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No. of Recommendations: 8
Hi everyone,

Everyone is probably familiar at least with the concept of a discounted cash flow (DCF) model. Build a model that projects cash flow of some type (earnings, free cash flow, dividends) into the future, discount back to the present by an appropriate discount rate, sum everything up and you have your intrinsic value (IV) for the company. Going through this exercise is really good on the one hand, and can be really bad on the other. Let me elaborate.

Building the model really makes you think about what is the driving force (or forces) behind the business. What does it do? How does it make money? What levers are there to increase the latter? By thinking this through, you get a better understanding of the business. That's important.

However, there are several drawbacks to the model. First, it can lead to a false sense of precision. I've often wondered why analysts give a precise dollar share price in their "price targets." Why $78 and not $80, for instance? The answer probably has to do with what their model is kicking out.

Second, it can give a false sense of understanding. I know this company! If it grows like this and it should, it will be worth that.

Third, there can be a whole bunch of moving parts and assumptions. The more moving parts in a model (why a 28% operating margin instead of 26%? why 10% R&D expense instead of 11%? why change revenue growth by 5% per year instead of 4.2%?), the more chances there are for something to be wrong and the greater the chance that the IV is completely wrong. I'm convinced that the ways for the model to go wrong are not just a sum of the number of variables, but more like some exponential function of the number of variables.

Fourth, the future is inherently unpredictable. We can make estimates for the next year, maybe two, but for five or 10 years? Give me a break! Senior management has plans for the next several years, but I've seen first hand how those plans change as new situations come into being. Yes, the analyst can update the model, but the accuracy is still probably not going to be very good.

Fifth, there's the whole issue of what discount rate to use. Traditional analysis has you building it from the risk-free rate added to a equity premium which is affected by one or more company-specific modifiers (called beta in the CAPM). Riskier investments are supposed to use a higher equity premium (and thus have a higher discount rate), while less risky stocks would use a lower premium. While this is a drawback of the DCF model, it also applies to what I'm doing, so I'll revisit this.

Yet, most analysts, even here at TMF, go through the exercise of building a DCF model, both for the good reason, but also for predicting IV. So, how can I get an advantage?

Well, one way is to not play that game, at least in the calculating IV way. Instead, study the company as necessary for the first part, to understand what makes it tick. Then, using a particular discount rate (DR), use a very simple DCF model to see what kind of growth is expected by the market at today's prices. I've seen this called (and have called it myself) a "reverse DCF" or "upside-down DCF." Let the price predict the growth for the analyst, rather than the analyst predicting the growth for the price.

Finally, compare those growth rates to what the company has shown it is capable of in the past and what it could reasonably expect today and ask, "Is that reasonable?" Not on an absolute level, as in "5% expected growth for the next five years, but 7% is reasonable" but in finding big disparities between what is expected by the price and what the company can likely do.

I'm sure everyone will get tired of the following example, but it illustrates my point exactly. In the spring of 2009, such an analysis with Apple at $90 per share had zero growth baked into the price at a moderate DR of 12%. Look at the company! It was growing sales in the middle of the worst recession we've seen in years. It had new products that were wildly popular and the expectation that it could introduce more products. And the share price showed that the market said, "That doesn't matter." That's a Messed-Up Expectation (MUE).

With RIG, I think I've found another one. In fact, I identified it last summer at about $50 per share, and the expectation was no growth (or possibly negative growth) in free cash flow for the next 10 years, at a fairly high discount rate. I bought for my personal account at that point, and, while I suffered a temporary decline, I'm now sitting on a very happy 23% gain on my entire position since then (bought 3 times). At last Friday's close of $63 and change, there's less than 1% growth in FCF priced in at a 15% DR, and I think that's ridiculously low, for the various reasons outlined in today's article. Thus, the recommendation and tomorrow's purchase (we're purchasing shares in the companies we recommend the day after publishing the buy article).

Cheers,
Jim
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No. of Recommendations: 1
Hi Jim,

I'm curious to know how your valuation analysis of RIG stacked up against ATW? Is RIG that much better of a bargain right now?

Thanks,

-Dave.
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No. of Recommendations: 3
I'm curious to know how your valuation analysis of RIG stacked up against ATW? Is RIG that much better of a bargain right now?

Hi Dave,

Through the expectations lens, Transocean is much the better value. Here are the corresponding numbers:

                            RIG      ATW
TTM FCF $2,946 $75 M (TTM to 6/30/10 for both)
# shares 318.9 64.4 M
Share price $62.90 $32.77
Discount rate 15% 15%
Expected growth 1-5 yrs 0.4% 29.5%
Expected growth 6-10 yrs* 0.2% 14.8%
Terminal growth** 0.0% 0.0% (kept the same between the two)
*While 1-5 years is varied by the Excel Solver, 6-10 years is set to half of the 1-5 years value.
**Terminal growth is usually set at 0% or 2.5%.

So, the market is expecting much more growth in FCF for Atwood than for Transocean at current prices (last night's close). That reflects, in my opinion, the uncertainty for liability currently weighing on Transocean's stock.

A note on liabilities and losses from legal wrangling. These fall under the category known as contingent liabilities. These are potential obligations that depend on a future event arising from a past event, such as a lawsuit. Accounting for a contingent liability depends on the likelihood that the future event will occur and the ability to estimate any future amount owed. It comes in three categories:

1) The future event is probable and the amount owed can be reasonably estimated. This is recorded on the balance sheet as a liability. Examples include vacation pay (expenses payable) and warranties.

2) The future event is remote (unlikely). These are not recorded and they are not disclosed in the financial statements.

3) The future event has a likelihood somewhere between the two extremes, that is it is reasonably possible. This is disclosed in the footnotes, but not on the balance sheet. For lawsuits, "a potential claim is recorded in the accounts only if payment for damages is probable and the amount can be reasonably estimated. If the potential claim cannot be reasonably estimated or is less than probable but reasonably possible, it is disclosed." (Financial Accounting, Wild, 3rd ed, pg 364) You can follow the progress of a lawsuit by looking at the footnotes. Only when it becomes pretty clear that the company will lose will it begin to take charges to set aside funds for paying out.

In other words, the market can speculate all it wants, but I expect that Transocean won't take a hit on earnings and it won't set up a liability account to pay lawsuits and fines for the Gulf incidence unless and until the payment becomes probable and the amount can be reasonably estimated. And the settling of the lawsuits and court cases could (and I expect, will) take years. While that will weigh down the stock in the near term (next year, maybe two), as it becomes clearer that the court battles will take a long time (and those expenses can be estimated more clearly), the market will become more comfortable again and the price should rise. Especially if the company actually grows FCF faster than is currently expected.

The question then arises, why did BP set aside the money it did and why did they take another $7.7 B hit on earnings this last quarter? In its case, I presume for two related reasons. Management feels that they have a better view on what is likely to be owed and the U.S. government forced it to.

Cheers,
Jim
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Jim,

Very interesting, thanks. I think I'm getting it, except that when I do my own calculation, I get a 3.4% growth in order to match the $62.90 price with your assumptions above. Just curious... how many years do you go out for the analysis?

Second question.... I know DCF calculations can get you into trouble by giving you a false sense of security. Is there generally a certain margin you are looking for here when examining what the implied FCF growth rate is?

-Dave.
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Hi Dave,

I'll post the math tomorrow when I have access to the spreadsheet on my work computer and we can see where we differ from each other.

For how much of a difference between priced in and what is obtainable will be sought, I'm still feeling that out. I've had the best success when the expected growth is zero or even negative (Apple in early 2009, Garmin in late 2008, Transocean today and last summer, and I'm sure there are others). When I've had the expectations match close to what analysts are expecting in their 5-year projections or what the company has actually achieved, then I've had less success (Teva Pharmaceuticals last summer, for instance).

So, obviously, a zero growth expectation is good, assuming that the company is viable. Tentatively, meeting analysts or history is not so good. Where to draw the line in between? Half way? I'll have to try it and see. The way that works out would probably play a role into how big a position I'd take (2% of total initial capital for least convinced, 4% for good with a couple of warts, 6% for strong conviction).

You can think of this portfolio as a painting. I've got the broad outlines brushed in with the expectations, a bit on position sizing, and how a set of criteria outlined by James Montier will play into things (haven't discussed that, yet), but the fine details are still being worked out. :-) However, I don't want the port or technique to get too mechanical and rule driven, either. After all, investing is still as much of an art form as it is a science.

Thanks for the questions and keep them coming!

Cheers,
Jim
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Hi Dave,

Sorry for the delay in getting back to you. Earnings season is a busy time and we've got 22 companies (at least) in this week's SA update.

Here's the spreadsheet I used to get the 0.6% / 0.3% / 0% growth at 15% discount and $62.90 price for Transocean:

Transocean Ltd. RIG
Latest stock price $62.90 11/1/2010

Predicted price $62.90 1 2 3 4 5 6 7 8 9 10 Term
Earnings $2,963 $2,980 $2,997 $3,014 $3,031 $3,040 $3,048 $3,057 $3,066 $3,075 $20,497
Discount rate 15.0% Discounted $2,576 $2,253 $1,970 $1,723 $1,507 $1,314 $1,146 $999 $872 $760 $5,067
TTM Earnings $2,946
Growth 1-5 0.6%
Growth 5-10 0.3%
Growth term 0.0%
# shares 321.0

The TTM earnings is free cash flow for the year ended 6/30/10, the latest available at the time. CFFO - capex = 5022 - 2076 = 2946.

Earnings in year 1 is 2946 * (1 + 0.6%) = 2963. Year 2 is Year 1 * (1 + 0.6%), and so on, through Year 5. Then Years 6 - 10 uses 0.3% instead.

Terminal = (Year 10 * (1 + Terminal rate)) / (Discount rate - terminal rate)

The discounted numbers are the earnings number discounted back to the present, and are in the form: (Earnings Yr N) / (1 + Discount rate)^N

Then, add up all the discounted values (all 11) and divide by the # of shares to get the predicted price.

The inputs are the last stock price (the target for Excel Solver), the number of shares (on the end of the TTM period), the TTM earnings, the Discount Rate, and the Terminal growth rate. Growth Rate Yrs 5-10 is half of Growth Rate yrs 1-5 by definition. I then run Excel Solver to vary Growth Rate Yrs 1-5 so that the predicted price matches the latest stock price.

Hmm, just discovered a minor mistake. The number of shares should have been 318.9 M instead of 321.0 M. The latter was actually on 3/31/10, not 6/30/10. That changes the growth rates to 0.4% / 0.2% / 0.0%.

A very simple DCF model and, with Excel Solver installed (check the installed plug-ins to make sure or to add it), very easy to use.

Hopefully with that, you can see where your model and the above differ.

Cheers,
Jim
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Him Jim,

I had an error in how I was calculating discounted value, so now I match your results. Thanks for posting the details!

The question now really is, in light of any contingent liability, what kind of growth is reasonable to expect going forward? Even 3% would say that RIG is worth $71 now. And as you mentioned, even if the liability becomes more certain, it seems like it will take a while to come to fruition. In the meantime, RIG can generate cash flow. I'm traveling now, but I'll have to take a look at the 10 Q/Ks when I get a chance.

-Dave.
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