- The DCF model may be the investor's most valuable tool.
- Assessing the contribution of equity value from each distinct period of Valuentum’s three-stage discounted cash flow model is a good way to assess underlying intrinsic-value uncertainty.
- Twitter's fair value composition may scare you. If not, it will surprise you.
Valuentum's methodology leaves a lot to digest. In this piece, let's walk through the key fundamental components of business quality, explain the nuts-and-bolts of our DCF, and evaluate the value composition of eBay (NASDAQ:EBAY), Facebook (NASDAQ:FB), and Twitter (NYSE:TWTR) to showcase the DCF's myriad uses. In my view, there may be no more valuable tool to the individual investor than the DCF, which forms the first of three pillars of Valuentum's stock selection methodology, the Valuentum Buying Index.
For starters, we have a variety of key data points that are derived from the DCF process. To calculate the ValueCreation rating of each company, the Valuentum team compares a company's return on invested capital to its estimate of its firm-specific weighted average cost of capital in order to assess whether the firm is creating economic profit for shareholders (ROIC less WACC equals economic profit). Assessing a firm's returns relative to the cost of generating those returns is par for the course in equity analysis.
The ROIC calculation consists of a firm's "earnings before interest" divided by its average net operating assets. ROIC is a far superior measure to return on assets (ROA) and return on equity (ROE), as it is not influenced by the firm's cash balance with respect to ROA and it is not inflated due to leverage with respect to ROE (the third component in the DuPont equation is leverage). The ROIC is a pure measure of the quality of a firm's assets. In our weighted average cost of capital calculation, we use a company-specific cost of equity (using a fundamental beta based on the expected uncertainty of key valuation drivers such as revenue and operating income) and a cost of debt (considering the firm's capital structure and synthetic credit spread over the risk-free rate). As with most fundamental investors, we don't use a market price-derived beta, as we embrace reasonable market volatility, which provides investors with opportunities to buy attractive stocks at bargain-basement levels. Most of the discount rates in our coverage universe are between 8% and 10%, though some high-risk airlines such as United Continental (NYSE:UAL), commodity producers such as Alpha Natural (NYSE:ANR) or Arch Coal (NYSE:ACI) or speculative biotechs such as Arena Pharma (NASDAQ:ARNA) or Ironwood (NASDAQ:IRWD) may garner much higher discount rates due to the volatility and significant uncertainty of their underlying business operations.
Firms that have improving economic profit spreads over their respective cost of capital score highly on the ValueCreation and ValueTrend measures. These firms are generating economic value and are growing the value generated to shareholders each and every year. Companies that aren't performing well score poorly on these measures. Firms that have relatively stable returns over time score well with respect to our ValueRisk evaluation, while those with significantly volatile performance have poor ValueRisk ratings. As we'll discuss below, the ValueRisk rating impacts the margin-of-safety, or the fair value range, that we use to bound each firm's intrinsic value estimate to determine if it is truly undervalued or overvalued. These three individual ratings -- the ValueCreation, ValueTrend, and ValueRisk ratings -- are included in each firm's report. All of this information is gleaned from the DCF.
After these ratings are established, we assess the fair value estimate of the firm on the basis of this three-stage free cash flow to the firm (enterprise cash flow) valuation model. The valuation model we apply to ascertain the cash-flow-derived fair value estimate of each company consists of three individual phases. The first stage is a 5-year discrete period (where all items on the financial statements are derived), the second stage fades incremental returns on invested capital at the end of the discrete period to a company's cost of capital over time, and the final stage is a standard growing perpetuity function. These model stages are not variable.
Our valuation model is primarily influenced by 1) revenue and earnings estimates during the next two years, 2) the normalization of working capital by year 5, 3) mid-cycle profit margins, 4) the capital expenditure/depreciation relationship, and 5) the discount rate. The model we use is vastly different than other discounted cash-flow models in that it focuses on about a dozen key drivers. The company's estimated equity value per share is based on its discounted future free cash flows (FCFF) and the company's net balance sheet impact, including other adjustments to equity value (namely pension and OPEB adjustments). Many companies have hidden assets such as Altria's (NYSE:MO) stake in SABMiller of Graham Holdings' (NYSE:GHC) overfunded pension, and these need to be accounted for. The fair value estimate is the most likely value of the company.
Though the DCF is criticized for not being precise, that's not its purpose. A savvy user of the DCF is looking for obvious mis-pricings, the no-brainers. As the saying goes: "you don't need to know exactly what someone weighs to know if they are fat." In the DCF, a user doesn't need to know exactly what the company is worth to know that it is undervalued. Even if a company's fair value is sensitive to a variety of inputs, if a company is materially undervalued under very, very conservative assumptions in the DCF, it is undervalued. This is significantly advantageous to the user.
Let's now expand on the ValueRisk rating, which sets the margin of safety bands around a company's fair value estimate. In the instance where a company's intrinsic value may be $50, the lower and upper bound of its fair value range may be $40 and $60 (depending on its fundamental risks). In this case, we'd say that the company is worth between $40 and $60 per share. For companies that are trading below the lower bound of our margin of safety band, we consider these companies undervalued based on our DCF process. For companies that are trading above the higher bound of our margin of safety band, we consider these companies overvalued based on our DCF process. For companies that are trading within the fair value range, we consider them to be fairly valued. Our framework only has three buckets: undervalued, fairly valued, or overvalued. Though we provide a single fair value estimate for each company, the fair value range should be more appropriately used in practice. Remember, the DCF seeks valuation outliers, and investors should embrace the concept that value is a range of probable outcomes not a single point fair value estimate.
Within each company's report, we show the value that each of the three stages contributes to the calculation of a company's total intrinsic value. The more value generated during the first two stages, the less volatile one might expect a company's fair value to be in future updates, while the more value that is generated in the perpetuity function (stage III), the more risky the valuation outcome and the more volatile the expected fair value. Fair values can and should change as new information comes to light and cash flows are generated through the passing of time. The ValueRisk rating captures the fundamental volatility of key inputs such as revenue and operating income in assessing future economic value, but the duration of a company's future free cash flows sheds further light on the uncertainty of a company's valuation profile.
For example, if you're holding a stock where, let's say, more than 70% of its value is generated in the "perp" (or beyond Year 20), the company has a lot to deliver upon to meet expectations embedded within the intrinsic valuation calculation. Generally speaking, the lower the percentage originating from the perpetuity, the lower the risk that the firm will not live up to long-term expectations. The higher the percentage generated from the perpetuity, the greater the risk that the company will not live up to expectations.
Let's examine recent earnings from three Internet giants to illustrate this concept. Let's also include the percentage of the company's total intrinsic value that is generated from the perpetuity and a discussion about what this might mean regarding intrinsic-value uncertainty. Please note that the DCF process (and its corresponding ratings) is but the first pillar within the Valuentum style and that an intensive relative valuation assessment and a technical/momentum view represent the remaining two pillars in the process, both of which have not been discussed in this article.
eBay *Best Ideas Portfolio Holding* (Perpetuity = 31% of intrinsic value)
eBay is a global commerce and payments company that uniquely benefits from a network effect in its auction business and a secular trend toward consumer online consumption in its payments business, PayPal. We think the firm may economically-split eBay and PayPal in a value-creating IPO in coming years, and we think patient investors will be rewarded greatly when this happens.
That said, we weren't happy with management's decision to repatriate foreign earnings, announced in its first-quarter results, resulting in an unnecessary and unexpected tax bill of $3 billion. To save from paying the tax bill, eBay could have issued new debt (like Apple (NASDAQ:AAPL), for example) to fund repurchases and/or refill its cash coffers. In our view, the move is roughly value-neutral and can possibly be considered value-destructive if an international opportunity comes along, and eBay is unable to capitalize on it.
Our value-neutral calculation is as follows: if eBay buys a total of $5 billion worth of stock (the magnitude of its buyback program) or about 96 million shares at current prices, the company would generate roughly $3.4 billion in shareholder value [96m x (87-52)], approximating the $3 billion tax charge [shares repurchased x (fair value - stock price)]. Though we're generally debt-averse, we think management could have issued new debt and generated the entire $3.4 billion of economic value in doing so, instead of repatriating profits and adding just $400 million in economic value, which inevitably has to be discounted as a result of lost international flexibility.
The unnecessary tax bill aside, eBay's first-quarter results showed 14% top-line growth and 11% non-GAAP earnings expansion, adjusted for the tax charge. Total company enabled commerce volume (ECV) increased 24% in the first quarter to $58 billion, while mobile ECV advanced 70% to $11 billion representing 19% of the volume. PayPal's net total payment volume grew 27% with Merchant Services volume up 32%, and we have no qualms with the firm's rapid pace of expansion. The company reiterated its full-year revenue and adjusted earnings per share guidance, though its second-quarter outlook was slightly below consensus views. Shares remain very cheap, and though we're not fans of management's decision to pay taxes to move profits back to the US (just to buy back shares), we're not budging with our position in the Best Ideas portfolio.
eBay's valuation distribution is rather normal, with the majority of value generated during Stage II, as it should be. Roughly 31% of its value is generated in the perpetuity.
Facebook -- VBI: 7 -- FVE: $97 (Perpetuity = 39% of intrinsic value)
As global data coverage improves, the number of mobile monthly active users will continue to grow. Facebook looks well-positioned to seize upon this trend, and Facebook's younger demographics are increasingly accessing its platform from mobile devices. We acknowledge that the likelihood of a single-stock bubble in Facebook is considerable. If the talk of Facebook possibly becoming the new Internet starts to expand across social media, the trajectory of its share price rise will be meteoric (whether it comes true or not) -- remember, share prices are based on future expectations (not future reality -- which will always be elusive). Facebook's first-quarter results revealed fantastic revenue expansion, impressive operating-margin expansion, and solid earnings-per-share growth. The firm continues to execute nicely, which is a prerequisite for price-to-fair value convergence in almost every case. Our fair value estimate of Facebook is $97 per share. With shares trading just under $60 each at the time of this writing, pricing upside exists at the social networking giant.
As for Facebook's valuation profile, the firm's valuation is riskier than eBay's but not nearly as risky as that of Twitter, which we'll see later. Nearly 40% of Facebook's intrinsic value is generated by the perpetuity calculation.
Twitter -- VBI: 4 -- FVE: $32 -- (Perpetuity >100% of intrinsic value)
Twitter's intrinsic value estimate completely depends on its ability to remain a going concern long into the future and generate gobs of cash flow decades from now (see how all of its value is generated in Phase III of the model below). The company's risk profile is tremendous, and investors should expect a volatile valuation assessment with every new update, particularly as new information comes to light. Perhaps needless to say, Twitter's quarterly performance is of little value to shareholders as all of the company's intrinsic value depends on what the company will look like beyond Year 5. The company's full-year outlook, which it released in its first-quarter results, came in lower than what shareholders had hoped. As we've stated previously, shares of Twitter can surge or tumble and the stock-price movement will largely remain within the probable range of fair value outcomes at this juncture. We think it's wise to stay on the sidelines.
Wrapping It Up
The DCF offers far more information about a company than just a fair value estimate. From assessing the duration risk of future cash flows and more, the DCF is every investor's most valuable tool. We continue to hold eBay in the Best Ideas portfolio, as we keep an eye on Facebook and stay as far away from Twitter as possible. Thank you for reading.
Additional disclosure: Some of the firms mentioned in this article may be included in Valuentum's portfolios.