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A Safer Way to Find Value

We’ve talked about how investors can value a company using the Discounted Cash Flow (DCF) methodology.

In essence, investors are finding out what’s the sum of the present value of all the cash that a company will be able to produce in the future.

Though it is a useful method and an important tool for any investor to have, the DCF model has its detractors.

For example, James Montier, a member of the asset allocation team of the investment management firm GMO Capital, has written about the problems with DCF-based valuations.

In his book Value Investing: Tools and Techniques for Intelligent Investment, Montier wrote about how the DCF method has “problems with estimating cash flows, and problems with estimating the discount rate.”

Estimating future cash flows comes fraught with problems, chief amongst those being the generally poor ability for us humans a group, to forecast the future accurately.

With the discount rate, as I’ve written before, it should “reflect inflation, your confidence in the sustainability of the company’s growth, and the price of no-risk investments.” The problem though, is that with so many levels of estimation needed, large errors can propagate through the models.

To mitigate some of the problems inherent with model, Montier suggests using a reverse-engineered DCF.

The idea behind the reverse-DCF is that, instead of estimating all kinds of fuzzy figures, investors should look at the current market price of a share, and work backwards  to determine what kind of growth is implied by that price.

Montier’s not alone in that line of thought. Michael Mauboussin, a strategist with the Swiss bank Credit Suisse and a widely respected investment thinker, shares similar notions.

Mauboussin has written a book titled Expectations Investing where he provides a framework for estimating the assumptions of growth that the market has priced into a share.

This is what Mauboussin has to say about the thinking backwards with regard to investing:

“Steven Crist, the well-known handicapper, has a line about horse race bettors in his eassay, “Crist on Value”, that I love to repeat. He says, “The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think they are following this principle, but few actually do.” Take out the word “horse” and insert the word “stock” and you’ve captured the essence of the problem.”

To see how we can apply the concept of a reverse-DCF, let’s take the example of three local telecommunication companies: SingTel (SGX: Z74), Starhub (SGX: CC3) and M1 (SGX: B2F).

For a reverse-DCF, here are some of the figures we’ll need:

  • Share price
  • Free cash flow per share for the last 12 months
  • A discount rate
  • A terminal growth rate for the company’s cash flows

The free cash flow (operating cash flow minus capital expenditures) they have produced in the last 12 months’ are shown in the table below:

Company Operating Cash Flow Capital Expenditures FCF
SingTel S$5.666b S$1.923b S$3.74b
Starhub S$626m S$331m S$295m
M1 S$286m S$131m S$155m

With the total number of shares in each company given, the free cash flow per share can be calculated:

Company FCF Share count FCF Per share
SingTel S$3.74b 15.943b S$0.235
Starhub S$295m 1.721b S$0.171
M1 S$155m 923m S$0.168

The discount rate can vary widely for each investor based upon their outlook on many factors, as mentioned previously. But for the sake of brevity, let’s stick with a discount rate of 15%.

As for the terminal growth rate for a company’s cash flows, we can use the historical rate of long-term inflation, which hovers around 2-3% for Singapore. And again, for brevity’s sake, 3% shall be our choice.

So, let’s put together what we currently know so far:

Company FCF Per Share Discount Rate Terminal Growth Rate Current Share Price
SingTel S$0.235 15% 3% S$3.71
Starhub S$0.171 15% 3% S$4.33
M1 S$0.168 15% 3% S$3.20

Using all the figures that we already know, we can then input various kinds of growth figures to see which leads us closest to the current share prices for the three companies. The figure that provides the closest estimation to their current share price would then be the implied-growth that the market has baked into the companies.

After spending a few minutes toggling with a spreadsheet, here’s what I came up with:

Company Implied FCF growth for the next 10 years Implied share price if FCF growth figures are met
SingTel 12.8% S$3.78
Starhub 19.5% S$4.28
M1 15.5% S$3.23

So, based on a discount rate of 15%, we see that the market’s expecting SingTel, Starhub, and M1 to grow their future cash flows at an annual growth rate of around 12.8%, 19.5%, and 15.5% respectively.

Investors can then check back upon the current industry-dynamics that affects the three telcos and see if the implied growth figures make any sense.

Of course, as sharp readers might notice, even the reverse-DCF is fraught with its own set of difficulties: investors have to come up with their own discount rates and estimate a share’s terminal FCF growth figure.

But nonetheless, with the reverse-DCF, investors will constantly have to ask themselves, “What’s priced in?” That is very helpful in itself.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.