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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1671  
Subject: Discount conundrum Date: 5/16/2011 12:50 PM
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I am very curious how other folks are deriving their discounts. Doing some research this weekend S&P consistently had companies valued substantially below where I would place them. I don't really care that S&P and I disagree. What interests me is that we all have access to the same public information. This means our FCF or adjusted earnings inputs can be reverse engineered and discovered. There really should be few surprises and the range of inputs should be fairly predictable.

We also know that for the most part various DCF methods are reconcilable with each other when we all start with similar inputs.

This leaves as the outliers near term growth, mid term growth(if 3 stage), terminal growth and discount. Growth projections are easy to come by, they are often published and changes to growth projections are often worthy of a press release. This leaves only the discount number hidden in the shadows.

Personally I use a built up discount that avoids the fallacies of beta.
Risk free
+company specific risk(appraised two ways, market assigned and market implied)
= cost of debt

Cost of debt
+equity risk premium
=equity risk

Apply appropriate capital structure division and I get WACC for FCFF/EVA. Straight equity risk would be applied to dividend discount or FCFE.

My current conundrum is that many folks in the media and on the boards are describing the current stock market as overpriced. My bottom up research disagrees. The difference has to lie somewhere in the discount because growth is known and starting FCF can be discovered and bracketed.

I also have a thesis that many folks are currently over pricing risk due to fear over the last meltdown and confusion or distrust of current macro economic trends. To be specific, if "risk free" is lower then everything built on it is lower. My suspicion is that folks are adding a risk premium to risk free, intentionally or unintentionally.

What say you?

jack
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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1655 of 1671
Subject: Re: Discount conundrum Date: 5/16/2011 1:49 PM
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Example

This is a table of my outputs for UPS based on various growth rates, discounts and starting inputs by type.



7.3% growth 7.3% growth 11% growth 11% growth 14% growth 14% growth
COE 8.7% COE 9.45% COE 8.7% COE 9.45% COE 8.7% COE 9.45%
WACC 5.65% WACC 5.96% WACC 5.65% WACC 5.96% WACC 5.65% WACC 5.96%

FCFF $203/sh $181 $281 $221 $290 $259
EVA $102 $87 $148 $107 $147 $126
DivDis $45 $40 $62 $47 $62 $55
FCFE $39 $35 $55 $42 $54 $46
2 stage, 5 year high growth, 3% terminal growth

Notice that there is dramatic difference between outputs if debt is on the table. Is this really the bet the market is making? UPS is rated AA-, three steps below AAA. By its balance sheet an argument could be made for it to be a AAA rated firm. Price its debt on the open market and it is not being priced as AA-, it is being priced as being higher quality.

This is this investors conundrum; is the market being overly punitive to debt users in an era where debt is cheaper than it has been in a century? If so, we should be backing up the truck to smart debt users who are actively managing their cost of debt. OR is there fair reason for caution?

I can tell you when I run my models for companies that carry little debt I get far less variation for IV output.

I know there are ways to reconcile MVA to FCFF to FCFE, I'm not interested in making them fit. The methods are raw and basic because precision is a myth. All the FCF input formulas I use are the simplest. One can smooth them in various rolling ways I still, without getting deep, deep into the voodoo of accounting inputs translated by discount cash flow precision formula I get these variances in price.

jack

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Author: iceberg0 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1656 of 1671
Subject: Re: Discount conundrum Date: 5/17/2011 9:28 PM
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<<I am very curious how other folks are deriving their discounts….What say you?>>

I have learned to use financial data as of the valuation date and I use the capitalized/economic income method/approach to est. equity fair market value (FMV) as commonly defined to compare to price so I want market risk premium data not my own required return.

When you quote the media & boards saying “market is overpriced”, I find they give little specifics, muddled dates and mixed value approaches/methods. For me, understanding them is not possible & I pay little attention. I might have an opinion if I est. the top 10 SnP FMV vs. price. I do not give the MSM or analysts much credit for doing that very well.

You ask an interesting question though. I use the build-up method also, based on market inputs (since I am going after FMV).

Cost of debt

<<Risk free + company specific risk>>

I figure on the valuation date the company could market all new debt pretty much at the weighted avg. cost (interest expense/total debt) * (1-TR). So that is my after tax cost of debt i.e. historic, what the company is really paying out. You could adjust this a bit better to market if recent debt is selling for say 105 or 95 but I do not take the time. Business appraisers would do this. It adds some meaningful precision but time is limited.

NB: A headache here is that many companies report on I/S “interest expense, net”. It is net of interest income meaning you have to go figure that out from the Notes and account for it. Some do so w/o using the “,net”, you can’t be too careful.

Cost of Equity

<<Risk free + company specific risk + equity risk premium>>

Here I use Ibbotson’s Year Book information. Their risk free is the 20-yr UST-Bond and they compute an ERP above it based on S&P500 equity market returns since 1926 & update annually.

For company specific risk, I don’t use the co. bonds since they have different terms & market dynamics. For me, I want to know the company specific equity risk vs. S&P500 equity risk during a 5 year look back period. That’s my compromise for the important to know but unknowable future specific equity risk vs. SnP equity risk during a long holding period. This limits my circle to steady eddie types of businesses. An analyst has got to know his limitations; this is one I live with. Company specifics change over longer terms and shorter terms reduce specific risk eventually to noise.

Ibbotson’s has some nice work on co. size risk premia, meaning investors want bigger discounts on the riskiness of small relative to large market cap.; I can buy this point. So I add a discount premium term for size:

Risk free + company specific risk + Ibbotson equity risk premium + Ibbotson size risk premium

Now I allow there is also unsystematic risk. For example, I have run into small companies with huge cash positions relative to assets. Management is scared stiff about surviving the next downturn. This is a more stable situation than your average dotBust or bioPharma. I am willing to add another unscientific guess term (but I rarely do) - this might be used to help adjust to market price if I can’t find anything else (e.g. indicates how the market values safety of enormous cash piles) thus:

Risk free + company specific risk + equity risk premium + size risk + unsystematic risk

over pricing

… many folks are currently over pricing risk…

The RFR & ERP are from the economy as a whole, whatever LT bonds & equity market prices, it is the current deal. Go into any country and that country economy sets these things w/volatility. Now you can go read a lot of gurus and get their input, I’m not going there. About all I would allow is short rates are now artificial low due to the Fed. decision but I don’t use short rates for any analysis except cash interest income & complaining about my bank account returns, so I try to minimize that issue.

If you ask me for my guess at the variable of importance in market price over/under media reports, it is the next year’s est. of EPS or FCFE not discounts. The “overpricing” is also “underyielding” and that yield numerator (E or FCFE) is easier to “get” in the analysis of financial statements than the denominators (discount, growth). YMMV.

KO Example

Now let’s use it in a sentence. Derive KO discount. Valuation date 12/31/2009.

Value Line has KO 5-yr specific equity risk 60% of the market ERP so it reduces ERP by 2.68% & here’s some other data as of value date:

RFR = 4.58%, Co. Specific Risk Premium = -2.68%, Ibbotson ERP = 6.7%, Ibbotson Size premium = -0.37%, unsystematic risk = 0, 2009 Interest exp. = $355Mln, Total debt= $11,859Mln, TR = 2040/8946. (No implied warranty on math or numbers, double check.)

Cost of Equity I’d use = 4.58 - 2.68 + 6.7 -.37 = 8.23%, rounded.

Cost of Debt I’d use = 3% * (1-.228) = 2.31%, rounded.

WACC = (.12 * .0231) + (.88 * .0823) = 7.5%, rounded.

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1657 of 1671
Subject: Re: Discount conundrum Date: 5/17/2011 10:08 PM
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Using my current methods

KO

CoD = 4.5% - 5.29%
COE = 8.7% - 9.7%
WACC = 6.82% - 7.73%

Funny how things balance out your cost of debt is lower than mine while my cost of equity is higher. The lower end of the range is market derived the higher end is based on "normal" ratings spreads.

Thanks for sharing Ice, it is much appreciated. Sometime you wonder if you are actually running the race really well or if you took a wrong
turn.

BTW if you are slow and steady for a fair price chaser you may want to re-look at KO unless you have enough already.

jack

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Author: iceberg0 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1658 of 1671
Subject: Re: Discount conundrum Date: 5/18/2011 8:51 PM
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Hi Jack – When I went thru the KO 10-K for FYE2010, I found many accounts significantly disrupted by the bottling company re-acquisition last year. I’m not able to form a view on KO FMV at present. It might take some significant time to do so (like many acquisitive companies).

For example, the mCapex is going to increase to keep more machines running & I use a 3-yr look back period to develop a current estimate. Margins will also be reduced and more leverage could affect the co. specific risk premium.

I remember the sale of the capital intensive bottling operations being hailed as a value enhancer in the mid-1980’s. Buffett saw that, big time. I don’t yet see how the partial reversal of that sale can accomplish the same thing. The 4/29/11 Value Line sure looks positive though. I think their capex est. is suspect, didn’t change much.

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1659 of 1671
Subject: Re: Discount conundrum Date: 5/18/2011 9:06 PM
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I agree on the bottler yo-yo game. According to public chatter KO has no policy to absorb bottlers the way PEP is but is looking at it on a case by case basis for purposes of quality control and cost advantage.

jack

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Author: atta9508 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1661 of 1671
Subject: Re: Discount conundrum Date: 6/7/2011 11:46 AM
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I am new to DCF and probably can't add much, but I tend to use a similar approach Jack.

For Game Stop Here is what I estimate.

Cost of Debt: 7.3 (based on lont term bond rate plus an adder for the companies cost of borrowing based on bond rating

Cost of Equity: 11.3%

For the cost of equity I use the risk free rate + market rate. I adjust this with a Beta (bottoms up) based on debt/equity relative to other companys versus a global index fund (taken from Damdoran).

WACC: 9.5%

Can either of you point me in a direction to where I can compare my valuations to others. As I said I am new to this and still feeling out reasonable assumptions, and my approach. I have looked at wikiwealth, but not sure if I agree with everything they do. I am hoping to find a work group where people can post either outputs, inputs etc...to compare with others.

Thanks,

Jared

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1662 of 1671
Subject: Re: Discount conundrum Date: 6/7/2011 12:09 PM
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Jared,

I am hoping to find a work group where people can post either outputs, inputs etc...to compare with others.

In the past we have wandered around various boards on Fool.com to recruit people for these kinds of projects. Often the Foolish Collective Board http://boards.fool.com/foolish-collective-115096.aspx?mid=29... has been used for this type of activity.

Your best bet is to round up a group of interested parties and see if you can agree on a company or three to work on and compare notes. I really don't know of a better way or a better place to do a project like this because most other sites bury some of their methodology and its transparency in method that brings clarity to outputs.

The other method that often works is to use your spreadsheet and play with various inputs in a controlled fashion until you are within the recent range of market prices. I don't believe in the "Efficient Market Hypothesis" in its strong or weak form, I do believe many smart people looking at the same data are likely to create a tight range. That may sound contradictory, it would take a small volume to fully explain the difference. The short answer is that the market is often close enough to "right" as to allow for a reasonable check on what you are doing. Where differences often exist is in the fact that the market tends to be short sighted, not looking out much further than 4 - 6 quarters depending on the fiscal year.

Our edge, if we you assume we can garner one, is that we don't have to use THE METHOD although it is a good place to start so that we can check our answers in the back of the book.

Make sense?

jack

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Author: PaulEngr Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1663 of 1671
Subject: Re: Discount conundrum Date: 6/20/2011 9:29 PM
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1. I use the long term S&P 500 historical average minus around 0.5% as my discount rate. Why? Because my decision is between investing in an index mutual fund or directly in individual stocks. If I can't beat the average, there's no reason to play. That being said using the short term average is fraught with obvious difficulties. So in other words, I use a constant 10%.
2. The stocks do seem undervalued. Same with the S&P 500. Most of the jitters are over Greek debt and/or whatever the feds are going to do because their debt game is almost expired. The concern is that it will spark another recessionary cycle. My problem is this:
A. If the Europeans default, the result in the U.S. will be that certain financials (Goldman-Sachs) will go nuclear. At this point it's uncertain how much additional effect this can really have.
B. If the U.S. defaults or virtually defaults (Treasury can't sell any more bonds which is almost true now, and the federal reserve can only buy them by devaluing the currency...hence a virtual default which has the same effect...runaway inflation), then only equities will have any value at all. The bond market turns into a black hole sucking in almost everything except some corporate bonds.
C. If neither happens eventually the fed is going to be forced to raise interest rates in a severe way. They've already fallen into the zero-interest black hole with no way out. This is unsustainable over the long term...again, runaway inflation.
3. Regardless of whether we somehow muddle through or go into inflation (deflation is basically mathematically impossible at this point), pretty much ANY equity except financials is a safe bet. Recession plus high inflation is certainly a very real possibility (think back to 1970's) but in this particular case, the government isn't in the driver's seat and at least with equities, not all the winds are blowing against us.

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