Discounted Cash Flow (DCF) Valuation Basic – Part IV

In previous articles, the basic concepts of DCF valuation such as time value money, FCFF, and WACC were discussed (Read more here), (Read more here), and (Read more here).

The next step is to forecast the future FCFF stream.  Normally analysts will forecast the numbers based on their understanding of the company business and development.  For beginner, you can refer to research reports that are available for free on Bursa Market Place.

As promised, we are going to analyse Top Glove.  The following tables are the summary of analysts forecast.  All analysts are expecting the revenue of Top Glove to be either doubled or tripled in 2021, but will decline starting 2022.  Which means the supernormal demand and high selling price of glove is not sustainable.

Most research reports will not provide forecast beyond three years, some even only provide two years forecast.  Thus, forecasting beyond 3 years horizon is challenging but in DCF model, based on Damodaran spreadsheet (Download here), at least 10 years horizon is required and estimating the terminal value is very important.  Terminal value means at a certain point of time, the company will grow at a nominal rate forever.  The usual assumption is the FD rate ten years later.  In order to cover the uncertainty of long term growth rate, it is recommended to have 3 different scenario, average, min, and max.  Same assumption is applicable to WACC, Revenue, and EBIT forecast.

Top Glove Revenue Forecast
Research House	2021F	2022F	2023F	Report Date	Source
MayBank	27,796.0	17,793.0	15,520.0	8-Oct-20	link
Public	17,827.9	12,345.9	10,672.9	18-Sep-20	link
JF APEX	12,513.0	8,057.3	n/a	30-Sep-20	link
AFFIN	16,882.9	10,922.5	10,759.0	17-Sep-20	link
Kenanga	17,290.0	13,514.0	n/a	18-Sep-20	link
Aminvest	21,810.7	11,589.7	9,229.3	18-Sep-20	link
MIDF	12,852.0	10,710.0	9,481.5	18-Sep-20	link
HLBANK	14,598.6	10,261.2	n/a	18-Sep-20	link
Average	17,696.4	11,899.2	11,132.5
Min	12,513.0	8,057.3	9,229.3
Max	27,796.0	17,793.0	15,520.0

Top Glove EBIT Forecast
Research House	2021F	2022F	2023F	Report Date	Source
MayBank	14,794.9	5,554.6	2,281.9	8-Oct-20	link
Public	10,622.4	4,929.0	2,893.3	18-Sep-20	link
JF APEX	5,630.9	1,611.5	n/a	30-Sep-20	link
AFFIN	n/a	n/a	n/a	17-Sep-20	link
Kenanga	n/a	n/a	n/a	18-Sep-20	link
Aminvest	7,963.8	2,867.3	1,513.8	18-Sep-20	link
MIDF	5,996.4	2,533.7	1,880.7	18-Sep-20	link
HLBANK	7,310.6	3,732.6	n/a	18-Sep-20	link
Average	8,719.8	3,538.1	2,142.4
Min	5,630.9	1,611.5	1,513.8
Max	14,794.9	5,554.6	2,893.3

	Min	Average	Max
WACC	7.43%	8.61%	9.80%
Terminal growth rate	2%	3%	4%

The spreadsheet framework that we are going to use here is the simplified version of Damodaran spreadsheet.  We will be estimating the value of Top Glove based on average condition.  There are a lot of cells that need to be filled in order to complete the sheet thus it will not be easy to explain in words and sentences.  Thus, an additional sheet that shows all the formula will be embedded as well.  Drop your questions on engineering2finance facebook page if you have any questions (link). 

Keep in mind that there are many assumptions made in formulating the model.  These assumptions did not go thru due diligence exercise, and most of the time they are made for easy understanding rather than accuracy.  However, the numbers in each cells are derived based on sensible financial principle rather than haphazardly. 

Finally, let’s come back to the most important question – what is the value of Top Glove based on this DCF model?

Here you go.

Try to build you own spreadsheet to find the Max value and post your answer on the engineering2finance facebook page (link).

REMINDER!  The example – Top Glove, used in this DCF model is meant for education purpose, to help readers to better understand the building block of DCF model.  It should not be interpreted, or relied upon, as financial or business advice.  Please consult licensed investment advisors for proper investment advice.

Good luck and have fun!

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 III

In previous articles, the basic concepts of DCF valuation such as time value money and FCFF were discussed (Read more here), and (Read more here).  This article will focus on basic concept of WACC and cost of equity, which are essential to “discount” the future FCFF stream to present value.

Some websites provide WACC and cost of equity for free, but the numbers provided by each site are slightly different.  This article will guide you to compute the WACC and cost of equity yourself. 

WACC is the cost of capital to run a company, which include debt and equity.  The formula of WACC is

where,

Debt      = market value of debt (or book value of debt)

Equity    = market value of equity (market cap)

kd           = Cost of Debt

ke           = Cost of Equity

Again, math is simple but getting the correct number to be inserted into the formula is not straight forward.  The following table shows the source to obtain the numbers and the level of difficulty to get them.

(for simplicity, kd is estimated using this year interest expense divided by average of this year and last year total debt)

CAPM is the most popular way to estimate cost of equity.  The formula of CAPM is

where,

Rf                          = Risk Free Rate (or Fixed Deposit rate for retail investor)

β                            = Beta (volatility of stock relative to overall market)

Rm                        = Market return

(Rm – Rf)             = Market Risk Premium

It is not easy to compute Beta but there are a lot of tutorials available on web or Youtube.  Fortunately, many financial websites are now publishing beta of company, but the issue is their numbers are different from each other.  This because each source is using different time horizon to calculate beta.  Some use 1-year, some use 3-year, and most of them do not state the time horizon explicitly.  Generally, those who do not state the time horizon highly likely are 3-year beta.

Market return, or more popular measure – “market risk premium” is also difficult to estimate.  Professor Damodaran from NYU Stern maintains a page to provide market risk premium for various country but only update occasionally for country outside US.  However, Malaysia investors can roughly estimate the market risk premium by using the implied ERP of S&P500 plus the yield spread between US T-Bill and Malaysia T-Bill.  Both data could be found in the Damodaran’s page and Bank Negara Malaysia website.

It is time to go for a real world example.  Again, we are going to compute Top Glove WACC.  The following table shows the respective data required to calculate WACC as at 9pm 18 November 2020.

Variables	Value	Source
Debt (FY2020)	RM0.54 bil	Top Glove Website
Equity (Market Cap)	RM59.0 bil	Bursa Market Place
Tax	17.4%	Top Glove Website
kd	2.3%	Top Glove Website
ke	9.88%	Compute
Rf	2.0%	Google FD Rate
[Rm – Rf]	6.85%	NYU & BNM
Beta (1-Yr)	1.15	TradingView
WACC	9.80%	Compute

The computed WACC is 9.80%  (WACC = 7.4% if 3-Yr Beta is used), which is higher than the numbers reported by some websites.  The main reason is we are using 1-Yr Beta (3-Yr Beta is around 0.8), which is highly volatile due to recent spike in prices.

We have covered three basic concepts of performing a DCF valuation, which are time value money, FCFF, and WACC (and cost of equity).  We will dive into the spreadsheet construction in the next article to estimate the value of Top Glove.

Stay online!  Stay safe!

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 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.