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Summary

  • I created a modified DCF called the Cycle DCF to account for variable growth for different business cycles.
  • By accounting for variable growth during business cycles I believe the Cycle DCF more accurately estimates the fair value for a company.
  • In this article I use Apple as my example to show the difference in value between my Cycle DCF and a regular DCF.

In this article, I will be showing the process I used to create a new method to value stocks, which I call the "Cycle DCF." The reason why I chose a new take on the regular DCF was that the DCF accounts for sustained growth for "X" number of years, and then growth levels off for every year after that period. Because of that, the DCF method of valuing stocks tends to inflate the value of the stock. My method takes into account the seven phases of the business cycle, and factors in that earnings vary and do not grow at a constant rate, which is shown in the chart below. Below, I will show an example of my method using the largest stock & most popular stock, which is Apple (NASDAQ:AAPL). While step #1 below may look complicated, you will not have to repeat this step, because I am just showing how I got to my final DCF formula, which I created a Google docs spreadsheet for anyone to use, and the only items you have to enter are Stock Symbol, EPS, Long-term Growth Rate, and the Discount Rate.

(click to enlarge)

[Image from typepad.com]

My Process

Step #1

The first step in my process to figure out the EPS growth rates I would use in my calculator for each corresponding phase of the business cycle. My Cycle DCF is a combination of forward looking and backward looking data that I believe when combined together make a quality valuation method. For the forward looking aspect I constructed the calculator with the assumptions that the estimated future long-term earnings growth rate would be used for the Expansion, Boom, and Peak phases of the business cycle. For the backward looking aspects of the calculator I wanted to see how earnings for large cap stocks performed in 2008,2009, & 2010, which in the business cycle corresponds to recession, trough, and recovery. To do so I looked at all 30 companies in the Dow (NYSEARCA:DIA) to look at what earnings did from 2005 to 2010 to cover what happened to the earnings of the constituents of the Dow during that period. I looked for companies in the Dow that grew earnings in 2005, 2006, 2007, and then saw a drop in earnings in 2008 for the recession. Out of the 30 companies in the Dow, 12 companies met these criteria. In the table below is the EPS data for the twelve companies that met my criteria, of having a growing EPS prior to 2008, and a drop in EPS in 2008.

 

2005

2006

2007

2008

2009

2010

(NYSE:MMM)

4.12

5.06

5.6

4.89

4.52

5.63

(NYSE:AXP)

2.97

2.99

3.36

2.33

1.54

3.35

(NYSE:BA)

3.2

2.85

5.28

3.67

1.84

4.45

(NYSE:DD)

2.07

3.38

3.22

2.2

1.92

3.28

(NYSE:GE)

1.54

2

2.17

1.72

1.01

1.06

(NYSE:GS)

11.21

19.69

24.73

4.47

22.13

13.18

(NYSE:HD)

2.72

2.79

2.37

1.34

1.57

2.01

(NASDAQ:INTC)

1.4

0.86

1.18

0.92

0.77

2.01

(NYSE:KO)

1.02

1.08

1.29

1.25

1.47

2.53

(NYSE:JPM)

2.38

4.04

4.38

1.37

2.26

3.96

(NYSE:TRV)

2.33

5.91

6.86

4.82

6.33

6.62

(NYSE:UNH)

2.48

2.97

3.42

2.4

3.24

4.1

[Data from Morningstar.com]

Now that I had this data, I calculated the EPS growth rates for the following periods for each stock: 2005-2007, 2005-2008, 2005-2009, and 2005-2010. The reason for this was to see how much EPS growth changed in 2008, 2009, and 2010, which represents the recession, trough, and recovery cycles. The final step I did was to subtract the 2005-2007 growth rates in the table below, from the growth rates in 2008, 2009, and 2010 to see the change in the growth rate for each stock. The second table below shows these results and I took the average of the twelve stocks to get my growth rate I will be using [In bold] for my DCF calculator for years of recession, a trough, and a recovery.

EPS Growth Rates

 

2005-2007

2008

2009

2010

MMM

16.59%

5.88%

2.34%

6.44%

AXP

6.36%

-7.77%

-15.14%

2.44%

BA

28.45%

4.67%

-12.92%

6.82%

DD

24.72%

2.05%

-1.86%

9.64%

GE

18.71%

3.75%

-10.01%

-7.20%

GS

48.53%

-26.40%

18.53%

3.29%

HD

-6.66%

-21.02%

-12.84%

-5.87%

INTC

-8.19%

-13.06%

-13.88%

7.50%

KO

12.46%

7.01%

9.57%

19.92%

JPM

35.66%

-16.81%

-1.29%

10.72%

TRV

71.59%

27.42%

28.38%

23.23%

UNH

17.43%

-1.09%

6.91%

10.58%

 

Recession

Trough

Recovery

 

2008 - [2005-2007]

2009 - [2005-2007]

2010- [2005-2007]

MMM

-10.71%

-3.53%

4.10%

AXP

-14.13%

-7.37%

17.58%

BA

-23.78%

-17.59%

19.74%

DD

-22.67%

-3.91%

11.51%

GE

-14.95%

-13.76%

2.81%

GS

-74.92%

44.93%

-15.24%

HD

-14.37%

8.18%

6.97%

INTC

-4.87%

-0.82%

21.38%

KO

-5.45%

2.55%

10.36%

JPM

-52.47%

15.53%

12.00%

TRV

-44.17%

0.97%

-5.16%

UNH

-18.52%

8.00%

3.67%

    

Average

-25.08%

2.76%

7.48%

Step #2

The second step is simple, just like in my previous articles where I have used a regular DCF calculator, I had to figure out what the calculator assumptions I was going to use. I used EPS and growth data from Zacks.com, and benchmark data from longrundata.com, and CPI data from the BLS. Data below is for my example of using Apple.

Current EPS [ttm]: $41.85

Estimated Long-term Growth Rate: 11.90% [Rate used for periods of Expansion, Boom, and Peak]

Rates used for Recession, Trough, and Recovery:

Recession

-25.08%

Trough

2.76%

Recovery

7.48%

Benchmark return: 10 yr annualized SPY return of 7.66%+2.00% inflation=9.66% benchmark

Step #3

Now that I have all my back-data, I plugged those inputs into my DCF calculator Google Doc, which calculates the estimated fair value the same way online calculators do expect my calculator uses variable growth rates. A SAMPLE of what the calculator looks like is shown below with the first 13 years of data. As you can see, each cycle is listed with its corresponding growth rate for that cycle phase, and instead of having growth level off like in a regular DCF, I repeated the cycles for a 100-year period. My example of using Apple showed that using my Cycle DCF method AAPL has a fair value of $651.88, where the regular DCF had the estimated fair value of AAPL at $762.23. Therefore based on my Cycle DCF method, AAPL is currently undervalued by 9.10%.

Symbol

AAPL

         
           

Current EPS

41.85

         

Long-Term Growth Rate

11.90%

         

Recession EPS Drop

-25.08%

         

Trough

2.76%

         

Recovery

7.48%

         

Level off to Growth

1.00%

         

Discount Rate

9.66%

         
           

Cycle DCF

$651.88

         

Regular DCF

$762.23

         

Current Price

$597.51

         
           
           

Regular DCF

Undervalued

27.57%

        

CYCLE DCF

Undervalued

9.10%

        
           
           

Regular DCF

 

Cycle DCF

 
  

EPS

PV

   

EPS

PV

Cycle Phase

Growth rate

Year 1

1

46.83

$42.70

 

Year 1

1

46.83

$42.70

Expansion

11.90%

Year 2

2

52.4

$43.58

 

Year 2

2

52.4

$43.58

Boom

11.90%

Year 3

3

58.64

$44.47

 

Year 3

3

58.64

$44.47

Peak

11.90%

Year 4

4

65.62

$45.38

 

Year 4

4

43.93

$30.38

Recession

-25.08%

Year 5

5

73.43

$46.30

 

Year 5

5

45.14

$28.47

Trough

2.76%

Year 6

6

74.16

$42.65

 

Year 6

6

48.52

$27.90

Recovery

7.48%

Year 7

7

74.9

$39.28

 

Year 7

7

54.3

$28.47

Expansion

11.90%

Year 8

8

75.65

$36.18

 

Year 8

8

60.76

$29.05

Boom

11.90%

Year 9

9

76.41

$33.32

 

Year 9

9

67.99

$29.65

Peak

11.90%

Year 10

10

77.17

$30.69

 

Year 10

10

50.94

$20.26

Recession

-25.08%

Year 11

11

77.94

$28.26

 

Year 11

11

52.34

$18.98

Trough

2.76%

Year 12

12

78.72

$26.03

 

Year 12

12

56.26

$18.60

Recovery

7.48%

Year 13

13

79.51

$23.98

 

Year 13

13

62.95

$18.98

Expansion

11.90%

Closing Thoughts

I believe my Cycle DCF is a good alternative to the regular DCF because I have improved upon the regular DCF because I take into account that unforeseen events occur, like a recession and during those times EPS can fall, where as a regular DCF does not account for variable EPS. I also believe the Cycle DCF is superior to the regular DCF because the regular DCF uses only forward looking data, where as my Cycle DCF uses both forward and backward looking data, which I believe makes for a more accurate estimate of a future value of a stock. I hope my Google Spreadsheet will be a useful tool for investors to value stocks.

Disclaimer

Source: A New Way To Value Stocks: Cycle DCF