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This analysis is updated regularly. For the most recent version, please visit my Instablog.

The valuations and rankings of all companies analyzed in this article are available here.

Introduction

The discounted cash flow (DCF) analysis is the gold standard of value investing. This simple formula theoretically tells you exactly how much a company should be worth. Unfortunately, in practice DCF analyses can be abused to justify absurd investments. By changing assumptions about future cash flows and the discount rate, a DCF analysis can be created to justify the assertion that almost any stock is overvalued or undervalued.

But what if it were standardized? What if the same methodology were applied to as many stocks as possible, and the resulting valuations were ranked? By making the same assumptions for every stock, then you can create a level playing field and have at least some degree of confidence that those elite stocks that appear MOST undervalued are actually a pretty good value.

In this article, I present my standardized DCF methodology and the two sets of five stocks that I consider to be DCF champions. The data for the 1,702 ranked companies was obtained from Yahoo! finance at the market close on December 21, 2012.

My Methodology

  1. Run a screen on Yahoo! Finance for all companies with current net income above zero, five-year analyst earnings growth estimates above one, and enterprise value above zero.
  2. For each ticker, project income for each of the next five years by multiplying the net income by the estimated five-year growth rate. After the fifth year, project a perpetual annual income equal to the income level in the fifth year.
  3. Assume future earnings will equal future cash flows. The net present value of the future earnings is the intrinsic value. Calculate a valuation percentage for each stock by dividing the actual enterprise value by the intrinsic value.
  4. Find the discount rate that most evenly distributes the resulting valuations. This process is described in greater detail below.
  5. Sort the companies in ascending order based on the valuation percentage.

It's as simple as that. I do not claim that the resulting valuations are the best or most comprehensive valuations possible. The objective is simply standardization. If I repeat this analysis, I may make changes to the methodology in future runs.

Finding The Discount Rate

One of the advantages of running valuations in this manner is that the discount rate can be calculated rather than assumed. This is done by making small iterative changes to the discount rate until the number of overvalued companies is most nearly equal to the number of undervalued companies.

I found the current discount rate to be 6.6%. At this rate, 849 companies included in the analysis were undervalued and 853 companies included in the analysis were overvalued.

When the proper discount rate is selected, the valuations should form a normal distribution. Here are the distributions of different valuation percentages:

Does this look bell curve-y?

Yeah, That Looks Pretty Bell Curve-y, Right?

(click to enlarge)

The Champions

According to the model, the following companies are trading at the absolute greatest discount to their intrinsic value:

5 Most Undervalued Companies

Ticker Valuation Percentage Target Price Per Share
NVTL 1.48% 31.50
OSBC 1.60% 32.63
EPAX 1.64% 51.32
RIMG 1.77% 40.89
MTEX 1.77% 79.90

It is worth pointing out that the valuation model relies on analyst estimates. So while there may be some gems in these five companies, any company where the analyst estimates are wildly optimistic will appear as an undervalued outliers.

I employ a simple estimate quality factor to help eliminate some of the more unrealistic analyst estimates. The following five companies are the most undervalued companies whose projected growth rate is no more than two times the return on assets.

5 Quality Estimate DCF Champions

Ticker Valuation Percentage Target Price Per Share
FLL 5.09% 43.20
HUM 8.45% 171.92
ASFI 11.36% 91.08
WLP 15.09% 255.68
BTN 15.43% 12.55

There is less upside for these five companies than for the pure picks, but the valuation should be more dependable.

The price targets in both tables represent the price per share at which the enterprise value would equal the intrinsic value with no changes to the capital structure. Some of the companies in the complete rankings have a target price of zero; this doesn't mean the stock is worthless, it just means the company would be overvalued at any price unless it pays down debt.

Investing In The Champions

In the interest of maintaining a standardized methodology I am making minimal corrections for errors in the database.

Whether you are interested in the pure rankings or the quality estimate champions, additional due diligence is warranted on all of these companies. Additionally, establishing a timeline for an investment in any of these companies would require understanding why these companies are so undervalued.

But if everything checks out, then knowing that these companies are deeply undervalued according to a fair analysis is the first step in establishing a long thesis.

Source: 10 Discounted Cash Flow Champions For December