## Friday, August 27, 2010

### DCF Valuation Explained - A Little

Say, someone was to sell you a vending machine. It is placed at a strategic place where it could consistently earns him RM1000 per year and is expected to increase at a rate of 5% each year. It has a lifespan that could last for another 5 years. How much would you pay for it?

This is where Discounted Cash Flow Valuation comes into play. That RM1000 is the net cash which is the coins you collected from the machine minus the maintenance cost....and so on. That is the amount of cash that goes into your pocket. And it is expected to grow at the rate of 5% for the next 5 years. So your free cash flow table would look like this:

If you sum it all up it is about RM6802. And if that person quote you this price, you can ask him to go to......well whatever you prefer. I bet most of you know there is a time value in money. RM1276 in 2015 does worth RM1276 today and the same goes the other way round. (Just like you char kueh teow. You use to buy it for RM3 5 years ago but now it is RM3.50). That is why the bank charges you interest when you borrow money from bank. And that's also why you need a discount.

So, what rate should you use? Let's go back to the bank. A bank charges interest at rate say 6% on loan because it thinks it can earns 6% if it has not lend you the money and invested it somewhere else instead. So, the bank thinks 6% is its opportunity lost and you will have to pay 6% extra when you return the money. Welcome to the world of capitalism. So for you, you are pretty sure the next RM1050 will arrive a year later and so on. By receiving the cash late, you have lost the opportunity to invest in something for a better return then you put a discount. The question is how much you more think you could earn elsewhere? That will determine your rate. You can use FD rate, EPF, or bonds you are able to purchase one. Let's just use 5.5% (roughly the average EPF dividend) for this. Your discounted cash flow table will now looks like this:

The one on the right most column is what those money worth today - for you. So you add it all up, and you'll get RM6299. That is the fair value for this machine. But it doesn't end here because you are not 100% sure you are able to get 5% return every year. So you need a margin of safety but what is the best rate? Any number that can make you sleep well at night. If you take 20%, RM5039 is the maximum amount that you will pay. Simple huh?

How bout for business then? The idea is the same, just that a little more homework is needed. You can try visit this wikipedia page about DCF; http://en.wikipedia.org/wiki/Discounted_cash_flow. Looks complicated huh? Forget about the mathematics, just click on the picture on the top right hand corner to enlarge it. It pretty much explains everything. A picture worth a thousand words ma.

Investing is a simple art but not easy. The trick here is to pluck in those numbers onto that table from left to right. What is the right number then? There is no right number, just numbers that make sense. Yea, you'll have to guess, assume or maybe just pluck from the air which ever makes sense to you. Whichever number that could make you sleep at night or more importantly makes you able to make DESICION.

DCF calculations can be explained in a few Greek letters. Since Greek can be difficult to understand at times, I'll try to explain in Manglish.
WARNING: You might fall asleep while reading this.

First thing you'll see is EBITDA. This earnings after you minus cost of sales and SGA expenses from revenue. The difficult part is to guess the future revenue. Okay la, forecast la..not guess. You can use historical earnings or growth consistent enough. Normally I use this for mature businesses. Or you can visit reuters.com, use the industrial average growth or S&P500 average growth to forecast its revenue. These are the average growth, value investor normally picks above average businesses. If the business consistently outperform the average results, you can be pretty safe using the average forecast. Will you undervalued a business if you do this? Yes you might.But what is the worst that can happen? You'll miss the boat. But remember Rule No.1 and No.2. Or if you are Buffett or Teng Boo, meet the management for forecast adn ask them to convince you how they come up with the number. Yes, if you read his letters, that's what he did. As for cost of sales and SGA expenses, consistency is the key. If the ratio for all these aren't consistent, chances are, you are looking at a company in a very competitive industry. So, you might consider to skip it.

And then you minus the capex, changes of working capital, taxes and whatever cash outflow that is relevant to the business. For these, I don't really have any guide to follow, they all depends on the business really or how they operate. To be comfortable, check all the announcements including pre-IPO plan see if there is any plan especially for Capex or talk to the IR see how the business works. If you are bit lazy, just use the average. That of course comes with higher risk lo. There you'll get the DFCF for the next few years.

That's for the first part. For the second, you'll try to get the terminal value. Market will eventually gets saturated. So growth are now limited. Or if not, competitors may arrive to have a slice of the pie. For this, free cash flow growth is lower than the discount for the terminal value equation to work. If you can't understand the equation, nevermind. It is basically like this. If growth < discount, you'll see or future FCF decreasing BUT leh, it'll never reach zero until it gets brankrupt or the end of the world. So you can see that it is converging. What this formula does is to add up all the numbers until the convergence that never happens. Confused? Nevermind, that's calculus. So just use the formula.

Now you have two numbers. Add them up and you'll get the fair value. Apply some margin of safety to it. And there you have it. Tada!

This is just the quantitative side of a valuation.

Sun Tzu: "Attack only when you know you are winning"

Anonymous said...

Very Interesting!
Thank You!

JW said...

Hi, i'm applying this approach to MAMEE. I realised that the working capital growth is about 20% in avg for the past 5 years. If I apply this value to get the forecasted change in working capital, i end up with negative free cash flow. What's going on here?

LuZeeker said...

Hi, JW. Haha..quite ironic when i say that. Cos there are ppl who call me JW as well.

Erm...first.
Working capital (WC) = current asset - current liabilities

Changes in working capital (CWC) = woking capital Y2 - working capital Y1

Okay for current asset, when calc working capital, we take off the cash items like cash and cash equivalent. As for current liabilities, we take off debts and stuff.

So when we say negative working capital, means the company is not tied up to its WC with its receivables or inventories. Basically means more cash la. If positive means otherwise. That's why in FCF calc, we minus off (CWC)because it has more cash flow.

So, if you see WC growing at 20% past 5 years. Then the company could in some serious trouble. Pretty serious actually. But i've took a look at their CWC, there aren't pattern that says it grows that way. Actually it is pretty hard to forecast CWC bcos it is basically how the management do business. Normally i'll just use the average.

Hope that helps :)

JW said...

Hi LuZeeker,
Thanks for the tip.

I have excluded cash,cash equivalent and short term debt in my calculation but I end up with a even larger WC growth!! Just 2008-2009 alone is 68%!

I use the figures obtained from MAMEE annual report. Help!

LuZeeker said...

Hi JW,
Since you are getting a negative cash flow, I'm suppose you get a positive changes in working capital. That can only mean these: Either the receivables or the inventories have increased or both. If that happens consistently, then you have to be careful, something might have gone wrong in that company. They could be either allowing their customer to delay payments longer or the got stuck with their inventories. For a company like MAMEE who sells foods, it is pretty bad if inventories piled up cause they have shorter expiry period. Chances are, these inventories might have to be written off cause they can't be sold. These are the bad points.

However, it can be good as well. Inventories are not just finish goos, they are raw materials as well. 2009 is a "crisis year" where most commodities prices drop. So, it might be the management increasing their inventories taking advantage of cheap supplies.

To answer this question, I think you would have to ask the IR officer.

I've take a look at their cash flow statement in their AR. Yes there is a significant increased in working capital changes from 2008-2009. However, looking at these values in the 5 years operations, I don't see an increasing patterns. It looks erratic to me. If I were to guesstimate, I'll use the average instead unless, you know for sure what's the management plan to do with their working capital.

If you have that inside info, it'll be great if you could ask them why.

JW said...

I wish i am that well-connected!
It'll be most helpful if you could supplement this post with a sample calculation. The tutorials online are too brief and leaves out many details (investopedia)
I am very eager to get this figured out before I put in my hard earned money into bursa.

LuZeeker said...

Yea. But I think the sample shown on Wikipedia is really helpful. Try click on the picture. It tells you everything.