Fundamental Investing
My first attempt to use DCF valuation on Hup Seng
Before I begin, let me apologize for any mistakes that I might make in this post because this is the first time I am using DCF valuation on any stock.
I have been studying a bit on DCF for the past few days and it looks complicated at first. Then I stumbled upon an article from Morning Star on DCF valuation which has been shared by Tan KW in his blog. It looked simpler to use, so I will be using it as an example here. The article: http://klse.i3investor.com/blogs/edu_morg_star/31670.jsp
The main idea of Discounted Cash Flow or DCF in short is that a stock's value is equal to the present value of all estimated future cash flow. Quite a few assumptions will be made.
The formula given is:
Hup Seng's Cash Flow from year 2011 to 2015 (all figures in RM'000):
So the first thing we need is to project future cash flow. I prefer to use past 5-year CAGR of Hup Seng's FCF as the growth rate but the rate of 19.2% is quite high in my opinion. I will therefore use 5% to assume that Hup Seng will not be able to grow much of its cash flow due to higher commodity prices and stronger Ringgit in the future. I will also use the average FCF as a base calculation instead of the figure from 2015 just to be on the safe side.
So here we will see the future projected free cash flow for Hup Seng for 5 years based on 5% growth rate:
Second, determine a discount rate. Hup Seng is a rather well known and stable company in Malaysia with limited growth catalyst (if any). It has been profitable for so many years and have never failed to pay dividends since year 2001. Here I am going to use 8% discount rate since the risk for this company is quite low.
Next, discount projected free cash flow to its present value. We multiply each year's future FCF by discount factor to get the present value.
Present Value of Cash Flow in Year N =
CF at Year N / (1 + R)^N
CF = Cash Flow
R = Required Return (Discount Rate), in this case 8%
N = Number of Years in the Future, in this case 5 years.
e.g. Year 1 = 40843.74 / (1.08)^1 = 37818.28
Year 2 = 42885.93 / (1.08)^2 = 36767.77
and so on
We also need to calculate the discounted perpetuity value or also known as Terminal Value.
Perpetuity Value =
( CFn x (1+ g) ) / (R - g)
CFn = Cash Flow in the Last Individual Year Estimated, in this case Year 5 cash flow
g = Long-Term Growth Rate, in this case 5%
R = Discount Rate, or Cost of Capital (cost of equity) in this case 8%
Perpetuity Value = 49645.82 x 1.05 / (8%-5%) = 1737604
We will also need to calculate the present value of it, which will be:
1737604 / (1.05)^5 = 1182584
Now, we have to add all present value from year 1 to 5 and also the perpetuity value, so it looks like this:
The final figure of 1,361,458 or 1.361 billion Ringgit is the Enterprise Value of the Company. By right, we have to exclude any debts from this figure. But because Hup Seng is a debt free company, this is the net value. Hup Seng's current TTM EV is at around RM 931 million, so this figure is not too far off.
Divide it by the number of outstanding shares (800 million shares), and we get the value per share of RM 1.70. The current trading price for Hup Seng is RM1.28, so that is a margin of safety of 24.7%. I think this is quite alright for me.
So, what do you think about my DCF calculation? I do appreciate any feedback including any error in calculation. Thank you.
Note: This post serve as information sharing on how I attempt to valuate Hup Seng by the means of DCF valuation. It does not serve as a BUY/HOLD/SELL call. Please do your research beforehand as you are responsible for your own actions. Do not follow blindly as my calculations may not be correct. I also have to disclose that I bought Hup Seng today at the price of RM 1.28 a piece.
Thank you.
shinado
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Discussions
5 people like this. Showing 22 of 22 comments
Jeffrey, my steps to calculate is as above. But I do not understand why your result and mine have a huge difference. Perhaps there is something I miss out?
2016-03-23 08:16
that fair value of 1.70 seems a little high to me... are the cash flow numbers obtained from the company's accounts?
2016-03-23 08:26
haikeyila, yes all from latest Q4 report and past annual reports. Now I am wondering if there is a mistake in my calculation.
2016-03-23 09:04
Shinado, there is no so-called right or wrong in your valuation. You get 12 people to do the valuation and you will end up with one dozen answers of different value. Anyway, thanks for sharing, appreciate it.
2016-03-23 09:33
Shinado, with DCF the devil is in capex. The number in the capex include maintenance + growth. You have to exclude the growth number. The reason being if a company takes 100% of their operating cash flow to buy PPE, in the hope of generating more future revenue, turning FCF into zero, the value of the company shouldnt be zero right?
There's no easy way to estimate what is the maintenance capex. But depreciation figure can be a starting point, and you need to set your growth and terminal rate in DCF to zero.
2016-03-23 09:59
JT Yeo, mind to explain why growth and terminal rate should be set to zero? Thank you.
2016-03-23 10:15
Should be set to zero if you only include maintenance capex in calculating FCF. And the reason of using maintenance capex only (excl growth capex) is that growth capex distort FCF.
2016-03-23 10:57
JT Yeo, thanks. It makes sense, however trying to calculate maintenance capex only will be difficult.
latjiu, Discount rate must always be higher than the long term growth rate. Think about it this way, if the long term growth rate of a company surpass the market expected rate (discount rate), it will become a no-brainer riskless investment.
2016-03-23 11:54
Hi Shinado,
1) There's a mistake on your calculation of perpetuity value (though the answer is correct)
You mentioned: Perpetuity Value = 33788.11 x 1.05 / (8%-5%) = 1737604
It should be: 49645.82 x 1.05 / (8%-5%) = 1737604
Nothing major here, it just confused me for a minute
2) The subject that I want to talk more is: Discount Rate
I personally very particular (and sticky) on determining discount rate as it is super sensitive to the final results of valuation.
I stubbornly think that 10% is the perfect discount rate to apply, simply because the stocks market returned approx. 10% a year (including dividends) over the long past. To perform at least in line with the market, 8% isn't enough, to me at least.
If you realise that the capitalisation rate you used in your terminal value calculation, i.e. (r-g), was merely 3%, or in other words, you are valuing Hup Seng's EV at 33.3 times FCF at year-5 (even before adding back the 5 years discounted FCFs), that sounds a bit too much to me.
If you up your discount rate to 10% as I suggested, (r-g)=5%, or 20 times FCF, still high but more reasonable. (Note: I personally don't easily put a '5%' LT growth rate to a normal company. Growing at 5% p.a. PERPETUALLY is too crazy if you imagine it properly, probably only Coca-Cola can do that feat. For Hup Seng, I would probably use 3% or 4% (max), which gives me a cap rate of 7-6% (14-17 times FCF))
3) On Enterprise Value (EV), yes Hup Seng has no debt, but you cannot ignore the cash in Hup Seng's balance sheet, i.e. RM120m. You shouldn't compare 'EV' of RM1.70 to 'equity' price of RM1.28, that's a mismatch.
In fact, to your good news, your equity value is actually even higher at RM1.85 [(1361458+119964-0=1481422) divide by 800m shares]
4) If I use your forecast 5-year FCFs but my own discount rate (10%) and LT growth rate (reluctantly using 4% for illustration purpose), my equity valuation is at only RM1.03 per share. Hup Seng seems overvalued at current price unless its FCF can grow at double-digit rate in the next 5 years.
5) Anyway, value is in the eye of beholder. Everybody can have their own valuation. I'm glad that you brought this up. Let me know your thoughts :)
Happy investing!
2016-03-25 12:13
Also, I think one shouldn't use 5-year DCF valuation (or 10-yr or 20-yr or whatnot) if one isn't willing to hold that investment for that specified period. I've seen many people valuing companies using 10-year DCF but hold the stocks for only 9 months.
2016-03-25 12:30
Hi fung9815, thank you for highlighting all these points to me. I would not buy Hup Seng in the first place if I did not think of long term. Actually most of stocks I hold in my portfolio is for long term.
For your point 1, it's just typo and I corrected it now.
For your point 2, I think I agree with the way you think. Discount rate of 10% seems to be a 'safer' percentage when I look back and think of it.
For your point 4, past 5-year CAGR of FCF is at 19.2%. Excluding year 2015, 4-year CAGR is still a double digit rate. But what about 5-10 years down the road? I have no idea and only assume Hup Seng will have cash flow problems when I place a 5% FCF growth rate in the calculation.
Overall, DCF really do depend on quite some assumptions. I guess having a more conservative assumption will enable us the 'margin of safety'.
As of now, DCF will still not be a major part of my valuation methods when selecting stocks. EV/EBIT, Graham's IV formula & P/FCF are still my main preference.
Cheers.
2016-03-25 14:10
shinado, thanks for your response. (Reading back my own comments, I feel I sounded a bit rude, hope you don't mind :D)
Glad to hear that you are long-term investor, I don't see many nowadays. Keep it up!
Yes, I think DCF valuation is fun to do but really impractical to use unless you are to buy up a controlling stake of a company. Many people try to seek comfort in using DCF because it normally gives a higher value than P/E or P/Book or whatnot.
I like EV/EBIT too, but I tweak slightly to EV/EBIAT as tax is NOT what you get. P/FCF is basically 1-year DCF valuation (or 0-year DCF if you use historical figure).
Most importantly, it's the cap rate (r-g) that matters. My way of playing with (r-g) is (a) fixing the discount rate at 10%; and (b) determining the g within the range of 0-5% based on qualitative factors.
Honestly, I don't like Graham formula because I cannot understand the essence of it. Luckily, i dont have too. :D
On Hup Seng, I think 5% FCF 5-year growth is appropriate and conservative enough for valuation. Better be safe than sorry.
I'm new here btw. Look forward to more posts like this in the future. :)
2016-03-25 14:57
fung9815, another name for EBIAT is actually NOPAT :)
Using NOPAT is an interesting idea because just like you said, tax have to be paid. And that means your EV/NOPAT value will be lower than EV/EBIT.
I will try to come up with better post and analysis in the future!
2016-03-25 15:14
Actually, it doesnt matter whether it's called EBIAT or NOPAT or PATBI, important is getting the common sense right, which is why I gave up pursuing CFA at level 3, you don't need one to be successful in investment.
2016-03-25 15:32
Hi, I am new here. I can't get the total value 1361458. Do you mind showing me the steps? Thanks
2016-03-25 22:20
Hi 86mmc, look at the last table above. We add the Present Value for year 1, 2, 3, 4, 5 & Terminal Value to get the figure.
2016-03-25 22:30
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I am using the same model of valuation.. by using FCF data from 2011-2015, the discount rate i usually used for my valuation between 9 for good sustain strong company up to 12% normal unsustain company, but i try to follow your discount rate of 8% as the company is in net cash (0% debt). Long term growth rate i usually put 10 for small to medium cap and 7 or 8 for large cap company. But i follow your 5% growth rate in this case. After all, I still got the fair value of RM0.92 for this company. If I use my standard DCF valuation, I found this company's fair value is RM1.12. I appreciate how you valuate the company and I wanna thanks for sharing your valuation.
I just wanna share this website as there is DCF valuation also from this great website.. http://www.isaham.my/stock/hupseng
2016-03-23 01:13