10 Discounted Cash Flow Champions For December

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:

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

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

Click to enlarge

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

Click to enlarge

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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Comments

[Boyplunger.com]

Hello Peter.

"to distribute the spreadsheet link"

Where is that link, please?

[Peter Larson]

Click on the word "here" in the first line of the article.

Be sure to check my instablog for updates! The most recent was mid-January.

[jfwelsh610]

NVTL eps -0.73 EGR 3.0
OSBC -0.4 0
EPAX +0.18 5.0
RIMG -0.81 10.0
MTEX -4.00 0
Not a buy in the group.

[Peter Larson]

Thanks for the comment-

The pure undervalued list is highly volatile and this article is now out of date. The latest version of this analysis is on my instablog.

http://bit.ly/W2SLWD

And you're right- none of those companies are still showing up on the undervalued list.

It is frustrating that the list changes that quickly, but on the plus side, with the exception of MTEX all of those companies have had a positive return since December 21st, and I believe all of them had a positive return during the time they were officially on the list.

[Sammy Lee]

I'm doing some reading on FLL when I ran across your article.

Question: How are you calculating your discount rate? CAPM? And why are you relying on valuations being normally distributed?

My thought on DCF, I use it as well, is that it is not the gold standard:
1.) It is highly sensitive to assumptions regarding discount rates and like.
2.) It is a fragile model that can crumble from many estimation errors.
3.) It gives the analyst false confidence in a single number.
4.) Most analysts on Wall Street do not use it.

It's better than relative valuation, but you should use it with caution. Also, writing about the "value" of companies without going into their specific business situation can be dangerous and irresponsible. No amount of fundamentals can justify a growth rate of 800%. APPL at $700 was justified on fundamentals and look what has happened. Another example is with FLL, they have a huge customer concentration risk: they're number one customer is the U.S. military at Fallon AFB in Northern Nevada. If that AFB were to close down, they could conceivably go out of business.

So telling someone that FLL is potentially worth > $40 is very irresponsible even if the article is filed under quick picks and a disclaimer.

[Peter Larson]

I calibrate the discount rate by varying it until the valuation ratios form a normal distribution.

The valuation ratio is the predicted enterprise value/ actual enterprise value. I want the ratios to form a bell curve around 100% because that means the formula is accurately predicting the prices of as many companies as possible.

That is the objective of a valuation model- to predict the trading price of a company.

As far as your comments on FLL-

Fair enough. This article isn't really about FLL and I hadn't heard of the company prior to performing this analysis. That's sort of the point of doing it.

As I mentioned in all three comments above, I regret the use of the "price target" terminology as all three commenters on this article have focused on that and taken it more literally than I intended.

For me, the price target is simply the price per share that my model calculates. Again, the whole objective of performing a valuation is to predict the price before you even look at the company or where it is currently trading. So I'm not trying to say that FLL is worth > $40/ share, I'm saying that there is a ~$35 discrepancy between the way that FLL is valued and the way it would be valued if it was an average stock.

The next step, if you are interested in FLL, would be to figure out why that discrepancy exists, and if it makes the company a buy or a sell. But that is outside the scope of this article.

-but not the scope of this comment-

The reason the discrepancy exists is because the profitable sale of an Indian casino company this year was classified as a one time gain, and partly because the cash outlay from the announced Silver Slipper acquisition has not yet hit the balance sheet, making the enterprise value appear lower than it actually is. Taking those two events into account brings the value ratio of the company close to 100%.

But both those things demonstrate high quality management. I'd consider a company that is fairly valued with excellent management, and fantastic momentum, to be a buy.

[Peter Larson]

Strikess-

Thanks for the comments.

Let me begin by pointing out that this is listed under "quick picks and lists" and that I've stressed due diligence. You can think of this list like you would think of a "screener" result, in that this is just the first step in the larger process of choosing an investment and trading strategy.

Also, I'd like to point out that both the article and the attached spreadsheet are free to view for everyone. I will receive perhaps $10 for my efforts putting this together. If you have a better methodology I would encourage you to become a contributor and share it.

With those two things in mind here are my answers to your questions:

1. All of your Target Prices for these companies are ridiculous. Do you believe these estimates to be accurate at all?

The target prices for the 10 companies listed in the article are ridiculously low, but that is the point. If you view the attached Google spreadsheet you'll see that that the price target for many, if not most of the 1,702 companies have a price target that is close to the actual trading value. For that reason I believe that my methodology- which I do not vary from ticker to ticker- generally does a good job valuing companies.

Look at that bell curve again- 50% of the companies ended up overvalued, 50% undervalued, most dead on. And they were distributed normally. I'm actively looking for tweaks to improve the model, but I think it is useful on a rudimentary basis as is.

My intention with the price targets were that people might find them useful for the bulk of companies that are actually trading somewhere near the middle of the curve- my methodology may turn out to be more useful as a trading vehicle for the companies that are not outliers than for investing in the companies that appear the most juicy.

For the "champions", however, the price target simply serves to illustrate how out-of-trend these companies are. I believe these companies will outperform; but I don't mean to suggest they ever actually will be 10 baggers. I'm regularly updating this analysis on my instablog and I no longer include the price target for the most undervalued companies because I can see how it is misleading in those cases.

2. If not, then what's the point of your methodology?

First of all, I'm looking for an excuse to distribute the spreadsheet link. In particular, I think that the back-calculation of the discount rate may be very useful to people.

Second, I do believe that the companies that appear dramatically undervalued, as a group, will outperform the rest of the market. In individual cases the stocks may appear more undervalued/overvalued than they actually are for some wonky reason, but the whole point of the analysis is that I'm not putting my finger on the scale by making special allowances for this, that, or the other.

The process is meant to identify companies that are good candidates for additional research. In the future, I intend to write more in-depth articles on some of these companies after I do some D.D. of my own, and I believe in full transparency throughout the investing process.

3. Analyst targets

The reason an analysis like this is needed is because unlike me (I'm an investor, not an analyst), analysts look at the trading price of the stock as they develop their price targets. Since analysts do not want to be viewed as "off-the-wall" they will tailor assumptions such as the discount rate, the terminal value, etc. to arrive at a number that looks right for the individual company.

I don't care if my number looks right, I just want to make money. So I use the consensus estimates without any tailoring.

3. FLL

In an above comment I addressed FLL, which is a bit of an anomaly under the model due to recent acquisitions and one-time gaines. I've made some tweaks to the model to compensate for these effects in future runs.

But even with those adjustments, FLL was still undervalued or fairly valued and it is up 12.9% since the 21st. Perhaps that's the bigger point- being systematic at least allows me to avoid overvalued companies.

[GoblinShark]

NVTL last price $1.29, your $31.50 Target Price represents a 2,341.86% increase. The Median Target is $1.80, High $2.00, and Low $1.10 according to 5 analysts on Yahoo Finance... All of your Target Prices for these companies are ridiculous. Do you believe these estimates to be accurate at all? If not, then what's the point of your methodology? Why calculate inaccurate estimates? I am astonished by these calculations, your methodology, and the fact that this article was published and sent to anyone.

[GoblinShark]

Your estimate for FLL is almost ten times the $4.75 Median Target Price of the four analysts offering price targets on Yahoo Finance. The estimates are the same on Financial Times and Market Watch. I have also looked at other research reports from TD Ameritrade that have similar price targets. How do you justify the $43.20 Price Target?

[Syarzhuk]

What estimates do you plug in - mean or median?

[Peter Larson]

That's a good question- I plug in the number that Yahoo gives me.

I actually plug in the five year growth rate, which is described as- Next 5 Years (per annum)- multiplied by the net income (I am switching to EPS x shares outstanding).

I have mixed feelings about the Yahoo data- it is very complete but some of the basic numbers appear far off the mark. If I can find another data source that gives the same information in downloadable format I'd switch.

But analyst estimates are particularly difficult to obtain. Analysts sell their reports for thousands of dollars in some cases, so sites that quote estimates are often limited in terms in what they are permitted to do with it.

[Peter Larson]

Update on FLL-

Picking through FLL's financial statements it appears the cause of the undervaluation for that company is basically a database error. A large one-time gain was included in Yahoo's net income figure, but it was not included in the earnings per share number. The analyst growth estimate is apparently based on the earnings per share.

In future iterations of this exercise I will use the EPS number multiplied by the shares outstanding in place of the net income to eliminate any potential discrepancy.

[Tom Boise]

To the Author:

You predict that a number of the ten candidates' share price will increase by a factor of ~10 times or so.

During what period of time do you estimate these increases will occur?

Thank you.

[Peter Larson]

I don't have a timeframe. More importantly, I'm not saying that these stocks will actually increase by a factor of 10.

What I am saying is that are undervalued by a factor of 10- the share price COULD go up 800%, 900%, and still be justified based on fundamentals. There is no particular reason to believe the market will ever award them a higher valuation, but an undervalued company is more likely to be bought out at a premium, announce a high percentage dividend, buy back shares on a meaningful scale etc. than an overvalued company.

What I would do is purchase these companies and hold them until they are no longer near the bottom of the list, then swap them out for companies that are at the bottom of the list at that time.