Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

The Mosaic of Stock Analysis

Part 4: Detailed discounted cash ow analysis

David J. Moore, Ph.D.

www.efcientminds.com

February 11, 2013

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction The basics

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction The basics

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Which stocks should I analyze?

Stock tips from your friends in industry. Stocks from the J.O. Cornerstone Value II screen. Stocks you believe are a good value. Closest competitors of those stocks!

Introduction The basics

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Does the stock appear over or under valued?

Graph of company stock vs. overall market in the past 3 to 12 months. Any recent news that impact the assessment of future cash ows?
Who is buying what they are selling?

Market multiple analysis:

What is the P/E compared to industry/sector average? What is the P/E compared to industry leader? What is the P/E ratio over time? Is the stock over or under valued based on the P/E numbers? Cheap target: forecasted earnings historical average P/E Maybe repeat with J.O.s P/sales instead, or P/CF.

The basic analysis here could be used to place a stock on ones watch list.

Introduction The basics

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Buy, sell, or hold

Look at DuPont over time and vs. competitors: ROE = PM TATR EM
With this single equation you can measure operational efciency PM = NI/Sales, investment efciency TATR = Sales/A, and nancing efciency EM = A/E.

Buy
Estimates for WACC and g. Sensitivity analysis of intrinsic value vs. WACC and g. Identical analysis of closest competitor to illustrate just how good of a buy this stock is.

Sell or Hold
Forecast vs. actual numbers for sales, free cash ow, residual income, etc. If we are meeting or exceeding forecasts, why sell?

Compare intrinsic value with current market value.

Introduction Details

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction Details

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Intrinsic value
The goal is to obtain the intrinsic value of a share of common stock. In general:

V0 =
t=

CFt (1 + r )t

(1)

The trick is in accurately (as possible) forecasting cashows (CFt ) and using the appropriate discount rate (r ). If we presume constant growth of cash ows at rate g, Eq. 1 simplies to: CF1 V0 = 1g However, discount rates (r ), cash ows (CFt ), and growth rates (g) all vary over time.

Introduction Details

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Getting to the valuation goal

Several different paths (models) to the summit of valuation:
Residual income model (RIM) Dividend discount model (DDM) Direct discounted free cash ow model (D-DCF) Whole rm discounted free cash ow model (F-DCF) Equity discounted free cash ow model (E-DCF) Value at Risk (VaR)

A little philosophy behind model selection (Occams razor): select among competing hypotheses that which makes the fewest assumptions and thereby offers the simplest explanation of the effect -Wikipedia 2012.03.08

Introduction Details

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Models to achieve the goal

Model RIM Comments Adds current book value to expected future additions to book value. Very simple but need to consider OBS items and FMV of assets and liabilities. Discounts future dividends by rs . Simple but only works for dividend-paying rms. Discounts free cash ows available to all investors by WACC. Easiest FCF extraction. Similar to D-DCF. Moderately complex FCF extraction. Discounts free cash ows available to equity investors by rs . High complexity FCF extraction. Universal applicability based solely on historical returns. Fin? Y

DDM D-DCF F-DCF E-DCF

N* N N Y

VaR

Introduction Details

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Which model to use? Simple and suite.

Start simple and suite: Use RIM, DDM, D-DCF, and VaR for each stock under analysis. Yes, all that you can. I acknolowedge DDM and DCF may be unapplicable to nancial rms. Each model has its own pros and cons. But the proposed analysis suite will look at the problem of valuation from many angles. Start with constant growth. The model is simpler (adheres to Occams razor) and produces conservative estimates. Complicate the model only as needed. Perhaps there is a strong reason to believe revenues will grow 3X the economy the next ve years (e.g., APPL in 2011-2013). We will see APPL is still a buy with the constant growth model at current (2012.03.08) market prices. In the cases where constant growth produces ambiguous results use multi-growth to further rene the analysis.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Weighted average cost of capital

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Weighted average cost of capital

Weighted average cost of capital

WACC = wd rd (1 ) + wps rps + wcs rcs

Lazy approach: just use 10%. Precise approach:
1

(2)

Estimate the expected target weights for long-term debt wd , preferred stock wps , and common stock wcs .
Do not include suppliers (AP) and employees (ACC) as sources of capital. We already adjust for AP and ACC when computing FCF.

Estimate the cost of debt rd , cost of preferred stock rps , and cost of common stock rcs

Q: is there any particular order about the capital components in Eq. (2)?

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Weighted average cost of capital

WACC weights
Morningstar.com (enter ticker symbol the select bonds) has weights based on book value. IFM10, CWS4, and RWJ4 suggest weights should be based on market values. Ideally you would use the target market weights as stated by the company in their SEC lings. Not all companies do this. Market value of debt MVd . MHS approximation: MVd BVnotes payable + BVST debt + BVcurrent port. of LT debt + BVLT debt Market value of preferred stock MVps . Since the income stream of preferred stocks is more stable Dps = rps Pps we can presume MVps = BVps . Market value of common stock MVcs . Just go to Yahoo and look at the market cap. Be mindful of the timing relative to MVd . MVtot = MVd + MVps + MVcs and wd =
MVd MVtot

, wps =

MVps MVtot

, wcs =

MVcs MVtot

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Weighted average cost of capital

WACC component costs

Cost of debt rd : Do not use rates on existing debt. These are historical rates. Use the current rate - the rate of a 10 year bond commensurate with their credit rating. Obtain credit rating from morningstar.com and current market rates for that rating on bonds.yahoo.com. Cost of preferred stock rps : Given the book value of preferred stock Pps and the most recent preferred dividend Dps the cost of preferred stock is: rps = Dps Pps

In theory this number is between rd and rcs . Cost of common stock rcs . Use the capital asset pricing model (CAPM).

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Weighted average cost of capital

The cost of common stock rcs

rcs = Rf + (E [Rm ] Rf ) Do not mix historical (i.e., geometric average) for E [Rm ] and current Rf . Use the 10-year Treasry bond for Rf . E [Rm ] estimation
Use the forward-looking arithmetic average (a B.L.U.E. estimator), or CGM DDM with a total stock market ETF such as VTI, or E [Rm ] = vti = r Analysts estimate. D1 +g P0 (4)

(3)

The market risk premium (E [Rm ] Rf ) should be between 3.5% and 6.5% (IFM10).

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Weighted average cost of capital

Application: EQR WACC

Introduction Growth rates

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction Growth rates

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Nominal vs. real

Do not mix nominal cash ows with real discount rates or vice versa. If WACC is nominal use nominal FCFs and g. From IFM10:

In other words, if g is real then the forecasted cash ows are real and likely inconsistent with the WACC estimate. I recommend staying nominal on everything. This avoids confusion and introduction of ination measurement error.

Introduction Growth rates

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Growth rate
In the long run nothing can grow faster than the economy. From 1930 to 2011 real GDP growth was 3.62%, ination was 3.73%, and nominal GDP growth was 7.48% (see next slide). In the short-run (3 to 5 years) a company may grow faster than the economy. Can base the estimate on sales or units depending on data availability. Approaches to estimating g:

Arithmetic average? Geometric average? Regression?

"

$ sensitive to time frame chosen $ sensitive to initial/end data points

Behind the scenes of LOGEST function of Excel: salest = (1 + g)t sales0 ln [salest ] = t ln[1 + g] + ln [sales0 ] = a0 + a1 t with a0 = ln [sales0 ] and a1 = ln[1 + g]. LOGEST estimates a0 and a1 and reports exp[a1 ] = exp[ln[1 + g]] = 1 + g (5)

Introduction Growth rates

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Application: GDP growth rate

The rate of 7.48% should be used for the long-run growth rate. One can infer the average rate of ination over the time period from the data with the Fisher equation: 1 + rnom = (1 + rreal ) (1 + INFL) INFL = 1 + rnom 1 1 + rreal 1.0748 = 1 = 3.73% 1.0362

Introduction Growth rates

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Application: EQR growth rate

Note: If performing a two-stage multi-growth model use the rate of 10.12% as the super-normal growth rate.

Introduction Residual income model

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction Residual income model

Discount rate and growth rate

Five intrinsic value models

Value at Risk

RIM Theory
Dene book value (book value of common stock) as: BV BVcs = TSE PS where TSE is total stockholders equity and PS is the book value of preferred stockholders. Dene residual income as the net income available to common stock holders less the cost of equity used to generate that net income: RIt = NIt BVt1 rs Therefore the current value of common stock is equal to the book value plus discounted future residual income: V0 = BV0 +

t=1

(1 + rt

RI

s)

If we presume constant growth of residual income the model simplies to: RI1 V0 = BV0 + rs g

Introduction Residual income model

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Application: AAPL

Apple has no preferred stock. Therefore total stockholders equity = book value of common equity.

Introduction Residual income model

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Comments
Apple was a simple case. No debt, no preferred stock. Greater care must be taken when calculating book value of common equity for nancial institutions. Specically, adjustments must be made to a nancial institutions assets (outstanding debts and loans). The adjustments should account for default risk, interest rate risk, and market risk. According to the residual income model Apple is undervalued with a market value of P0 = 541.99 (Yahoo Finance 2012.03.08) and an intrinsic value of V0 = 1, 257.61. Even if you use the proverbial 10% discount rate Apple is still undervalued with an intrinsic value of approximately V0 = 700.

Introduction Dividend discount model

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction Dividend discount model

Discount rate and growth rate

Five intrinsic value models

Value at Risk

DDM Theory

The present value of a share of common stock is the discounted value of all future dividends:

P0 =

t=1

(1 + r

Dt

t s)

If we presume dividends grow at a constant rate g this formula simplies to: P0 = D1 rs g

Introduction Dividend discount model

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Application: GE

Presume GE is in the mature long-run constant growth phase.

Introduction Dividend discount model

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Comments

The constant growth DDM model suggest GE is overvalued with market value P0 = 19.03 and intrinsic value V0 = 11.35. However, if you set the discount rate to the proverbial rs = 10% you obtain an intrinsic value V0 = 19.05 that is close to the market value. We know that the growth rate will vary over time going forward. However, if we are accurate with our estimate for the average growth rate going forward the CGM still holds.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Direct discounted free cash ow model

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Direct discounted free cash ow model

D-DCF Theory
The value of any asset is the present value of discounted expected future cash ows. The constant growth model is utilized in all three approaches here. This can complicated as needed (although Occams Razor suggests that will not help). The three ingredients of the constant growth model are free cash ows FCF , the weighted average cost of capital WACC, and the growth rate g. V0 = FCF1 WACC g

In the direct approach we obtain FCF directly from the statement of cash ows: FCF = NCFoperations NetCAPEX

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Direct discounted free cash ow model

D-DCF Theory
... continued

Now that we have FCF we can compute the intrinsic value by following these steps: 1 Compute the value of operating assets. Vop =
2

FCF1 WACC g

Compute the value of non-operating assets. Vnon-op = short term inv. + long term inv.

Compute the total value of the rm. Vtotal = Vop + Vnon-op

Compute the value of common stock. V0 = Vcs = Vtotal Vdebt Vps

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Direct discounted free cash ow model

Application: AAPL

Presume Apple in the mature long-run constant growth phase.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Direct discounted free cash ow model

Comments

Value increases with growth rate. Value decreases with WACC. At a current market price of $541.99 on 2012.03.08 the stock is a buy (or hold) . g = 6.51% is a conservative estimate given AAPL has grown at 11% the last couple decades.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Whole rm discounted free cash ow model

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Whole rm discounted free cash ow model

F-DCF Theory
FCF is the cash available to all investors after paying taxes and making necessary investment. Lets dive into the FCF equation: FCFt = NOPATt TNOCt = EBITt (1 ) ((OCAt OCLt + FAt ) (OCAt1 OCLt1 + FAt1 )) = EBITt (1 ) ((FAt FAt1 ) + (OCAt OCAt1 ) (OCLt OCLt1 )) = (EBITt (1 ) + DEPt ) (FAt + DEPt + OCAt OCLt ) = (EBITt (1 ) + DEPt ) (FAt + DEPt ) (OCAt OCLt ) = Operating cash ow Gross xed asset exp. Change in working cap Where OCA = cash+AR+INV and OCL = AP + ACC Note that depreciation is added in operating cash ow because it is a non-cash expense. However, it is effectively removed because in the long run the dollar amount associated with depreciation must be spent to maintain equipment.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Whole rm discounted free cash ow model

Application: AAPL
Same theory as direct discounted cash ow only free cash ow is calculated differently.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Whole rm discounted free cash ow model

Comments

Model RIM D-DCF F-DCF Average

V0 (WACC = 8.63%) 1256.73 1869.65 1689.87 1605.42

V0 (WACC = 10.36%) 705.12 1065.13 966.03 912.09

2012 Forecast ($million) RI2012 = 23, 217 FCF2012 = 35, 435 FCF2012 = 31, 881

Sales in 2012 is forecasted to be between 115,296 @ g = 6.51% and 120,432 @ g = 11.25%. In all cases AAPL is a buy/hold. Prior to 2012 one could verify AAPL is on track to meet the four forecasts here.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Equity discounted free cash ow model

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

Equity discounted free cash ow model

E-DCF Theory
The approach is the same as direct (D-DCF) and whole rm (F-DCF) with a different calculation of FCF and discounting by rs as opposed to WACC. In this approach free cash ows are calculated as: FCFcs = NOPAT TNOC INT PRIN You will need to make decisions regarding future interest and principal payments. This will involve in-depth nancial statement gyrations to extract FCFcs . However, once you have FCFcs you can get to Vcs relatively easily. Google-ing can reveal this approach has been applied to bank valuation. Good luck! I wont cover this here.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

VaR Theory
Value at risk measures the worst-case loss in value over a future period. VaR is used by nancial institutions to measure interest-rate, exchange-rate, market risk, etc. We will use it to measure market risk two ways:
1

Worst case loss in dollars of an investment in stock X in isolation. Worst case loss in dollars of a portfolio that contains stock X.

The second approach is interesting because it enables us to examine the impact of correlation without ever measuring correlation!

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

IsoVaR - VaR for asset held in isolation

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

IsoVaR - VaR for asset held in isolation

In isolation...
Begin by dening worst case. In the context of normal distributions, the 5% worst case would be 1.65 below the mean. In other words, given daily returns compute and dene the daily earnings at risk as: DEAR = dollars invested 1.65 The N-day 5% VaR is computed as: VaR = DEAR N The end result is interpreted as a 5% chance of losing VaR dollars over the next N days.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

IsoVaR - VaR for asset held in isolation

IsoVaR application: BAC

Interpretation: There is a 5% chance that we would lose $4,490 over the next year on a $6,250 investment in BAC.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

PortVar - VaR for an asset held in a portfolio

Outline
1

Introduction The basics Details Discount rate and growth rate Weighted average cost of capital Growth rates Five intrinsic value models Residual income model Dividend discount model Direct discounted free cash ow model Whole rm discounted free cash ow model Equity discounted free cash ow model Value at Risk IsoVaR - VaR for asset held in isolation PortVar - VaR for an asset held in a portfolio

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

PortVar - VaR for an asset held in a portfolio

In a portfolio...

Compute the last 500 days of returns for hypothetical portfolio containing stock of interest and remaining portfolio. Sort by the portfolio return. Consider the return on the 25th worst day the price volatility (note 25/500 = 5%). Compute DEAR and VaR as before.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

PortVar - VaR for an asset held in a portfolio

PortVaR application: BAC

The following results are for a portfolio with $6,250 BAC and $243,750 SPY.

We have a 5% chance of losing $89,178 over the next year with a portfolio containing BAC compared to $85,336 with just SPY. From a VaR perspective, we are better off without BAC, at least with the portfolio weights under analysis.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

PortVar - VaR for an asset held in a portfolio

Summary
Five approaches to measuring intrinsic value and two applications of the Value-at-Risk model were presented. The model matrix provides guidance on what scenarios these models work best. The residual income model puts more emphasis on measurable current value (book value). In contrast the DDM and DCF models place more empahsis on future cash ows. Only constant growth models are presented here. One could easily expand the models to multi-growth. Bear in mind Occams razor as you complicate any of the models. Do not be affraid to apply as man models as possible. You are painting the mosaic of stock analysis.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

PortVar - VaR for an asset held in a portfolio

Where to obtain data

Source nance.yahoo.com zacks.com mergentonline.com morningstar.com Naders comp sheet

Compustat

valueline.com

Description Stock quotes, beta, links to SEC lings, historical prices, etc. Stock screening tools. See my presentation on stock screening. Corporate bond data Capital structure data, SEC lings, etc. Pulls data from multiple sources. Data includes stock prices, historical nancial statements, ratios, etc. Probably very useful for nancial rms. Historical SEC lings for all companies going back multiple decades. I am working on getting this loaded on the TAH2009 SIF ofce machine. Historical P/E ratios plus a lot more.

Introduction

Discount rate and growth rate

Five intrinsic value models

Value at Risk

PortVar - VaR for an asset held in a portfolio

References

IFM10 Brigham and Daves (2010), Intermediate Financial Management, 10th edition. CWS4 Copeland, Weston, and Shastri (2005), Financial Theory and Corporate Policy, 4th edition. RWJ4 Ross, westereld, and Jaffee (1996), Corporate Finance, 4th edition. MHS Mark Hoven Stohs, Finance Department Chair, CSU Fullerton.