Equity Research for Value Investing
Despite many of the negatives that we hear about DCF-based stock valuation these days, it is nevertheless a mainstream method for stock valuation as part of basic equity research. In his 1992 Berkshire Hathaway (BRK.A) annual report concerning the DCF stock valuation method, Warren Buffett stated “In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” Many of the popular stock market report bands equity examination resources that retail value-investors rely on utilize this stock valuation method. This article will examine the strengths and weaknesses of DCF-based inherent value calculations and why it is importing for value investing.
Let’s review the main weaknesses of DCF-based stock valuation.
The first is that it requires us to predict cash flows or earnings long into the future. Data shows that most equity analysts cannot predict next-year’s earnings precisely. On a macroeconomic level, the “experts” have a terrible track record in predicting jobless claims, the year-end S&P, or GDP. This is no different when it comes to projecting the future cash flow of a business when picking stocks. We have to let in to ourselves that we have tremendous limitations in the ability to forecast future cash flows based on past results and recognize that a small error in the forecast can consequence in a large difference in the stock valuation.
The second challenge is calculating the appropriate discount rate. What is the discount rate? Should we dust off our college or graduate school notebook and look at the CAPM, which calculates the discount rate as the risk-free rate plus the risk premium?
Well, since this I learned this formula from the same guy (by business school finance professor) that convinced me as a 22-year old, wet-behind the ears student that markets are efficient, I am skeptical. The most famous value investor Warren Buffett’s public comments about the issue have evolved as he has stated that he uses the long term US treasury rate since he tries “to deal with things about which we are quite certain but reminded us in 1994 that “In a world of 7% long-term bond rates, we’d certainly want to think we were discounting the after-tax stream of cash at a rate of at the minimum 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we’re willing to play.” I’m inclined to take these seemingly contradictory guidelines from Buffett and from there origin a reasonable calculate of the discount rate as part of my stock research. With the September 1, 2011 30-Yr treasury provide at 3.51%, we must think that our discount rate for large cap stocks is closer to 10% than to the risk-free rate.
Finally, the problem with calculating a possible growth rate is that a DCF will simulate the growth rate to be eternal, and we know that no business can sustain an above-average growth rate in perpetuity.
Let’s now move to the strengths of a DCF form as a stock valuation tool.
George Edward Pelham Box, a Professor of Statistics at the University of Wisconsin, and a pioneer in the areas of quality control and experimental models of Bayesian inference famously remarked:
All models are wrong, some are useful.
I would argue that the DCF form can provide a useful stock valuation calculate as part of basic stock research if the user follows the following principles:
1. Invest in companies that have a sustainable competitive advantage. Stock investing should be though of as ownership interests in these companies.
2. As Buffett alluded to in his 1994 letter, certainty in the business is basic. I consequently look at different measures of stability in revenues, earnings, book value, and free cash flow as part of my equity research.
3. Your stock research should include by due diligence in analyzing companies financials (income statement, balance sheet, cash flow statement, efficiency ratios, and profitability ratios over at the minimum a 10-year period of time.
4. Before using a DCF stock valuation form or a PE and EPS estimation method for valuation, kick the tires by using a valuation form that requires no assumption of future growth. Jae Jun at http://www.oldschoolvalue.com has some very nice articles and examples on this topic (reverse DCF and EPV). I like to use the Earning’s strength Value (EPV) form (described below).
5. Look at simple relative valuation metrics such as P/E, EV/EBITA, PEPG, P/B etc.
6. use conservative assumptions of growth and a discount rate between 8-13%.
7. A healthy measure of intellectual honesty is needed so as not to modify the meaningful growth and discount rate assumptions to arrive at a pre-conceived inherent value.
8. Always use a Margin of Safety!
As mentioned, I am a big fan of Professor Bruce Greenwald’s Earnings strength Value calculation. Earnings strength Value (EPV) is an calculate of stock valuation that puts a value of a company from its current operations using normalized earnings. This methodology assumes no future growth and that existing earnings are sustainable. Unlike discounted cash flow models, EPV eliminates the need to predict future growth rates and consequently allows for more confidence in the output. It is a valuable tool as part of thorough equity research.
The formula: EPV= Normalized Earning’s x 1/WACC.
There are several steps required to calculate EPV:
1. Normalization of earnings is required to eliminate the effects on profitability of valuing the firm at different points in the business cycle. This method that we consider average EBIT margins over the past 10, 5, or 3- years and apply it to current year sales. This yields a normalized EBIT.
2. Subtract the average non-recurring charges over the past 10 years to the normalized EBIT.
3. Add back 25% of SG&A expenses to, as a certain percentage of SG&A contributes to current earnings strength. We use a default add back of 25%. This assumes that the company can continue current earning’s with 75% (1-input) of SG&A. The input range can be 15-25% depending on the industry. Where applicable, repeat for research and development expenses.
4. Add back depreciation for the current year. We use a default add back of 25%. This assumes that the company can continue current earning’s with 75% (1-input) of capital expenditures. The input range can be 15-25% depending on the CapEx requirements of the industry.
5. Subtract the net debt and 1% of revenues from normalized earnings (this is an calculate of cash required to function the business)
6. Assign a discount rate (or calculate WACC if you wish).
7. Earnings strength of Operations = Earnings of the firm * 1/cost of capital
8. Divide the EV of the firm by the number of shares, to get Price per proportion.
The DCF stock valuation form.
In this 3-stage DCF form, free cash flow growth rates for years 1-5, 6-10, 11-15, and the terminal rate, are estimated. The sum of the free cash flow is then discounted to the present value.
The formula for a DFC form is as follows:
PV = CF1 / (1+k) + CF2 / (1+k)2 +… [TCF / (k – g)] / (1+k)n-1
• PV = present value
• CF1 = cash flow in year I (normalized by linear regression or 10, 5, 3-yr average of FCF)
• k = discount rate
• TCF = the terminal year cash flow
• g = growth rate assumption in perpetuity beyond terminal year
• n = the number of periods in the valuation form including the terminal year
Again, we must recognize that inherent value that is produced by our form is only as good as the numbers put into the form. If as part of our stock research we assume unrealistic growth rates (or terminal value), or discount rates, you will get an unrealistic inherent value consequence. No stock valuation form is going to magically provide the completely accurate inherent value but, if you are conservative and intellectually honest, and dealing with a company with substantial inner economics in addition to a long track record, you can find this method useful in identifying stocks that are priced below their inherent value. Buffett seemed to do OK for himself using this methodology so, if you follow the above principles, you can too.