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No. of Recommendations: 10
Hi VS,

check out whatever stock floats your boat or bails out your goalie.


I've "spoken-out" against canned DCF's like ValuePro on several venues around the Fool. I think it rather 'f'oolishly misleads people into focusing on a certain value per share as if that is the be-all and end-all of the process, rather than on spending enough time and effort on considering the inputs to the model where the real art lies. It also incorporates erroneous numbers into the model, and makes financial errors of a rather disturbing nature (a couple of which, you highlighted).

Looking, as you did, at the default screen for QSII on ValuePro, it shows an intrinsic value per share of $161.23 But look at the assumptions that lead to this value:

Growth Rate: 30%

Excess Return Period: 10 years

You asked if the 30% is reasonable. I say yes, it likely is, perhaps for two-to-four years. But assuming 10 years of 30% growth is foolish (note - small-f). Better to assume slowing growth as the firm gets larger (law of large numbers). Plus, given the strong growth over the past few years, and what I believe is reasonable evidence suggesting that management is having difficulting collecting these rapidly growing sales (receivables growth rate is 1.6x sales growth, DSO growing quarterly, cash flow from operations less the tax benefit from stock option exercises is less than reported net income) I'm not sure the company could do sustained 30% if they wanted to.

Net Operating Profit Margin: 28.6%

Good enough, but the firm has been growing this margin, from 9.9% in FY2000, to 28.6% in the TTM ended today (30.6% in most recent quarter). They've been able to grow this margin because of their early lead and good product in their space. But success breeds competition, and this margin will certainly be coming down over the 10-yr period built into ValuePro's model.

Tax Rate: 36.8%

Low end of historical range. From FY2000 to FY2005, effective tax rates have been: 42.6%, 41.7%, 38.0%, 36.6%, 38.9%, 36.8%.

Depreciation Rate (% of Revenue): 3.37%

Investment Rate (% of Revenue): 1.91%

First major error on the part of ValuePro.

Most of QSII's 'investment' is in the form of capitalized software development (appropriate for their business). However, the 1.91% is only Capital Expenditures, it ignores capitalized software. BUT, the 3.37% depreciation rate DOES include the subsequent amortization of the capitalized software. To defenders of ValuePro I say, you can't have it both ways. If you're going to recognize the amortization, you need to recognize the capitalization that creates the amortization. More correctly, the Investment Rate should be raised to 5.07% (the TTM figure for capital expenditures + capitalized software).

Working Capital (% of Revenue): 36.07%

Another error inherent in Valuepro. For them, working capital is A/R + Inventory - A/P. But QSII's major working capital item is the current liability of Deferred Revenue, which matches against the higher and higher A/R balance. Ironically, inclusion of Deferred Revenue actually raises the intrinsic value as calculated by ValuePro, but it's a gross error nonetheless.

Company Beta: 0.84

Wrong. QSII's beta, calculated using the last 60 month-ending prices and regressed against the S&P500 is 1.224. I showed a beta calculation for QSII in this post:, although that ended in September 2005, so you can see that beta has risen in the past couple of months. You can also review the criticisms of beta as a determinent of cost of equity.

One thing I'll draw your attention to is the concept of Confidence Interval for a beta calculation. For the current calculation, the 95% Confidence Interval is 0.482 to 1.966. So we can say with 95% certainty that the 'true' value of beta is somewhere between 0.482 and 1.966. Really inspirational, isn't it.

Equity Risk Premium: 3%

Company WACC: 7.52%

Quite simply too low. Arguably, laughably low. Humourous if it wasn't dangerous for a prospective investor who isn't as well-versed in the financials as others, but who might have wandered by ValuePro after seeing how well TomG's done with QSII in Stock Advisor. Seeing an intrinsic value double today's stock price might have him quivering with greed.

But because the beta is wrong (and arguably useless at the best of times), and because the risk premium is too low, and because it explicitly ignores that things like beta, cost of equity, and discount rates are fluid (and will not be stable throughout the life of the valuation), our investor is being misled.

In all things regarding valuation, we need to ask 'Does This Make Sense?' When I see a low discount rate like this, I always like to play a 'bottom-up' game. I've written this somewhere up-board, but I'll regurgitate for this example. A classic discount rate (K) should be the compilation of risk-free-rate (RFR), inflation premium (IP), and risk premium (RP).

(1 + K) = (1 + RFR)*(1 + IP)*(1 + RP)

So, if we choose the 10-yr T-Bond as our RFR, we have 4.51% (and again, we'll igore that this number is going to rise in the future, most likely, as the Fed continues to tighten rates)

For the IP, we'll be generous and say 2%.

Since ValuePro has calculated 7.52% as WACC, we'll input that as our K, and back out a calculation for our risk premium RP.

(1 + RP) = (1 + K)/(1 + RFR)/(1 + IP)
(1 + RP) = (1.0752)/(1.0451)/(1.02)

RP = 0.86%


Is that the risk premium that an investor should be demanding from a company like QSII? How about if that RFR goes up, and IP is 3% or 4%? In deference to Hewitt ( ;-) ), I'll say that the evidence suggests that discount rate is far too low. Go to ValuePro, change the Beta to 1.224 and the risk premium to 6% (in the ValuePro world, their risk premium is a compendium of the IP and the RP listed above) and see what that does to their calculated value....

Other problems with Valuepro (bullet points):

* Ignores off-balance sheet forms of financing like operating leases (try doing a valuation of
FedEx without considering its off-balance sheet loans).

* Ignores executive stock options. This has been a well-publicized problem with QSII.

* Ignores any growth whatsoever after the explicit forecast period. Their terminal value is a
unrealistic perpetuity (NOPAT/WACC).

Other than that, I guess it's a fine website.


(Who promises this is the last time he'll beat up on ValuePro...until next time probably....)
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