Background - Valuation 101
When valuing companies investors normally (disclaimer: investors seldom act "normal") estimate a given company's estimated future cash flow and discount it back with a given discount rate. The discount rate is dependent on a variety of factors. Most importantly it's dependent upon the so-called risk-free interest rate (the treasury interest rate is often used as a proxy) and the perceived riskiness of the given company. Investors should theoretically at least receive a return that is as big as the return that they could have received by investing their money in risk-free assets. Investors then normally add minimum required rate of return to the risk-free rate based on the perceived riskiness of the investment. The riskiness of the company can be calculated by using a variety of methodologies. One of the most common used ones is the weighted average cost of capital ("WACC"), which is calculated in general by using the following formula:
where is the number of sources of capital (securities, types of liabilities)
is the required rate of return for security ;
and is the market value of all outstanding securities .
Let's for the sake of simplicity assume that company XYZ has a WACC of 8% and that the company's annual free cash flow is $100 million. Let's furthermore assume that the company's free cash flow is generally growing at a rate of 2% per year. The long-term growth rate of 2% is assumed because the projected growth rate of the industry that the company is operating is approximately 5% and for the sake of being conservative we assume a lower growth rate. But, due to the fact that the company's customers have to order the products that the company sells two years in advance, we have a very clear earnings visibility for the coming two years. From the orders we can see that the company is actually going to grow at an annual rate of 10% in the coming two years.
In regard to the company's capital structure let's assume that the company has a total of about $200 million in debt and that there are a total of 100 million shares outstanding. The following is a discounted cash flow ("DCF") analysis based upon the above-mentioned assumptions:
As the DCF analysis above shows the present value of the future cash flow of the company is in the range $1,330 million to $1,716 million, dependent upon which perpetuity growth rate (corresponding to the long-term growth rate) is used. This implies a fair value per share in the range $13.30 to $17.16.
What you should notice about the DCF analysis is that the net present value ("NPV") of the free cash flow of the company for the next fiveyears (2015-2019) is $459 million. The NPV of the company's estimated future cash flow for the enterprise dependent upon the perpetuity is in the range $1,071 million to $1,457 million. That means that the NPV of the cash flow in the coming five years is 2.33 to 3.17 times smaller than the NPV of the future cash flow after the first initial 5 years. The following chart sums up the valuation:
As the chart clearly shows the NPV of the cash flow in the coming five years has little impact on the implied fair value of a company, as the ballpark of the value is created more than five years from the date of investing.
Lets now pretend that Company XYZ was delayed in the proper filling of legal paperwork of a project so that the cash flow and recognition of revenue would happen a 1-2 month later than first anticipated in the company's pipeline. That means close to nothing for the company's implied fair value of the company as (1) the company will still complete the project and receive the cash flow and (2) a 2 month delay in cash flow has a little impact on the company's total NPV as the ballpark of the company's value is created more than five years from now.
However, as the current market functions, there are a big amount of traders and short-term investors who don't really care about the long-term NPV of a company. Instead try to outguess a company's next quarterly results. This makes the stock of the likes of Company XYZ very volatile in the short-term as these short-term traders and investors tend to overreact on a quarterly EPS miss of a few percentages. This however creates a tremendous amount of opportunities for investors who have made their due diligence and thoroughly understand the companies that they are potentially investing in. They can use the short-term fluctuations to buy below NPV and sell at or above NPV.
So, in which parts of the market do such opportunities exist?
The business model and cash flow profile of Company XYZ is a looking a lot like some companies operating in the solar sector. Especially:
…and to a less degree the following companies as they are still in the process of moving more downstream in the value chain:
It can be very profitable for investors to exploit market inefficiencies.
The short-term investment timeframe of many investors and traders create big opportunities for the disciplined long-term investor, who buys when the trading price of the shares are significantly below the implied fair value per share. However, it does require thorough due diligence and knowledge of the companies that you do follow and potentially invest in, in order for you to fully exploit these opportunities.
Disclosure: I am long CSIQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.