Valuation Methods – Discounted Cash Flow Discussion

The entire idea of valuing companies using a discounted cash flow method is based on the premise that the value of a company is the value of its future cash flows, discounted by an appropriate rate to the present.

Now, DCF models provide a very elegant solution to the valuation problem. Simply plug in your implied growth rate, your starting cash flow and tadah! You have the intrinsic value of a company.

However, what most people do not realise is that DCF faces several challenges that can potentially overvalue or undervalue a company.

The first challenge is that DCF is extremely imprecise. Put in garbage and you get garbage valuation. Its notoriously hard to predict whats going to happen the next year, much less 20 years into the future. I would be very suspicious of anyone claiming to be able to do so!

Secondly, if you look at a discounted cash flow model, it only shows results getting better year after year (entirely ridiculous!). There is never a down year. Furthermore, high growth rates are impossilbe to maintain over time due to the law of big numbers. For example, its a mathemtical impossilibty that Apple can keep growing at its current growth rate in the long run so it would be suicidal to use a DCF model here.

Finally, there is the problem of choosing an appropriate discount rate. Academics have debated it to the death and still no firm consensus has been ironed out. I have even seen people deriving a discount rate from beta (which I consider to be a ridiculous concept..) which makes no sense whatsoever to me.

That being said, I still feel that Discounted Cash Flows are still the best method in many situations to evaluate companies. It’s really a situation whereby there are a lack of better tools avaliable to do the job. In other to deal with the flaws of the DCF Model, I normally try to do the following:

1) DCF Valuation should be the last step of your entire evaluation process.
2) Look for a company with relatively stable free cash flow throughout a long number of years.
3) Be extremely conservative in your growth rates. If it looks to good to be true, it probably is. As a rule of thumb, companies that post growth rates exceeding 15% rarely meet expecations.
4) Look at the relative valuations like P/E to see if your valuation makes any sense.

The above discussion highlights why Margin of Safety is the most important aspect of investing. Valuation is really more art than science. Benjamin Graham once valued a company to be worth between $15 – 40 – reflecting how imprecise he knew it to be.

Always demand a Margin of Safety no matter what kind of valuation tool you use.

Conclusion:

In the end, DCF is only one of the methods to go about valuing a company. My advise would be to look at different valuation methods to see where yours stands before making an investment decision.

Fundamental Analysis Report – VICOM

There’s an active discussion regarding VICOM at one of the local investing forums – Value Buddies.

Let’s go through the qualitative aspects of the company first.

I think VICOM has a narrow economic moat at the very least for its vehicle testing services.

The good thing about their business is that their profits are recurring. You have to get your car certified with them at some point in your lives.

Lets look at the fundamentals of the company.

Revenue & Earnings

VICOM has been growing its bottom line really well over the past few years.

Its average annual growth rate is an astonishing 18.2%.

Financial Leverage

The great thing about VICOM is that its a very cash rich company. It has no debt on its balance sheets – a very big plus for me.

Returns on Equity

Returns on Capital are nearly identical to Returns on Equity as there are no borrowings.

Average ROE is 18.3% which is great.

Free Cash Flow Per Share


Free cash flow has also been growing at a reasonable rate – about 10% per annum since 2004.

It’s important to note that Free Cash Flow growth is sometimes slower – especially when a company is expanding it’s operations.

Conclusion:

VICOM was a real surprise find for me. High returns on capital, good growth rate, and a reasonable price all add up well.

VICOM in my opinion, wont be surprising anyone with high growth rates or sudden surges in profits anytime soon. However, if your a long term investor, VICOM will probably do quite well for you over time.

Disclaimer – The author has no position in VICOM at the time of writing.

 

Fundamental Analysis of Challenger Technologies

As promised, I did up a financial report of Challenger Technologies.

Let’s go through the qualitative aspects of the company first

If your living in Singapore, you pretty much know everything there is to know about Challenger. Its a simple business model – selling a wide array of electronic goods throughout the island. Loo Leong Thye has done an impressive job of growing Challenger from its store in Funan to recognizable brand around Singapore.

I really like businesses that have great franchise models (think McDonalds, Starbucks, KFC). A proven success formula is always preferable to a business model that is tested & unproven.

Now, lets look at the quantitative data -

Revenue & Earnings

Revenue & Earnings have been increasing steadily over the years. This is probably due to the expansion of Challenger Technologies into different parts of Singapore.

Return on Equity

Challenger has also done exceedingly well on this front.

Its Average Return on Equity over the past few years is 31.2%.

Financial Leverage

What really liked about Challenger was that it had almost no debt on its balance sheets.  Returns on capital are almost identical for that reason.

Free Cash Flow Per Share

Free Cash Flow – like Revenue and Earnings has grown comfortably over the past few years.

Always look out for companies with consistent and healthy free cash flow. Free Cash Flow allows companies to fund their acquisition’s/expansions/capital expenditures easily without much debt.

Always remember – Cash is King.

Conclusion:

I like Challenger Technologies a lot.  Before the run-up in price, I found Challenger trading at an extremely attractive valuation. Its price has since appreciated around 50% in the last 3 months (mainly due to the shares issue) so it offers a much smaller margin of safety than before.

Nonetheless, I recommend keeping it on a “To – Watch List” for any price dips. I think that Challenger will continue to growth steadily over the years without much hiccup.

Disclaimer:  The author is long Challenger.