Maths : Valuation Models: Discounted Cash Flow and Application to PE Ratio

Within the recent months, those who have mostly invested in Australian stocks such as ボーイフレンド and myself would have seen returns come up mostly flat whilst watching US stocks soar well past their February peaks. 

Stacked atop each other, it is very striking to see the differences in how far the ASX200, S&P500 and NASDAQ have performed since the March crash. If you had invested in NASDAQ at the start of the year, you would currently be up 31.7% whilst you would still be down 12.8% if you were solely in ASX 200. 

For those who have followed the news, it has been apparent that most of the gains made in the US markets are largely attributable to the tech sector. By way of illustration, the following charts show the current year to date return on the ASX, S&P when compared to Tesla, Microsoft, Amazon and Zoom. 

As you would expect from this kind of level of growth, stocks like TSLA, ZM and APPL have dominated a lot of the talking points in quite a few share forums and a few friends have been talking about buying into them lately too. 

As a value investor, whether or not a stock is worth purchasing depends largely on whether it represents good value when considering its growth and return prospects. So this is what we will attempt to discern for the aforementioned stocks by use of the Discounted Cash Flow method for security analysis with specific reference to the current PE ratios of said securities. 

Discounted Cash Flow

Discounted cash flow is a method to calculate the value of an investment based upon the sum of its' total future cash flows and applying net present value of the total of the cash flows. The formula is as follows:

The formula provides a framework to determine what the fair value of the investment is, thereby aiding the determination of whether or not the current pricing is above or below fair value, showing whether or not it is a good buy. 

Usually when calculating DCF, projected cash flows are estimated for the upcoming five years with every year subsequent estimated at the standard 3% being standard GDP growth indefinitely. 

In applying this model, you arrive at a total expected value for the company, which can be divided by the current amount of shares to determine a fair value of the share given it's projected growth (in the next five years). 

Application to PE Ratio

As mentioned earlier, PE ratio is determined by price divided by earnings. This can be utilised by the DCF model to show what the anticipated growth of a company is based on what the PE ratio currently is. 

Without using actual earnings figures, if you assume the first year's earnings to be one and project the next five year's growth and then apply DCF, the resulting figure is the fair PE ratio for anticipated growth. 

By way of example, take the current Australian CAPE ratio, which sits at 17.5 per StarCapital as at 31 August 2020. With an inflation rate of 1.25% and risk free rate of 7.5% it shows that with a PE of 17.5 is fair value if earnings are expected to grow at 3% per year to perpetuity. 

In contrast, we can take a quick look at TSLA, ZM and APPL figures as they are now:

To justify a PE of 1083, Tesla will need to grow at 300% per year for the next five years.

To justify a PE of 472, Zoom would need to grow at 250% per year for the next five years.

To justify a PE of 36.7, Apple needs to grow at 25% per year for the next five years.

The question then as to whether or not these securities are worth purchasing depends on whether the investor considers the expected growth to be in line with the potential growth of the company. In looking at the above three companies, it would not be unfair to say that TSLA and ZM are very unlikely to be able to achieve the growth required to justify their PE ratio, whereas it could be plausible that APPL could achieve it. Given the uncertainties surrounding the tech sector though, these are still not securities that I would really be in a rush to purchase.

by 小福

Case Study: On UNV, TER and margin of safety

One highly technical post calls for another. I hadn't intended to go into another so soon but due to the recent chain of events, it was too good an opportunity to pass, so today's post will be on the complete debacle that was TerraCom's (ASX: TER) purchase of Universal Coal (ASX UNV). In the words of ボーイフレンド it was basically a murder suicide with retail shareholders forming unwitting collateral damage. 

All good stories though, start from the beginning. So that's where we will commence. Late last year ボーイフレンド was considering industries that would be likely to outperform in the medium term. With a fairly contrarian perspective compared to the average retail investor, he decided that with the uprising popularity of renewable energy and the social pressures surrounding ethical funds, traditional fuel sources like coal and oil would be fairly discredited and undervalued in the short term. As a result of this, he and Mr D started looking into individual companies in the industry for potential individual picks for investment. 

In their research, they came across UNV, a London based Thermal Coal company with operations in South Africa. One look at their financials shows why it was such an attractive company to buy into. With steady growth in revenues, reasonable and proportionate expenses, healthy cash flow, a history of generous dividends as well as excellent asset to liability ratios whilst management also appeared to be sound. In applying discounted cash flow models to value the shares, ボーイフレンド determined that each share was worth within the vicinity of 0.6 to 0.9 which obviously meant that his purchase price of 0.24 when the PE was about 5 (and my subsequent purchase at 0.23) was definitely a steal, so we purchased a small amount of holdings each.

For reference, I have extracted some financials of UNV current as of 6 Apr 2019. Although there has been a bit of time lag, you can definitely see the solid fundamentals in the reports.

Testament to the unpredictability of stocks and also a lesson in the importance of diversification, the unexpected did in fact happen and TER, an Australian based coal producer with projects in Queensland and Mongolia launched a takeover bid for UNV. Judging by the condition of the health of the company from its financial reports, it was easy to see why they wanted the takeover. TER had sustained a couple of years of losses with an increased net loss projected in the current year with an indeterminate time for return to profitability despite an increase in revenues. Cash flows were abysmal and assets to liability ratios were not ideal. This was definitely not a company that I would want to hold.

Again, for reference, I extract a copy of the financials currently posted on 6 Apr 2020.

Under the offer, UNV shareholders will get 10 cents in cash and about 0.6026 new TER shares for each UNV share held. As at the point where we were made this offer, TER was selling at around 0.24 per share. This meant that accepting the offer, I would break even at 10 cents plus roughly 14.4 cents of TER per UNV.

At this point, the board of UNV issued advice to shareholders not to take any action with respect to the unsolicited bid whilst they instigated litigation to suspend voting rights of TER but strangely three members of the board itself Tony Weber, Shammy Luvhengo and Hendrik Bonsma proceeded to accept the offer on 22 March 2020, raising serious concerns to me about acting in good faith when they undertook a course of direction to which they advised shareholders not to. In the end, ボーイフレンド and I held out to the end and didn't accept until we saw that 75% of shareholders had accepted. The final figure stood at over 90%.

Within a couple days my cheque for $4,347.80 arrived in the post and 26,200 shares of TER appeared in my SelfWealth Account. The cheque was easy enough to bank and transfer back into my SelfWealth but the 26200 shares of TER were a lot harder. There was no doubt in my mind that TER was not a company to hold for the long therm, but with the continued falling price and no fundamentals to even justify a potential rebound at a later date, there was nothing to do other than to sell.

Initially when I was first issued my shares, TER was trading for around 14 cents per share, wanting to break even at around 17 cents, I held on as I watched it drop to 12 cents, by which point ボーイフレンドcashed out. Holding for another two days, I finally gave up and sold for 10.5 cents per share, the lesson to be learnt is apparently not to be greedy, because even though you may hope that a share may go up, without sufficient justification as to why it ought to go up, it has just as much or maybe even more reason to go down.

In the end, my $10k investment in UNV resulted in a payout of $7,098.80. Although by absolute figures this was a pretty big loss of almost 30%, given the most recent drops in the market, the outcome was largely the same as what I would have gotten if I had bought into index instead. If nothing, this highlighted to  me the importance of making individual purchases with a generous margin of safety, because if individual equities are not bought at a price that is significantly below their intrinsic value, when unexpected situations like this do happen, the losses that are sustained could be critical indeed.

As to what I put my $7,098.80 into? VGE and WGB.

 By 小福