Determining intrinsic value per share of a stocks (Part 2 of 2) - A company is worth the present value of all its future cashflows?

I shall now follow through the discussion on how to calculate the present value of a company's future free cashflows. Before I continue my discussion, please be cautioned to take my sharing with a pinch of salt. This is because I am by no means a qualified accountant or analyst. I am just an average retail investor doing my own research into investing methodologies and principles from reading investment literature and attending investment seminars. However, I believe in constant learning and correcting my mistakes so as to become a better investor with time. One has to start off somewhere to fall and pick oneself up and fall again and repeat the whole process of falling and picking oneself up constantly in order to grow no matter in which areas of life, not just in investing.

An old traditional method - Looking at present value of future cashflows to determine investment value

Early economists more than 60 years ago like Irving Fisher and John Burr Williams proposed that the value of a stock is equal to the present value of its future cashflows. In my earlier post, we have seen how free cashflows are important to a company as it is the freed up cash that can be taken out of a company yearly without harming its business. Portions of free cashflows can be reinvested into a business, paid out to shareholders as dividends or be used in share buy backs to increase the % ownership of each shareholder.

There is a need to calculate the present value of future free cashflows a company is projected to generate. This is because the future cashflows investors would expect to receive is worth less than the current free cashflows. Two reasons abound regarding why future cashflows is worth lesser than current cashflows. Firstly, money we receive today can be invested immediately to start generating returns, but we cannot invest future money until we receive them. This is also called the opportunity cost of receiving money in future compared to receiving money today. Money at hand always has better immediate investment value than future money as it can be put into investing straight away to start compounding returns. Secondly, there is a risk an investor may not receive a company's future projected cashflows, and there is a need to compensate this risk taken, also called the risk premium.

Risk premium also depends on the nature of the business, whether its free cashflows is consistently stable or unstable. A company where its free cashflows keeps fluctuating through the years with no stability makes it difficult to predict its future cashflows with certainty, thus such company carries a higher risk premium.

Due to opportunity cost of receiving money in future compared to now and also risk premium, there is a need to discount the future cashflows a company is projected to generate by a discount. The higher the opportunity cost and risk premium an investor has to absorb, the higher will be the discount on a company's future cashflows to calculate the present value of the future projected cashflows.

As such, this simple idea of discounting a company's projected future cashflows to a present value is called the discounted cashflow (DCF) model for valuing a company's intrinsic value.

No investing methodology is perfect and an investor has to understand the possible limitations of every methodology. DCF assumes that a company's intrinsic value depends solely on the present value of future cashflows it is projected to generate. So, this method places importance on valuing a company based on free cashflows. If an investor is convinced a company's value is tied strongly to the amount of free cashflows it can generate for a period of time and he is willing to only pay for a company's free cashflows, then this method will make absolute sense for him. If an investor is not convinced by DCF model, it maybe better for him to adopt other ways of valuing a company (e.g. looking at P/E ratio).

Mathematical calculations behind Discounted Cashflow (DCF) model

It is not my wish to bother with complex calculations when doing investment. After reading some literature on Warren Buffett's investing wisdom, I remember one quote from this master investor which mentioned that investing is not a simple exercise, neither is it meant to be a complex exercise requiring intense mathematical calculations that it is not attainable by many without a relevant degree of certification. So, a high IQ investor with ability to crunch complex data and financial figures may not necessarily make a better investor than one with some basic financial and investing knowledge. As more variables and factors are considered in assessing an investment, it may not necessarily make an investment sound as an investor has a chance of misjuding each variable being considered. So, the more variables being considered in assessing an investment means more chances of misjuding the investment.

Thus, I will try to keep the discussion of the DCF model simple. My hope is not to provide a rigourous discusssion over this model but rather to bring out only simple appreciation on the required calculations and later to discuss this model's usefulness and limitations based on the context of its required calculations.

CFn = Free cashflow generated for nth year (e.g. CF1 means free cashflow generated for first year),

r = discount rate (depends on opportunity cost and risk premium)

Step 1: We have to forecast the free cashflow (FCF) a company can generate for next 10 years. For simplicity (since I am not an analyst trying to be as accurate as possible; anyway I don't think analysts can be perfectly accurate or else they would have make millions themselves in forecasting a company's future prospects so perfectly if they are really able to do so), I forecast a stable company should grow its free cashflows over 10 years at a pre-determined fixed compounded annual growth rate (CAGR). The compounded annual growth rate to use is rather subjective depending on individual investor. I use the same compounded annual growth rate based on a company's past cashflows.

For calculations of future cashflows for 10 years at my pre-determined annual growth rate, I use the formula Future cashflow = Present cashflow X (1+ r/100)^n, where r is the compounded annual growth rate and n is the number of years.

E.g. Company A's current cashflow is $100. It can grow at 10% compounded annual growth rate. At first year, company A can generate cashflow CF1 of $100 X (1+10/100)^1 = $110. At second year, it can generate cashflow CF2 of $100 X (1+10/100)^2 = $121. The calculation goes on until the 10th year.

Step 2: After forecasting all the future cashflows, we have to discount each cashflow by a discount rate to account for the opportunity cost and risk premium. Again, determining an appropriate discount rate is subjective. An investor can consider the yield he will receive on an alternative risk free investment (e.g. government bonds) had he not considered this current investment which is being assessed. Let's assume Singapore government bonds over a 10 years maturity period provide yields around 3 to 6% annually. So, an investor can have a discount rate of at least 3% over here. An investor can consider a higher discount rate than 3% (say 12%) if he perceived the company is risky and he should be compensated at higher discount rate on the future cashflows to calculate the present value of these future cashflows. So, a more conservative investor considers a higher discount rate when discounting future cashflows to their present value.

Step 3: Now, we have worked out the sum of all discounted cashflows for 10 years period (based on steps 1 and 2 plugging in the various values like current cashflow of a company, its cashflow compounded annual growth rate and its discount rate). We still need to determine discounted perpetuity value. Discounted perpetuity value is necessary to account for present value of a company's projected cashflows beyond 10 years. It is not feasible to compute all discounted future cashflows to infinity number of years, so a discounted perpetuity value estimates the present value of future cashflows far beyond 10 years.

(I will not present the calculations for discounted perpetuity value since my intention is not to provide a rigourous discussion on the mathematical calculations behind DCF model)

Step 4: Calculate total discounted cashflows (DCF) by adding 10 discounted cashflows for 10 years to the discounted perpetuity value. (Refer to DCF formula above)

Step 5: Calculate intrinsic value per share by dividing total discounted cashflows (DCF) by total number of shares outstanding for a company.

Discussion points on DCF model for determining intrinsic value per share of a stocks:-

1. There are at least two important variables affecting the calculations of discounted cashflows (the forecasting of future cashflows and the discount rate applied to discount the future cashflows to their present values).

2. It is by no means easy to forecast future cashflows. The compounded annual growth rate (CAGR) to use for determining future cashflows is subjective. An investor who is optimistic about a company's future cashflows can use a high CAGR to determine future stream of cashflows. Similarly, a conservative investor can use a lower CAGR. It depends on the investor's assessment of the company's future abililty to generate cashflows.

3. The discount rate an investor chooses can also be subjective. A conservative investor may use a high discount rate to discount the future cashflows to their present value. This is to account for the opportunity cost and risk premium he thinks he has to absorb when investing in the company. The discount rate may go as high as 15% to 20% up to the comfort level of an investor.

Conclusion:- DCF model is not a sure-win magic formula for determining intrinsic value per share of a stocks.

Different investors using the same DCF  model may still arrive at different intrinsic value per share for the same stocks depending on the CAGR they use to determine the future cashflows and the discount rate they use to discount future cashflows to their present value.

As such, DCF model is just one of many tools available for determining intrinsic value per share of company stocks. Valuation by DCF model may not be totally exact science, but it is partly an art since there is no absolute perfect forecast of future cashflows and no one perfect discount rate to be taken in the calculations of discounted cashflows. 

Thus, as with any other valuation tools, DCF model serves only as a guide and is not an absolute way to determine intrinsic value per share. No one can really peg a true intrinsic value to a company. Intrinsic value does change with time also. Therefore, an investor should always seeks to invest at a margin of safety below calculated intrinsic value per share to account for any misjudgment of the intrinsic value of a company. 

More discussions on using DCF model to determine intrinsic value per share for stocks in my portfolio, and I will also seek to discuss some mistakes I have commited by investing at higher than intrinsic value per share for some stocks in my portfolio in later post.

Determining intrinsic value per share of a stocks (Part 1 of 2) - Why free cashflows matters to a business and shareholders?

Why the need to determine intrinsic value per share of a company?

Since I started investing in June 2008, I have not conducted a rigourous determination of intrinsic value per share for the stocks I bought. I understood the importance of intrinsic value per share as it reveals how much the business underlying a stocks is worth. However, due to the lack of discipline to follow through the mathematical calculations behind determining intrinsic value per share, I kept procrastinating on learning this technique. This is an important exercise seeking to determine the true value of a company based on its cashflows. If the stocks market is not to be viewed as a speculative playground whereby securities are bought and sold by the minutes or at best only by the hours, this is where determination of intrinsic value for a stocks comes into play for the serious investor who wishes to invest his money carefully into only prospective stocks that are undervalued for their businesses.

Determining intrinsic value per share for a stocks has its place of importance because whether an investor is aware or not, whenever he is buying shares of a company, he is already having a part-ownership in the business of the company. The returns from his investment in the chosen company is determined by the economic prospects of the company and the price he pays for the shares of the company. If the company does well economically and is exceptionally profitable, the investor can expect bountiful returns from his investment (especially if he has invested at undervalued share prices). If the company fails, the investor may risk losing his invested capital in the company. Even if one is adopting a short-term attitude towards holding shares of a company, it still pays to know some important fundamentals about a company before investing one's money in the company as any unpleasant surprises can catch an ignorant investor unprepared even in short time period. There are already some examples of China concept stocks engaged in bad corporate governance and lack of integrity in management that caught investors unaware short-term before they can react.

Free cashflows is the lifeline of a business

Since I seek to be a focused value investor, determining intrinsic value of a business should be one important skill to master. Determining intrinsic value per share of a business depends on the present value of  future free cashflows a business can generate over a period of time (usually taken to be 10 years). Free cashflows are the lifeline of a company. The ability to generate continuous free cashflows ensures survival of a business. A business needs to generate free cashflows continuously as free cashflows can be used for purposes such as further investing in the business or payout as dividends to shareholders. A business that is unable to generate free cashflows consistently is destined for failure in a matter of time (as this suggests the business is basically not profitable at all).

Free cashflows = Net cash from operating activities - Capital expenditure 

To arrive at positive free cashflows, a company needs to have positive net cash from operating activities. The figure for "net cash from operating activities" can be directly taken from an annual report under the section, "consolidated cashflow statement". A positive net cash from operating activities is important as it shows that the business can generate cash from its operations. A consistent negative net cash from operating activities for a few years maybe a red flag signalling problems with the ability to generate cash from a business's operations. Who wants to invest in a business that cannot even generate cash from its operations? On the contrary, a business that shows consistent growth in its net cash from operating activities over the years shows its excellent business characteristics that allows continued generation of more and more cash from its operations.

Capital expenditure refers to money a company needs to spend on items to keeps its business running and growing at its current rate. Such items include plants, properties and equipments. As such, capital expenditure is a basic necessity to allow the business to maintain its operations and growth. For example, a biscuit making company needs to expend capital to buy a production plant to produce biscuit. It cannot produce biscuit without the necessary production plant with its equipment, so capital expenditure is necessary to produce biscuits. A company that can keep its capital expenditure to a minimum and yet maintain a good rate of growth in business is a good one. An investor can refer to the subsection "cashflow from investing activities" under "consolidated cashflow statement" and look for items such as "investing in/aquisition of plant, property and equipment" to have an idea on how much capital expenditure a company puts into its business.

Thus, free cashflows is whatever free cash left over after necessary capital expenditure is deducted from the net cash produced from a business's operations. An excellent company can produce large amounts of net cash from operating activities while keeping its capital expenditure to its lowest. This is the kind of business an investor will want to invest in, especially if a company can consistently produce significantly large amounts of free cashflows.

Free cashflows can be reinvested into a business to further its growth or to be paid out to shareholders. So, free cashflows is the lifeline of a company, it cannot do without.

More further discussions on determining intrinsic value per share of a company in later posts. I will also seek to critique my own investment portfolio to point out mistakes I committed in purchasing shares of companies that are overvalued based on their intrinsic value per share.

Discussion points:- Free cashflow = Net cash from operating activities - Capital expenditure

It is important to look for companies that shows consistent growth in net cash from operating activites while maintaining low capital expenditure, and yet has high return on equity (ROE).

The ability to consistently generate high free cashflows from a business allows the cash to be reinvested in the business or to be paid as dividends to shareholders.

My stocks portfolio (as at 30 Sep 2009) - Result of living out a focused value investment philosophy.

After I had divested out of Jaya Holdings (see earlier post) around August this year, I bought into shares of SembCorp with the small profit on divestment. I also increased my other holdings with the small profits on divestment. My reasons for divesting Jaya Holdings are mentioned in my earlier post. I bought into shares of SembCorp as I find that it is a large cap blue chip stocks dealing with multi-industry businesses. It owns the subsidary company SembMarine which is the world's second largest oil rig builder. I decided that investing in an already established large conglomerate like SembCorp is afterall better than investing in a smaller business like Jaya Holdings. Given a large cap and a small cap businesses are both comparable in future long term prospects, it is the larger one having far longer consistent track record that may provide more stability in long term investment. Afterall, the larger business has already established itself with a longer proven track record providing more credibility to continue its operations based on good branding and business characteristics.

My stocks portfolio

Learning to live out a focused value investment philosophy

As I have mentioned in my earlier posts, I started entering the stocks market during late June 2008. My two earliest stocks that were bought included CapitaCommercial Trust and Parkway Holdings. As I was still reading up books and researching on stocks investment during that period, I did not firm up an investment philosophy unique to my personality. My earlier buying trades into CapitaCommercial Trust and Parkway Holdings were based on gut feelings with some emotions involved. It was later that I aligned my learning from these practical experiences with my investment reading and research that I firmed up my own investment philosophy, which is that of a focused value investing philosophy. An investment philosophy is necessary for an investor. It is his own guiding principles on making every investing decisions (e.g. what stocks to buy, when to buy and when to sell). An investor without his own living investment philosophy will be confused and clouded by emotions whenever executing his investing decisions. This is because his thinking keeps changing based on emotions affecting his every decisions. He always questions what he is doing and is unsure if a decision is rightly made since there is no inherent investment philosophy to draw upon as a guide.

After I have firmed up my focused value investing philosophy, every decision and thought becomes clear always supported by the investment philosophy. Making a decision is no longer difficult since it is backed by the investment philosophy. Owning only a few stocks in concentrated positions; buying stocks only at a margin of safety below its intrinsic value; selling stocks only when it is grossly overvalued or underlying business fundamentals have deteroriated permanently or there is a better alternative stocks worth investing; always look at buying stocks as part-ownership in a business, so it is vital to constantly analyse and monitor underlying business of a stocks. These are the guiding principles of my investment philosophy and once an investor has lived out his own investment philosophy, making an investment decision is as easy as breathing since he carries out every decisions naturally. It becomes his own natural investment style.

Therefore, my current portfolio is the result of slightly more than one year of practical learning to live out my investment philosophy, that of a focused value investment philosophy. The more I practise my investment philosophy in thinking and making decisions, the more it becomes a natural part of me. I am still learning and will be always learning to live out a focused value investment philosophy.

Weightage of individual stocks in my portfolio

There is a conventional portfolio management style which says an investor must seek to rebalance the weightage of the stocks in his portfolio. As such, he should sell some shares that have appreciated too much in value and buy other shares so as to keep the weightage of individual stocks in his portfolio constant. E.g. an investor's portfolio is made up of 30% stocks A, 30% stocks B and 40% stocks C. If the price of stocks A has run up such that the portfolio is made up of now 50% stocks A, 20% stocks B and 30% stocks C, by conventional portfolio rebalancing management, the investor must sell some shares of stocks A and buy more shares of stocks B and C to rebalance the % of each stocks back to the ratio 30%: 30%: 40%. This is to reduce the risk of any particular stocks dominating the portfolio and rebalances the weightage of individual stocks according to a pre-determined ideal fixed ratio.

However, based on focused value investing philosophy, the investor does not care about % weightage of individual stocks in his portfolio. He assigns more funds constantly into the stocks he thinks is more promising than others and/or is more attractively priced to acquire more of its shares. As such, there is no fixed % weightage for individual stocks in his portfolio and it keeps changing according to the prospects of individual stocks. As such, I do not believe in rebalancing as an approach to portfolio management. Ride the winners and weed out the losers constantly.

Transaction costs drag down investment returns

The total transaction costs of $1425.29 incurred for all my trades translates to a decrease in 1.52% from my total returns resulting in net 40.5% returns since I started out in late June 2008. I was amazed by such a hefty sum in transaction costs incurred considering that I do not practise active trading of stocks. I really wonder how an active trader trading frequently in many small positions can achieve good returns after deducting the hefty transaction costs even through low cost online brokerage trading?

As such, I am now more conscious of transaction costs. Afterall, a focused value investor waits for the perfect pitch to buy and sell shares only when the best opportunity strikes. Inactivity really matters to prevent having a high turnover in portfolio magnifying transaction costs. Execute trades only when necessary. Otherwise it is better to do nothing.

Further discussions will be provided on my portfolio in subsequent posts.

Discussion points:- It is vital to have a unique investment philosophy aligned to one's personality. When one lives out his investment philosophy, he is no longer basing his every investment decisions on changing emotions. Every investor is unique and may not share similar investment philosophy.

Rebalancing is not an effective way to manage portfolio. Instead, have the courage to invest heavily in the most promising stocks in one's portfolio. Ride the winners and weed out the losers constantly in one's portfolio.

Avoid a high turnover in trading one's portfolio. Transaction costs is a real drag to investment returns.