Enlightening article. Most of the time for newbies like me, even if we knew certain stocks which are already undervalued, we just have this psychological barrier to invest in it, due to adverse economic news coming everyday from every direction. Wonder if it would do me good to distance myself from the market noise for now.
Hi Kcchong this is a very well written article. Like it. When you are doing valuation model like DCF,DDM or Residual income , how do you make the assumptions on the growth rate? Using the methods like Relative to GDP? Relative to industry growth? Or the company historical growth rate? If I am not mistaken, you favor historical growht rate over other methods. My next question is, how do you see the company's historical growth rate? Using EPS,Net Income, FCF, Revenue, or other methods?
I never use historical growth rate for DCF as it will over estimate the intrinsic value of a stock, taking mean reversion into consideration. In investing we need to be conservative. I prefer sustainable growth rate with formula given by you during super-normal growth, an then terminal growth about the long term growth in GDP, or inflation.
For cash flow, sometimes I use an average FCF over a few years, but often I start with latest revenue and then use the average margin over a business cycle to obtain the NOPAT, and then less off reinvestment needs to get an estimate of FCF.
All the above is an art, and everyone does differently.
How do you calculate Reinvestment ratio(capex)? Growth/ROIC? or you use cash conversion cycle to foreast working cap and use increase in sales to forecast capex?
As I have said, valuation is an art. I have said it thousand times. There is no right or wrong if you use average earnings, or latest revenue multiply by its ebit margin. I prefer the later because a company grows in size, and using average revenue of the past say 10 years may understate the revenue going forward. Rather I use the average margin.
For reinvestment rate, I look through the last few years and see what is the average, and from there I obtain the structural super-normal growth rate. From there on I assume growth in reinvestment follows the growth rate.
Expected Growth = Reinvestment Rate * Return on Capital where
Reinvestment Rate = Capital Expenditure - Depreciation + Change in Non-cash WC and
In asset light industry, you need little reinvested capital. For a company with ROC of 100%, you only need to reinvest 20% of NOPAT to grow at 20%, theoretically. If you reinvest 50%, theoretically it can grow its NOPAT by 50% a year, if there is such reinvestment opportunity.
Reinvestment rate=(capex- depreciation+ change in working cap)/ebit(1-t)
What if it is a mature company? the depreciation >(capex+change in working cap).
Therefore, you end up getting -reinvestment rate.How do you adjust the reinvestment rate?or you get negative growth rate?
Capex, change in net working capital, etc. are lumpy in nature. You shouldn't just look at one year figure. On average, and over a long period, depreciation can't be more than capex. How can it be when only there is capex, then only you have depreciation.
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Posted by gbk5566 > 2015-08-21 21:51 | Report Abuse
Thank you, kcchongnz.