Question on DCF

(04-01-2015, 07:14 PM)Musicwhiz Wrote: I haven't though - is that a Company or a new concept? I've read up extensively on moats (mainly through Pat Dorsey) but am always ready to add on to my knowledge. Thanks.

Tree says that is a book. And it is about economics and maths.

Hyperion will checkout Pat Dorsey.

(04-01-2015, 08:01 PM)HyperionTree Wrote: Tree says that is a book. And it is about economics and maths.

Hyperion will checkout Pat Dorsey.

Thanks, I may check it out. I have quite a few books on my plate now to complete reading. Always good to gain more knowledge though, and in different aspects.

Have a good evening.

I agree with Hyperion Tree and Musicwhiz that DCF method value is largely dependent on the terminal value. Do you apply a simple multiple or use the gordon growth rate? As d.o.g. had mentioned in one of the old posts, the problem with DCF is usually the discount rate to use. It is extremely difficult to calculate WACC or the specifically the cost of equity capital.

However, imho, the one key thing in the DCF method is to force investors to think through carefully the assumptions made in the financial model. The revenue growth rates, the inclusion of additional revenue stream, the impact of tax rates, CAPEX figures etc.

Ultimately, the whole exercise of DCF is to give investor a single value which is not useful if the margin of safety is not applied. However, in that case, most of the companies would be overvalued based on my trial and errors made so far.

(04-01-2015, 02:47 PM)GFG Wrote: 5) is a simple steel trading business, easy to understand, they pretty much do the same thing every yr. Buy and resell steel. nothing fancy, not expanding into anything new etc.
Even then you can see their long term cashflow can vary from 1.3mil to 14.5mil. So which FCF figures would you use if averaging would not help?

Thanks

Hi GFG,

Hyperion and Tree here. We took a quick look at Asia Enterprises Holdings cash flow statement.

1. Adjustments
Tree said there is a line item call Bills Payable that has to be removed from the Trade and Other Payables item from year 2011 to 2005 and it significantly affects the analysis of the business. Tree noted that before 2011, Asia Enterprises Holdings classify Bills Payable as working capital when in fact it is a short-term loan(guaranteed by directors and some are secured by assets) which should be classified under the Cash Flow from Financing Activities Section. If you look at 2012 Annual Report, you'll notice that in 2012 Bills Payable was correctly classified under Cash Flow from Financing Activities in 2012 Annual Report.

As for the Inventory and Trade and Other Receivables which are part of working capital, Tree did not find anything to adjust.

The effect on the Net Operating Cash Flow From Operating Activities is as follows(all figures in thousands):
Year, Net Operating $, Adjustments, Adjusted Net Operating $
2013, 10783, 0, 10783
2012, 2499, 0, 2499
2011, 4444, 0, 4444
2010, 12063, -587, 11476
2009, 14660, 26116, 40776
2008, 12747, -11813, 934
2007, 1565, -4992, -3427
2006, 8168, 11772, 19940

2. About Averaging
As observe from above, the Adjusted Net Operating Cash Flow is not stable and averaging would be very risky.

Hyperion noted that in the early years from 2005 to 2008, Asia Enterprises Holdings probably benefited from strong steel demand worldwide due to China's development and thus there might be shortages in supply in the short term which allow Asia Enterprises to earn a net profit margin of 10% which is highly uncommon for a middle man type of business. For example, another middle man business call DKSH which trades on Bursa Malaysia and distributes consumer goods, only earns 2% net profit margin on good years. In bad years, they'll earn -2 to -5% and shareholders will cry. From 2009, the net profit margin of Asia Enterprise Holdings has been on a down trend towards 2% in the recent quarter which is actually more normal. In 2012 especially, the oversupply of steel in China cause the Chinese producers to export overseas and thus affecting the worldwide steel market. This is likely to persist given the situation in the current quarter had worsen due to Chinese exporters.

Further, given Asia Enterprises' main customers are in the Marine and Offshore Busines, oil prices would be a main driver of their business. Hyperion observes that the Cash Flow from Operations before Changes in Working Capital does seem to correlate well with Crude Oil Prices.

Given the past cash flow trend of Asia Enterprises Holdings seem to relate to a period of abnormal margins and is related to crude oil prices, averaging might be risky since the structure of the market has changed from shortage to one of oversupply and crude oil prices have also changed.

3. Build up and Liquidation of Inventory and Receivables
During early periods of the oil price boom, Asia Enterprises build up inventory and receivables causing a drag in operating cash flow. When oil prices drop in 2008, Asia Enterprises liquidated the inventory and account receivables because they lack liquidity. This results in a jump in Adjusted Net Operating Cash Flow in 2009 and 2010 as inventory and account receivables are liquidated. Thus given this situation, averaging does not make sense. One solution is to separately model the liquidation of inventory and account receivables from the Cash From Operating Activities before Changes in Working Capital.

4. FCF Modeling
Hyperion suggests you wait one more quarter to see the real effect of oil prices on Asia Enterprises Holdings because oil prices have drop significantly in 4Q 2014. This means you can take the quarter 4Q 2014 operating cash flow before changes in working capital as a better and conservative estimate for future cash flows.Thus, Multiply this quarterly number by 4, minus CapEx of 200k a year to get the Free Cash Flow from the business assuming no changes in level of inventory and receivables for next 5 years. Alternatively, you can model a SGD10mil liquidation of inventory and account receivables for next 3 years. These two methods should give you a conservative estimate of the value of Asia Enterprises Holdings.

A very comprehensive discussion on DCF/FCF. Let me contribute in a small way to the topic.

A meaningful usage of historical FCF, is to forecast the future FCF, and thus producing a fairly accurate IV, thru DCF methodology.

Should we calculate the FCF, up to the final dollars?
IMO, an estimation of historical FCF, by OCF ex-Capex, with Capex as PPE purchases, should be sufficient. You may roughly adjust the final number with considerations highlighted by HyperionTree (or should be Tree ).

Is DCF methodology useful and meaningful way to calculate a IV?
IMO, the most useful and meaningful part of the DCF results, are the boundaries, either top and bottom. I will calculate the PV base on several discount rates, and pay more attention on boundaries, and sensitivities, which should give a rough idea on valuation of existing share price.

As scientists, we prefer the maximum accuracy. As engineers, we prefer a suitable accuracy to suit our need, with a comfortable margin, of course.

(sharing a supplementary view)

"Should we calculate the FCF, up to the final dollars?"
Yes i think so. If you don't want to be caught by surprise there are more than one way to the final FCF.

{Cash Flow From Operations (Operating Cash)
- Capital Expenditure
---------------------------
= Free Cash Flow}

It looks very easy for everyone to just go and pluck the proverbial "low hanging fruits" by using this formula. But there are FCFs and FCFs. It's always true the devil is in the details how CFO has been derived. That's why i tend to be very wary of what i read and see. It's best to learn from "official authorities".
You never know what you don't know until you stumble upon or "discover" something for the first time.
That's what i don't know, i don't know what i don't know. Am i confusing you and myself?
Maybe?

Hi!
Some questions about DCF valuation:

To calculate WACC, we need to get the Cost of Equity, with formula:
(Re) = Rf + Beta (Rm-Rf).
- Rf is the risk-free rate
- Rm-Rf is the Equity Market Risk Premium

- For risk-free rate, I intend to use the 10-year government bond yield.
- For Equity Market Risk Premium, I intend to calculate the average difference between the earnings yield (E/P) and the 10-year government bond yield
- For beta, I intend to leave it as 1. Reason is because I think volatility is not equal to risk. Beta is a measure of volatility, and if you are investing for the long term, beta shouldn't be important.

Do you think these are OK approximations for Rf, Rm-Rf, and beta? Thanks!

(11-03-2015, 08:37 AM)gzbkel Wrote: Hi!
Some questions about DCF valuation:

To calculate WACC, we need to get the Cost of Equity, with formula:
(Re) = Rf + Beta (Rm-Rf).
- Rf is the risk-free rate
- Rm-Rf is the Equity Market Risk Premium

- For risk-free rate, I intend to use the 10-year government bond yield.
- For Equity Market Risk Premium, I intend to calculate the average difference between the earnings yield (E/P) and the 10-year government bond yield
- For beta, I intend to leave it as 1. Reason is because I think volatility is not equal to risk. Beta is a measure of volatility, and if you are investing for the long term, beta shouldn't be important.

Do you think these are OK approximations for Rf, Rm-Rf, and beta? Thanks!

Dear gzbkel,

Hyperion says:
There are 3 choices for Beta, namely 1, 0 and -1, each with different assumptions. Beta = 1 means you expect your stock price to be move in 100% same direction as the market index. Beta = 0 means your stock's price movement is independent of the market index. Beta = -1 means your stock's price movement is in the opposite direction as the market index 100% of the time. So when index up your stock down.

Choosing Beta = 1 means, if the market index PE is high, your discount rate is low. Thus when the market is overvalued, you tend to also overvalue your stocks. This is risky.

Tree suggests:
You might want to use peer group long term PE instead if you want to ignore the CAPM because volatility, as you say, is not risk.

For example, if you have 5 stocks in the same industry, you can construct an index based on these stocks. Then you may calculate the average 10 year E/P and use this to be your discount rate. Without a peer group, you can use the average 10 year E/P for the market index to avoid overvaluing your stock when the market is up. To be safe, test a range of discount rates to calculate your fair value.

There are times when you will be unable to ascertain the discount rate for a stock due to various reasons like market uncertainty or risk free rate policy uncertainty or exchange rate effects. In this case, it is better to look for another stock idea.

Cheers,
Hyperion and Tree

I have not done many calculations of WACC but I generally use 10% as a shortcut to quickly see what may be the magnitude of DCF. Possibly I may vary my WACC with a sensitivity analysis of +/- 0.5% for 6 increments. The most important thing in my view is to determine what is the margin of safety. Generally I have not seen for companies with P/E above 10 able to justify it's DCF per share value.

(11-03-2015, 08:37 AM)gzbkel Wrote: Hi!
Some questions about DCF valuation:

To calculate WACC, we need to get the Cost of Equity, with formula:
(Re) = Rf + Beta (Rm-Rf).
- Rf is the risk-free rate
- Rm-Rf is the Equity Market Risk Premium

- For risk-free rate, I intend to use the 10-year government bond yield.
- For Equity Market Risk Premium, I intend to calculate the average difference between the earnings yield (E/P) and the 10-year government bond yield
- For beta, I intend to leave it as 1. Reason is because I think volatility is not equal to risk. Beta is a measure of volatility, and if you are investing for the long term, beta shouldn't be important.

Do you think these are OK approximations for Rf, Rm-Rf, and beta? Thanks!

For Risk free rate, I use the investment horizon as a benchmark. I.e 10 yrs use 10-yr bond yield. 5 yrs, use 5 yr bond yield.