Stock research for value investing
Despite many of the negative things we hear about DCF-based stock valuation these days, it remains a mainstream method for stock valuation as part of fundamental stock research. In his 1992 Berkshire Hathaway (BRK.A) annual report on the DCF stock valuation method, Warren Buffett stated: “In the investment theory of value, written more than 50 years ago, John Burr Williams established the equation of value, which we condense here: The present value of any stock, bond, or business 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 research resources from stock reporting groups that retail value investors trust use this method of stock valuation. This article will examine the strengths and weaknesses of DCF-based intrinsic value calculations and why it is important for value investing.
Let’s review the main weaknesses of DCF-based stock valuation.
The first is that it forces us to predict future cash flows or earnings. The data shows that most stock analysts cannot accurately predict next year’s earnings. On a macro level, the “experts” have a terrible track record at predicting jobless claims, the year-end S&P, or GDP. This is no different when it comes to projecting a company’s future cash flow when choosing stocks. We have to admit that we have tremendous limitations in the ability to forecast future cash flows based on past results and recognize that a small error in forecasting can make a big difference in stock valuation.
The second challenge is determining the appropriate discount rate. What is the discount rate? Should we dust off our college or grad school notebook and look at the CAPM, which calculates the discount rate as the risk-free rate plus the risk premium?
Well, ever since I learned this formula from the same guy (from business school finance professor) who convinced me as a wet 22 year old student that markets are efficient, I’m skeptical. The public comments of the most famous value investor, Warren Buffett, on the subject have evolved, since he has declared that he uses the US Treasury rate of long-term bond rates of 7%, we certainly want to think that we are discounting the after-tax cash flow at a rate of at least 10%. But that will depend on the certainty we have about the business. The more confident we feel about the business, the closer we are willing to play.” I am inclined to take these seemingly contradictory guidelines from Buffett and derive a reasonable estimate of the discount rate as part of my stock market research. With the September 2011 30-year Treasury yield at 3.51%, we should think that our discount rate for large-cap stocks is closer to 10% than the risk-free rate.
Finally, the problem with determining a feasible growth rate is that a DCF will simulate the growth rate to be eternal, and we know that no firm can sustain an above-average growth rate in perpetuity.
Let us now turn to the strengths of a DCF model as a stock valuation tool.
George Edward Pelham Box, professor of statistics at the University of Wisconsin and a pioneer in the areas of quality control and experimental models of Bayesian inference, commented:
All models are wrong, some are useful.
I would say that the DCF model can provide a useful stock valuation estimate as part of fundamental stock research if the user follows the following principles:
1. Invest in companies that have a sustainable competitive advantage. Investment in shares should be considered as ownership interests in these companies.
2. As Buffett alluded to in his 1994 letter, certainty in business is essential. Therefore, I look at different measures of stability across revenue, earnings, book value, and free cash flow as part of my stock research.
3. Your stock market research should include due diligence in analyzing the companies’ finances (income statement, balance sheet, cash flow statement, efficiency ratios, and profitability ratios over at least a 10-year period).
4. Before using a DCF stock valuation model or a PE and EPS estimation method for valuation, kick the tires by using a valuation model that requires no assumption of future growth. Jae Jun at http://www.oldschoolvalue.com has some very good articles and examples on this topic (reverse DCF and EPV). I like to use the Earning’s Power Value (EPV) model (described below).
5. Look at simple relative valuation metrics like P/E, EV/EBITA, PEPG, P/B, etc.
6. Use conservative growth assumptions and a discount rate between 8-13%.
7. It takes a good deal of intellectual honesty not to change the key assumptions of growth and discount rate to arrive at a preconceived intrinsic value.
8. Always use a safety margin!
As mentioned, I am a big fan of Professor Bruce Greenwald’s calculation of the value of the power of earnings. The Earning Power Value (EPV) is an estimate of stock valuation which puts a value on a company from its current operations using normalized earnings. This methodology assumes that there is no future growth and that existing earnings are sustainable. Unlike discounted cash flow models, EPV eliminates the need to predict future growth rates and therefore allows for greater confidence in production. It is a valuable tool as part of a thorough stock investigation.
The formula: EPV= Normalized Earnings x 1/WACC.
There are several steps required to calculate the EPV:
1. Earnings normalization is required to remove the profitability effects of firm valuation at different points in the business cycle. This means that we consider the average EBIT margins of the last 10, 5 or 3 years and apply them to the current year’s sales. This produces normalized EBIT.
2. Subtract the past 10-year average non-recurring charges from normalized EBIT.
3. Add 25% of SG&A, as a certain percentage of SG&A contributes to current earning power. We use a default add-on of 25%. This assumes that the company can maintain current profits with 75% (1 entry) 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 the depreciation for the current year. We use a default add-on of 25%. This assumes that the company can maintain current profits with 75% (1 input) of capital expenditures. The input range can be 15-25% based on industry CapEx requirements.
5. Subtract net debt and 1% of income from normalized earnings (this is an estimate of the cash required to operate the business)
6. Assign a discount rate (or calculate WACC if you want).
7. Profit holding power = Firm profit * 1/cost of capital
8. Divide the EV of the company by the number of shares, to get the Price per share.
The DCF stock valuation model.
In this 3-stage DCF model, free cash flow growth rates are estimated for years 1-5, 6-10, 11-15, and the terminal rate. The sum of the free cash flow is then discounted to present value.
The formula for a DFC model is as follows:
VA = CF1 / (1+k) + CF2 / (1+k)2 +… [TCF / (k – g)] / (1+k)n-1
Where:
• PV = current value
• CF1 = cash flow in year I (normalized by linear regression or average of 10, 5, 3 years of FCF)
• k = discount rate
• TCF = the cash flow of the last year
• g = assumption of growth rate in perpetuity beyond the terminal year
• n = the number of periods in the valuation model including the final year
Once again, we must recognize that the intrinsic value produced by our model is only as good as the numbers included in the model. If we assume unrealistic growth (or terminal value) rates or discount rates as part of our stock research, you will get an unrealistic intrinsic value result. No stock valuation model will magically provide completely accurate intrinsic value, but if you are conservative and intellectually honest, and dealing with a company with strong underlying economics as well as a long track record, you may find this method useful for identifying stocks. that are priced below their intrinsic value. Buffett seemed fine for himself using this methodology, so if you follow the principles above, you can too.