Discount cash flow analysis: A case study on Pintaras Jaya kcchongnz

We have attempted to use the most common valuation method of relative P/E ratio to estimate a fair value for Pintaras Jaya as shown the appended link below.

http://klse.i3investor.com/blogs/kcchongnz/46422.jsp

However we encountered many difficulties. Firstly one has to understand that the E or earnings in the denominator is an accounting number which can mean many different things. It can easily be twisted, prodded and squeezed into various numbers by creative accounting. It also often includes other items which are non-cash, non-recurring. Furthermore those construction companies used for comparison are not equal in many aspects in terms of performance, efficiencies, capital structure, stability of earnings and cash flow, growth prospects, sizes, financial strength etc. The result is that we often don't know whether we are comparing the same figures, or apples to oranges. Furthermore, relative P/E ratio isn't very useful if the entire construction sector is over or undervalued. This leads us to another method of valuing stock; the discount cash flow analysis.

Discount cash flow analysis (DCFA)

Financial theory postulated by John Burr Williams in his “The theory of investment value” suggests that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. This is similar to what Seth Klarman described as the Net Present Value analysis in his book “Margin of Safety” which he said is the most appropriate method to be used to value a company of on-going concern. Arguably the best reason to like DCFA is that it produces the closest thing to an Intrinsic Value.

There are two major assumptions in using the DCFA:

1) The cash flows for all future years. Obviously, this is a difficult task to forecast the future cash flows not only for us as retail investors, but also for the professional analysts. Alternatively we can base on its existing business and its previous performance and make a guess on the growth rate of these free cash flows. This estimate doesn’t have to be accurate. Just be reasonable and use common sense. We should be conservative if we were to base on it for our investment thesis.

2) The discount rate. This is the rate at which you discount future cash flows. For the DCFA of a firm with both equity (E) and debts (D), we will use the weighted average cost of capital (WACC) as the discount rate.

V = E + D, Re and Rd are the required return of equity and debt holder respectively. Tc is the tax rate.

Re can be academically obtained from the capital asset pricing model as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/44336.js

However, I would use a Re based on the stability of the earnings and cash flows of the business, its efficiencies and the health of its balance sheet. It generally varies from 8% to 15%.

The cost of debt is the borrowing cost which can be as low as 5% in the present low interest rate environment. As interest cost is tax deductible, and the cost of debt is lower than the cost of equity, it is not hard to see WACC is lower with debts, and hence the ingenious use of other people’s money (OPM) to do business.

For those who are interested about the DCFA, please refer to the following link:

http://klse.i3investor.com/blogs/edu_morg_star/31605.jsp

DCFA of Pintaras Jaya

1. Forecast of future cash flows

Based on the cash flows of last two years as shown below, we use the average free cash flow (FCF) of 35.2m as the base and assume that this FCF will grow at 5% for the next 10 years, and 3% subsequently for the rest of its economic life, in accordance to the grow in inflation.

Note that the cash flows from operation above have been adjusted with the deletion of non-operating gains such as gain in sale of financial assets and interest income from its cash and cash equivalent. This FCF is hence purely from its ordinary business of metal can fabrication and construction work.

2. Discount rate

As Pintaras has no debt, the discount rate used will be the required return of equity holder, Re. A 10% discount rate is deemed reasonable in view of its stable earnings and cash flows, plus a very healthy balance sheet. The risk premium is hence at 6% above the risk free rate of about 4%. The FCF and the present value (PV) of FCF are shown in Table 1 in the appendix.

The analysis shows that the value of the firm is worth RM600m from its ordinary operations. Adding back the cash in bank and in equity investment of RM157m, the total value of the firm is 756m. As Pintaras has no debt, all the future cash flows belong to the equity holder, which works out to be RM4.72 per share with the enlarged 160m shares outstanding.

Margin of safety

Although DCF analysis certainly has its merits, it also has its share of shortcomings. For starters, the DCF model is only as good as its input assumptions. Depending on what you believe about how a company will operate and how the market will unfold, DCF valuations can fluctuate wildly. If your inputs - free cash flow forecasts, discount rates and terminal growth rates - are wide of the mark, the intrinsic value generated for the company won't be accurate. Hence it is prudent to invest with a wide margin of safety in case we are wrong in our assumptions.

At the closing price of Pintaras at RM2.96 on 21^st February 2014 and the intrinsic value of RM4.72, the margin of safety investing in Pintaras is at 37%, higher than my required minimum of 30%. Hence Pintaras Jaya continues to fit in my investment thesis.

K C Chong (22^nd February 2014)

Appendix

Table 1: Discount free cash flows analysis

Margin of safety = (4.72-2.96)/4.72 = 37% which is higher than my 30% requirement.

4/3/2014

We approach the discount cash flow analysis in another manner. Let us assume that we intend to invest in Pintaras with a 5 years holding period at the close of its share price on 3/3/14 at RM2.88.

We again use the base Free Cash Flow of  RM35.2m as before, being the average FCF of the last two financial years, and the same discount rate of 10% for the reasons as explained in the original post.

FCF has been growing at compounded annual rate of 17% since 2006. The construction industry remains robust with the LRT and MRT and other ETP projects and most analysts are positive about this industry for some years to come. Hence I assume the FCF of Pintaras grows at 10% for the next 5 years which I think is reasonable.

When the 5 years is up, we assume we will sell the share at an expected price of 12 times the FCF.

The analysis shows that the present or intrinsic value of the firm is RM611m from its ordinary operations as shown in the table below. Adding back the cash in bank and in equity investment of RM157m, the total value of the firm is 768m. As Pintaras has no debt, all the future cash flows belong to the equity holder, which works out to be RM4.80 per share with the enlarged 160m shares outstanding. This represents a margin of safety of 40% investing in Pintaras now at RM2.88.

Table 2: DCFA with terminal P/FCF

17/4/2014

What is the “new” intrinsic value of Pintaras?

In the discount free cash flow analysis of Pintaras in this post, it was assumed that the FCF will grow at 5% for the next 10 years and subsequently 3% forever, even though it has been growing at a CAGR of 17% for since 2006. The intrinsic value is RM4.72.

It appears that this assumption is a little conservative. Many analysts are bullish about the construction industry for the next 5 years. This coming year, Pintaras has already secured RM303 m contracts to be completed in the next one year, as compared to the trailing twelve month revenue of RM184.4m. It does appear that Pintaras is one of the leading foundation contractors, if not the top foundation contractor. So what is the growth for next year, and the next 5 years? 64% (303/184.4-1) ?

Of course FCF is very difficult, I would say impossible,  to grow at 64% for another 5 years. I wouldn’t even assume half of that rate. But let us assume that it grows at a moderate rate of 10% for the next 5 years, 5% the subsequent 5 years, and then 3% forever. Are those assumptions too liberal? And what is the intrinsic value of Pintaras then?

With the new assumptions, the present value of all its future cash flows, or the intrinsic value is RM5.60. At the closing price today at RM3.95, the margin of safety investing in Pintaras is a comfortable 42%.