How do you go about estimating the absolute value of any company? Estimating a stock's fair value, or intrinsic value, is no easy task. In fact, it is quite complex, involving all kinds of variables that are themselves tough to estimate. Morningstar analysts use discounted cash flow modeling to estimate the intrinsic value of stocks. The main idea behind this model is relatively simple: a stock's worth is equal to the present value of all its estimated future cash flows. Putting this idea into practice is where the difficulty lies.
One of the most elaborate methods for establishing the value of a company, discounted cash flow analysis (DCFA) has a lot of credibility. If one understands value in the sense of “quality”, then DCFA potentially leads to tangible performance results. It strives to project future cash flows and bring them back to present value by applying a discount rate.
This simple formula covers a process of analysis and calculations that can become extremely elaborate and complex, explains Michael Schnitman, senior vice-president and head of products at Mackenzie Investments.
Schnitman, a veteran practitioner of DCFA, illustrates the method around a company like John Deere. You project revenues and expenses over five years, for example, and line up other expenses, like sales of different equipment categories, general and administrative expenses, cost of goods sold, depreciation and amortization, earnings, etc. You add in expected capital expenditures in new plants, new designs of existing products, design of new products.
As an overlay, you consider market trends, business and economic cycles, exports, land values, interest rates. “You will presume a trend of earnings and extend those to the next 30 years of cash flows, and finally, you make a present value calculation of those future cash flows by applying a discount rate that is a mixture of things like the 10-year T-bill rate, an equity risk premium rate and a company-specific risk rate that will be quite different for John Deere compared to a utility company,” he says.
The analysis doesn’t stop there. You weigh the numbers in view of perceptions gathered from interviews with management, suppliers and clients and from visits at headquarters and in manufacturing plants.
Complex and uncertain
That complex process is full of uncertainties. “The problem with DCFA is that forward projections are difficult to pinpoint and are usually wrong,” comments Andrey Pavlov, professor of finance at the Beedie School of Business. “Small changes in the discount rate make huge differences in the current value, so the final result is uncertain."
Granted. But other methods of analysis, the most popular being earnings per share (EPS) analysis, are certainly not better. “Earnings per share can be highly manipulated,” points out Richard Guay, professor of finance at the École des sciences de la gestion and a former CEO of the Caisse de depot et placement du Québec. “One simple example: a company that is just a wee bit more aggressive in its accounting will register a sale even if it is not closed and is conditional on a financing clause. Focusing on cash flow reveals that the money for the sale is either there or inexistent. Such numbers are less easy to cook.”
“Earnings have become less and less reliable over the past 20 years. It’s pretty much the Wild West,” says Phil Taller senior vice-president and portfolio manager at Mackenzie Investments, who systematically practices DCFA. “Free cash flow is more difficult to fake. You either have it or you don’t.”
Numbering the irrational
It is worth noting that DCFA has been sharply criticized by proponents of behavioral finance. This faction considers that markets are rife with irrational decision making, that the pricing of securities is of questionable relevance to valuation, and that the impact of subjective bias undermines quantitative methods in general, and DCF in particular, reports Anders J. Maxwell, partner and managing director at Peter J Solomon Company, in a Financier Worldwide article.
That contradiction between subjective bias and contrived spreadsheets is only apparent and can be overcome through the power of narratives, claims Aswath Damodaran, professor of finance at the Stern School of Business.
“Narratives” (a pet notion in academic circles) are essentially the storyline you can read into a company’s past and anticipated future. For example, a startup company with awful numbers (excessive leverage, absent earnings, obese R&D budget, etc.) can be on its way to cornering a whole market, like Uber (UBER) or Facebook (FB), and one day royally reward investors that bought into its “narrative”.
It’s a question of marrying the left and right sides of the brain. “A narrative-based valuation, which has little, if any numbers to back it up, can very quickly veer away from reality to fantasy,” writes Damodaran. On the other hand, a pure number perspective can totally miss the opportunity hidden in the startup’s storyline.
Whistling in the dark
Then, is DCFA only a way for a portfolio manager to calm his anxiety about risk, a sort of sophisticated whistling in the dark, hoping for a “narrative” to reach its tipping point into success? Not really, but... sort of, recognizes Schnitman: “I don’t know of any study showing that DCFA produces any better results,” he says. It all boils down to character and an individual’s preference for certain tools or a set of tools.
Pavlov reads into DCFA more than just personal preference. “It’s not just a shot in the dark; rather a tool to summarize your thinking. What I like to do is vary the inputs (of a DCFA model), for example change the discount rate by 1% or 2% and explore different scenarios. It gives me a range where the true value of a company is likely to fall.”
Guay takes a bolder step. He couples the notion of “value” with that of “quality”, and this way discovers that DCFA, as a tool to uncover quality, can lead to superior performance of a portfolio. He refers to a recent Financial Analysts Journal article which observes that “unlike standard factors, such as value, momentum, and size, “quality” lacks a commonly accepted definition. Practitioners, however, are increasingly gravitating to this style factor.”
“The link between quality and DCFA is maybe not that clear, but what I read in ‘quality’ is higher future cash flows and a stable growth, therefore a less risky company, all components that point to the higher valuation of a stock,” Guay says.
Investors should definitely be on the lookout for portfolio managers that practice DCFA, for two reasons thinks Laura Lutton, Head of North American Research at Morningstar. “First of all, we always like to see portfolio managers that have a repeatable, well established process of analysis, and Richard Guay’s process points in this direction. Secondly, investors face the danger of the ‘value trap’: companies with very low valuations but that are permanently damaged and won’t go anywhere. Having a quality factor perspective in there is very sensible.”
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