Determining intrinsic value of some stocks in my portfolio - Do not overpay for stocks!

The Singapore stock market has rallied over the past few months on the news of gradual recovery in the global economy. All stocks in my portfolio have seen gains, some more than others. Though I am satisfied by the gains in share prices of stocks in my portfolio, I still do not feel comfortable with a few stocks in my portfolio because I found that I am holding them at average share price higher than their estimated intrinsic values. Thus, I will seek to discuss on the mistakes I may have made in holding a few stocks in my portfolio at higher than their intrinsic value per share. Intrinsic value is very important to me as a focused value investor as it provides a guide to me as to whether I am overpaying for a particular stocks. By overpaying for a particular stocks (even if the stocks is supported by good underlying business), it will diminish long term returns and does not provide any margin of safety in case the business does not fulfill the intrinsic value as judged by the investor. As such, I am not comfortable with overpaying for any stocks.

Before I seek to estimate the intrinsic value per share, I will first present some financial statements for a few companies I have invested in. The statements include net cash from operations, capital expenditure and free cashflow. Then, I will provide a simple analysis on these companies based on their financial statements. Also, I will provide a sample on how I estimated the intrinsic value per share for one of the company.

Please bear in mind that I am not a qualified accountant nor analyst. I do not guarantee the accuracy of the financial statements presented here. Also, the opinions expressed here are my own personal judgments. So, please take my sharing with a pinch of salt. The purpose of my discussion is to provide a training and discussion ground for the exercise of evaluating a company's cashflows and determining their intrinsic value per share based on their present value of projected cashflows. All figures presented are just estimates and may not be accurate.

Recap:- Free cashflow = Net cash from operations - Capital expenditure

Keppel Corp

Keppel Corp's net cash from operations have been fairly stable for 10 years. It has grown steadily over the years to the current level of around $ 2 billion. This indicates consistency and stability in generating cash from its operations.

The capital expenditure has remained fairly constant over the years and is not excessive. This results in positive free cashflows for most of the years. The free cashflows has also risen slightly over the recent years.

Thus, I peg a consistent growth of around 2% compounded annual growth (CAGR) for its future cashflows as I think the company is mature and its future cashflows may not outperform its current cashflows significantly which is already steep. As the company is able to generate consistent cash from operations with positive cashflows, I see this as a stable company going forward. So, my discount rate used in the calculation of DCF is 10%, a fairly conservative discount rate to account for my opportunity cost in investing in this company and also my risk premium (see earlier post for details on DCF model).

I have created an excel spreadsheet incorporating the calculations for DCF. The estimated intrinsic value per share for Keppel Corp based on my spreadsheet after taking into account the 2% CAGR for future cashflows, 10% discount rate on future cashflows to their present value, total number of shares, and a long term rate of growth on its cashflows of 3% beyond the 10 years is $13.04 per share.

As this is just an estimate on what each share of Keppel Corp is worth, this intrinsic value may not be accurate. To account for any misjudgments, it is always wise for the investor to invest at below the estimated intrinsic value. Investing at below the estimated intrinsic value per share allows a margin of safety to account for possible errors in estimating the intrinsic value. The lower the share price an investor buys its shares below this estimated intrinsic value, the better safety margin to account for any errors in misjudging the worth of a company's shares.

My current average holding price for Keppel Corp's shares is $4.05 per share (see earlier post on my stocks portfolio). Thus, my margin of safety is around 221% which is very significant. Even if I overestimated the intrinsic value per share for Keppel Corp, I should be well buffered against my misjudgment since my holding price for Keppel Corp's shares is very low.

Sample of the Excel spreadsheet I use for estimating intrinsic value per share

SembCorp

Fairly consistent net cash from operations with only two years showing negative values. Fairly consistent capital expenditure over 10 years. Most years with positive free cashflows.

I peg a CAGR of 5% for its future cashflows and a 10% discount rate on future cashflows to present value on the consistency of its cashflows generating ability.

The estimated intrinsic value per share I arrive at is $4.55 per share.

My current average holding price is $3.35 per share. This provides a margin of safety of 35.8%.

Tat Hong Holdings

Its net cash from operations is a bit inconsistent with some years having a significantly lower net cash from operations. Its free cashflows is also inconsistent with negative free cashflows for some years.

I peg a 5% CAGR for its future cashflows since this company is still growing and expanding its operations in China. However, I peg a slightly higher discount rate of 12% on its future cashflows to present value because of its inconsistent cashflows to account for a higher risk premium that its cashflows may not materialise in future.

The estimated intrinsic value per share is $0.65. My average holding price is $0.658 per share. Thus, I do not have any safety margin for this stocks.

Parkway Holdings

Net cash from operations has been growing steadily through the years. Capital expenditure has also grown throught the years. Free cashflows has also grown steadily through the years expect for negative free cashflows in latest year. The high capital expenditure in the latest year could be due to its aggressive expansion overseas resulting in a negative free cashflows.

I peg a 5% CAGR for its future cashflows on the consistency of its ability to generate free cashflows based on the defensive nature of its healthcare business. As such, my discount rate on future cashflows to present value is also lesser at 8%.

The estimated intrinsic value per share is $1.29. My average holding price is $1.758 per share. I have invested at a higher premium than its estimated intrinsic value (fatal mistake for a value investor). This would have been risky saved for the fact that the nature of its healthcare business is defensive and provides stable stream of cashflows. Thus, I am still willing to hold my shares to allow the intrinsic value of this company to grow beyond my holding price per share.

Discussion points:- The exercise of estimating intrinsic value per share for a company is both science and art. The estimated intrinsic value is by no means an absolute since it is difficult to forecast the future cashflows of a company accurately.

Valuation of a company (estimating its intrinsic value per share) is only part of the game. An investor has to analyse more parameters apart from just cashflows from a business to determine whether a business is worth investing in.

A value investor always seeks to invest at a margin of safety below the estimated intrinsic value per share. This is to account for any misjudgments in the intrinsic value per share of a company.

An investor may still invest at a slightly higher premium to the estimated intrinsic value per share of a company if he is convinced after sound analysis that the company is able to grow its intrinsic value in future beyond the investor's current holding share price.

More discussions on my experience with analysing the fundamentals of the companies in my portfolio in later posts.