Discounted Cash Flow (DCF) Valuation Basic – Part II

In a previous article, the basic concepts of DCF valuation such as time value money were discussed (Read more here).  This article will focus on basic concept of Free Cash Flow to Firm and Free Cash Flow to Equity (FCFE).  There are many ways to compute FCFF and FCFE.  For more detail, you can refer to Professor Damodaran’s slides (Read more here).  This article will only focus on deriving FCFF and FCFE from Earnings Before Interest and Tax (EBIT).

FCFF is not something readily available like Price to Earnings (PE) ratio.  Investors need to compute FCFF from financial data (annual or quarterly report), and then forecast the future FCFF based on their understanding of the company business model, direction, and development.

FCFF can be interpreted as the cash flow available to all the firm’s capital contributors such as debtholders, preferred stockholders and common stockholders, without impacting the firm’s daily operation and future development.

FCFE can be derived from FCFF.  It is the cash flow available to the firm’s common stockholders after the FCFF has accounted for payment (and receipts from) debtholders and preferred stockholders.

Mathematically, FCFF can be computed by

where,

EBIT      = Earnings Before Interest and Tax

Dep       = Depreciation

CAPEX  = Capital Expenditure

∆WC      = Changes in Working Capital

The formula is simple but getting the right numbers to be inserted into the formula is not straight forward.  Thanks to Bursa Market Place (link), the official market info portal by Bursa Malaysia.  You can find financial data, technical chart, company rating, research report, and all other related financial info under one roof.  And it is free!

Let’s take one real world example, Top Glove.  The annual financial reports can be found in the following link.

1.      Annual Income Statement

a.      Web View

b.      Download Excel Spreadsheet

2.      Annual Balance Sheet

a.      Web View

b.      Download Excel Spreadsheet

3.      Annual Cash Flow Statement

a.      Web View

b.      Download Excel Spreadsheet

 

From the annual financial statement, the EBIT can be found in income statement on row Normalized EBIT.  Depreciation can be found in either income statement or cash flow statement, they are the same.

Tax rate, CAPEX, and Changes in working capital are a bit tricky.  You need to calculate them from financial statement rather than obtaining them directly.  Thanks to Bursa Market Place, you can download the financial statements in excel format and let the spreadsheet do the calculation for.

For tax rate, you can obtain it by dividing the Provision for Income Taxes with Net Income Before Taxes.  Both can be found in income statement.

For changes in working capital, it is a bit tricky but still be able to estimate from balance sheet.  The information you need are Total Current Assets, Total Current Liabilities, CASH AND SHORT TERM INVESTMENTS, Notes Payable/ Short Term Debt, and Current Port. Of LT Debt/Capital Leases.

Under normal condition, working capital is defined as current assets minus current liabilities.  However, for FCFF valuation purpose, we exclude cash and short term debt, please refer to this link for the rational.  Working capital can be computed as

Changes in working capital is simply this year working capital minus last year working capital.

For simplicity, CAPEX can be computed by using this year gross properties, plants, and equipment (PP&E) minus last year gross PP&E.  Please refer to the following link for detail in estimating CAPEX.

Now you have all the information to compute FCFF.  Try to build one using Excel or Google Sheet, and then compare your results with the following embedded Google Sheet.  Congratulations!  You are one step nearer to build your own DCF model.

Disclaimer:  The above analysis does not imply any buy or sell recommendation.  The author disclaims all liabilities arising from any use of the information contained in this article.

Disclosure: The author may have interest in the stocks of the companies in this article.

Discounted Cash Flow (DCF) Valuation Basic – Part I

There are three major categories of stock valuations, namely Relative Valuation Model (or Multiplier Model), Present Value Model (or Discounted Cash Flow Model), and Asset-based Valuation Model. 

The Relative Valuation Model uses financial multiples such as Price to Earnings (PE), Price to Book (PB), and Enterprise Value (EV) over Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) etc, to evaluate the stock.  Multiples are seldom used independently.  Most of the time, investors like to compare multiples of several companies in the same business field to make investment decisions.

The Present Value Model, or DCF model, estimates the value of a company using projected future cash flow such as dividend (Dividend Discount Model), or Free Cash Flow (FCF) Model, and then discounted the future cash flow to present value.  It is more complicated than multiplier model because some of the key parameters of the model are not readily available, and the future cash flow stream is hard to estimate.

Asset-based Valuation Model values a company by subtracting the value of liabilities and preferred stocks of the company from the estimated asset value.  This model is used when the company future cash flow stream is uncertain, losing money, or the company is in distressed condition.

These series of articles will focus on DCF model, particularly on FCF model as DDM model was discussed in previous articles (Read more here).  To understand FCF model, few fundamental concepts need to be explained before we dive into Excel spreadsheet to churn out the value.  The three basic concepts are:

1.      Time value money;

2.      Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE); and

3.      Weighted Average Cost of Capital (WACC) and cost of equity.

Let’s begin with time value of money.  Example, if you are going to receive RM100 from an investment in one year time, how much would you pay for the investment today, if you expect your investment return is 5%?  Mathematically, it can be estimated by

5% is the discount rate for your investment, one of the important parameters of DCF model.  Now you see that the RM100 (future value), is worth only RM95.23 (present value) today.  How about an investment that will pay you RM100 every year for 3 years, how much would you pay for it if your required rate of return is 5%?  The math looks like this,

Simple right?  Last example, if you expect an investment will pay you RM100 every year indefinitely, how much would you pay for it if your expected return is 5%?  And here we go,

You can easily compute the value using Excel spreadsheet or Google Sheet.

What Does 100 PE Mean?

100 is a good number.  It means perfect in many contexts.  In finance, 100 could mean a lot of things, especially in financial ratio analysis.  Price to Earnings (PE) ratio is a very popular ratio in investment world.  As its name implies, PE means stock price over earnings.  Mathematically written as:

 

According to CEIC data (Read more here),  PE ratio for KLCI in the past ten years were in the range of 13 – 23, never hit 100.

Now let’s look at Facebook Inc (FB).  Currently FB is trading around 20 – 30 PE.  Nevertheless, according to the data from TradingView.com, FB were trading around 100 PE during 2016.  Since then, FB stock price soared more than 100% to over $200 per share in 4 years!  100 PE is great right?

Ok, let’s do more analysis before we jump the gun.  In FY2015, the earnings per share (EPS) of FB was $1.31.  The next year, 2016, its EPS was $3.55, more than 100% increase (see 100 again yeah), and it continued to grow rapidly to $7.65 by end of 2018.  During this period, its PE continued to slide from 100 to 25 as a result of growing EPS.

So, what does 100 PE mean?

The investors are expecting the earnings might double or triple in the near term when they keep buying the stocks and pushing the price up.  Once they think the company could no longer grow at such a rapid rate, the PE will come down, revert to market average.   

The essential questions that you need to ask when buying a stock at 100 PE are:

1.      Can the company double or triple the earnings in the near term?

2.      Does the company operate in an exclusive market where no other competitor can enter the market easily?

3.      Is the company selling a product that no other competitor can easily produce?

4.      Is the demand of the product will double or triple in the near term?

If you answer “Yes” for all the above questions, then 100 PE is a good indicator to buy the stock!

 

 

Disclaimer:  The above analysis does not imply any buy or sell recommendation.  The author disclaims all liabilities arising from any use of the information contained in this article.

Disclosure: The author may have interest in the stocks of the companies in this article.

Growth versus Value Investing on the Bursa Malaysia during Covid 19 Pand...

The objective of this exercise was to examine the performance of 885 stocks listed on the Bursa Malaysia. The analysis was based on their Price to Earnings (PE), Price to Book (PB), Dividend Yield (DY), and Debt to Equity ratio (DE), during the Covid-19 pandemic from January to early-June 2020. Three different phases or ranges were presented. Range 1, the sell-down period spanned from the beginning of January to mid-March; Range 2, the rebound period spanned from mid-March to early June; and Range 3, the pandemic sell-down and rebound period from January to June. The results showed that neither high nor low ratios consistently outperformed each other in different periods. The only consistent result was investors tend to prefer low DE during the entire period.

The video is the summary of this research.  The research paper was published in CFA ARX on 30 June 2020 (Read more here).  Engineering2Finance is the main author of the paper.

The infographics in the video were first appeared in MPCA's blog (Read more here), where engineering2finance is the co-author as well.

The Sell Down, The Rebound, The Pandemic (Updated with Sector info)

In a previous article, 885 stocks were grouped based on their performance during Jan – Mar, Mar – Jun, and Jan – Jun 2020 (Read more here), but no sector info were presented.  This article updated the sector info.

Graph 1 is the sell down range sector info that correspond to Table 1 in previous article.

Graph 2 is the sell down, rebound, & YTD (4th June 2020) sector info.

Table A is the summary of performance with sector info.

Based on the info, energy sector is the worst hit sector with average sell down around 62%, and dominate the worst sell down range 50% - 90%.  While this sector has rebounded about 111% from March till 4th June, it is still 31% down from Jan high.

Healthcare is the best performance sector where the YTD (4th June 20) performance was 138%.

Technology, Industrial, Telco, and Utilities also almost recouped back to Jan level.

Plantation, Property, Construction, Transportation & Logistic, Closed-End, Financial, and Consumer sectors were still 10% to 20% below their Jan level.

Graph 1: Sell Down (Jan - Mar) Range Sector Info

Graph 2: Sell Down, Rebound, & YTD (4th June 20) Performance by Sector

Table A: Summary of Performance with Sector Info

The Sell Down, The Rebound, The Pandemic

885 stocks were grouped based on their performance during Jan – Mar, Mar – Jun, and Jan – Jun 2020.  All data were taken from Bursa Market Place (Read more here).  About 95% of stocks were battered down during the sell down time frame.  50% of them dropped between 30% to 60%.

During the rebound period (Mar – Jun), the group of stocks which were hammered down the most in Jan - Mar period were the best performers.  If you bought these 11 stocks in Mar, your average return is 187%!  But their YTD performance is still -55%.

Generally, the rebound magnitude is directly proportionate to the magnitude of the sell down.  Will these stocks continue to recoup their loses in the next three months?  We shall update the results by the end of RMCO.

Stay Safe!

Table 1

Sell Down Range	Average Sell Down	Average Rebound	Average YTD	No. Stocks
-80% to -90%	-84%	187%	-55%	11
-70% to -80%	-74%	157%	-32%	48
-60% to -70%	-65%	100%	-30%	89
-50% to -60%	-55%	98%	-12%	147
-40% to -50%	-45%	64%	-10%	150
-30% to -40%	-35%	46%	-5%	160
-20% to -30%	-25%	36%	1%	115
-10% to -20%	-16%	26%	6%	85
0% to -10%	-6%	5%	-1%	39
10% to 0%	4%	20%	25%	27
20% to 10%	13%	128%	156%	8
30% to 20%	22%	132%	184%	4
40% to 30%	33%	415%	587%	1
50% to 40%	n/a	n/a	n/a	0
60% to 50%	59%	12%	77%	1
70% to 60%	n/a	n/a	n/a	0
80% to 70%	n/a	n/a	n/a	0
90% to 80%	n/a	n/a	n/a	0
100% to 90%	n/a	n/a	n/a

Worst Performers (-40% to -90%) During Jan - Mar Period

Disclaimer:  The above analysis does not imply any buy or sell recommendation.  The author disclaims all liabilities arising from any use of the information contained in this article.

Disclosure: The author may have interest in the stocks of the companies in this article.