer loyalty or some kind of trade secret for extracting hemoglobin from anthracite. Other than that, the post-acquisition company (ZACXBY?) just keeps consolidated books reflecting the combined performance of both units on the same page and business goes on in frictionless bliss.

That's all for this time. See you in November. And remember to keep those questions coming in here to

fundy central.