Equity Research for Value Investments

September 18, 2021 by No Comments

Despite many of the negatives we hear about DCF-based equity valuation these days, it remains a conventional method for equity valuation as part of fundamental equity research. In his 1992 Berkshire Hathaway (BRK.A) Annual Report on DCF’s Stock Valuation Method, Warren Buffett stated “In the theory of investment value, written more than 50 years ago, John Burr Williams established the equation of value, which we condense here: The value of any stock, bond or business today is determined by the inflows and outflows of cash, discounted at an appropriate interest rate, that can be expected to occur over the remaining life of the asset. ” Many of the popular stock market reporting band stock analysis resources trusted by retail value investors use this method of stock valuation. This article will examine the strengths and weaknesses of DCF-based intrinsic value calculations and why it matters to invest in value.

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 equity analysts cannot accurately predict next year’s earnings. At the macro 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 a company’s future cash flow when selecting stocks. We have to admit to ourselves that we have tremendous limitations in our ability to forecast future cash flows based on past results and recognize that a small forecast error can make a big difference in the valuation of stocks.

The second challenge is determining the appropriate discount rate. What is the discount rate? Should we dust off our college or graduate workbook and look at the CAPM, which calculates the discount rate as the risk-free rate plus the risk premium?

Well, since I learned this formula of the same kind (from the business school finance professor) that convinced me when I was a 22-year-old student and was wet that markets are efficient, I am skeptical. The public comments of the most famous value investor, Warren Buffett, on the subject have evolved, as he has claimed that he uses the US Treasury rate in the long term, as he tries to “deal with things that we are pretty sure about. , but he reminded us in 1994 that “in a world of long-term bond rates of 7%, we would certainly like to think that we are discounting 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 from there as part of my stock research. September 1 As of 2011 30-year cash 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 that the growth rate is eternal, and we know that no company can maintain a growth rate above the average 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 Bayesian inference experimental models, commented:

All models are wrong, some are useful.

I would say that the DCF model can provide a useful estimate of stock valuation as part of fundamental stock research if the user follows the following principles:

1. Invest in companies that have a sustainable competitive advantage. Investing in stocks should be viewed as ownership interests in these companies.

2. As Buffett alluded to in his 1994 letter, business certainty is essential. Therefore, I consider different measures of stability in income, earnings, book value, and free cash flow as part of my stock research.

3. Your stock research should include due diligence in analyzing company finances (income statement, balance sheet, cash flow statement, efficiency ratios and profitability ratios for 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 using a valuation model that does not require future growth assumption. 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, and so on.

6. Use conservative growth assumptions and a discount rate between 8-13%.

7. It takes a good deal of intellectual honesty not to alter the key growth and discount rate assumptions to arrive at a preconceived intrinsic value.

8. Always use a safety margin!

As mentioned, I am a huge fan of Professor Bruce Greenwald’s Earning Power Value calculation. Energetic Earnings Value (EPV) is an estimate of stock valuation which puts a company’s value on 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 comprehensive stock investigation.

The formula: EPV = Normalized Gain x 1 / WACC.

There are several steps required to calculate the EPV:

1. Normalization of earnings is required to eliminate the effects on profitability of valuing the company at different points in the business cycle. This means that we consider the average EBIT margins for the last 10, 5 or 3 years and apply them to the sales of the current year. These returns have normalized EBIT.

2. Subtract the average non-recurring charges for the last 10 years from the normalized EBIT.

3. Add back 25% of SG&A expenses as a certain percentage of SG&A contributes to current earning power. We use a default add-on of 25%. This assumes that the business can maintain current profits with 75% (1 entry) of SG&A expenses. The input range can be 15-25% depending on the industry. When applicable, repeat for research and development expenses.

4. Add back the current year’s depreciation. We use a default add-on of 25%. This assumes that the company can maintain current profits with 75% (1 entry) of capital expenditures. The entry range can range from 15% to 25%, depending on the capital investment requirements of the industry.

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 the WACC if you wish).

7. Earning power from operations = Company earnings * 1 / cost of capital

8. Divide the EV of the company by the number of shares to get the price per share.

DCF’s stock valuation model.

In this 3-stage DCF model, the 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:

PV = CF1 / (1 + k) + CF2 / (1 + k) 2 + … [TCF / (k – g)] / (1 + k) n-1


• PV = current value

• CF1 = cash flow in year I (normalized by linear regression or 10, 5, 3-year FCF average)

• k = discount rate

• TCF = the cash flow of the terminal 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

Again, we must recognize that the intrinsic value our model produces is only as good as the numbers included in the model. If we assume unrealistic growth rates (or terminal value), 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 a strong underlying economics as well as a long track record, this method can be useful for identifying stocks. that are priced below their intrinsic value. Buffett seemed to get it right on his own using this methodology, so if you follow the principles above, you can too.

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