A NEW WAY OF APPROACHING THE DISCOUNTED CASH FLOW VALUATION (DCF)

Introduction:

The stock market is not an easy place. The amount of information and the complexity of the latter makes it hard to play the stock game. To win in such a difficult environment, I tried to come up with a different approach to downsize my risk when investing.

One important criteria when purchasing a stock is the price. Are you buying cheap? Is the stock too expensive compared to its intrinsic value? The difficulty for determining the price comes from the fact that we can't predict the future of any company. It also comes from the fact that we have a tendency to follow our emotions when investing.

When we evolve in an optimistic environment, we are more inclined to become very optimistic as well. It impacts our assumptions when we value the targeted company through a Discounted Cash Flow (DCF). At which rate am I supposed to grow earnings over the years? Should I create a good, medium and bad scenario when making the projections? Well, I don't follow any of those "institutional" methods. Worst, I assume that to get closer to the reality of the future of any company, we need thousands of scenarios.

I have implemented that philosophy in all the stocks I try to value.

Discounted Cash Flow 3.0:

If you let me have a look at the last 50 000 days of your life, I would be more enclined to predict what will your future be. It is the same thing for a company.

We all have this tendency to magnify the growth rate of earnings and assume lower risks in a bull market. We do exactly the opposite during a bear market. To avoid including emotions in the process of valuation, I developped a DCF based on a Monte-Carlo Simulations.

What's the idea behind it? Who tells me that the company I am valuying will have a constant earnings growth rate over the years? Who tells me that the company will not experience a decrease of revenues? Nobody knows about that.

The purpose of my model is to create 50 000 scenarios for the Free Cash Flow projection of the firm based on a range of assumptions. For example, I will assume that the Net Income will experience variations between -20% and 20% for the next 10 years. The same for the Non-Cash items, the change in Working Capital and the Capital Expenditures. Each year, we will have different scenarios that can be very good or very bad for the firm. The ultimate goal is not to give a precise value of the stock - as it is the case today for many valuation templates and examples-, it is rather to give a range in which you are sure with a certain level of confidence that the stock is not below or above some price.

Any person that tells you that the stock of Apple Inc. is worth 158 dollars and 56 cents is lying to you. My model is not based to provide this kind of conclusions. It is rather meant to tell you that the fair value of  Apple's stock is situated somewhere between 120$ and 190 $ after 50 000 different scenarios of how could behave the free cash flow. If you see the stock price going under 120$ it provides even more margin and increases your probability to be right. It may sound strange, but I actually found some very interesting stocks with it.

Gilead Sciences and Valero are two stocks for which I found a 25% margin of safety when performing the simulation of 50 000 potential free cash flows. They will be presented on the next article. 





Being rich with penny stocks

Penny stocks are very attractive investment opportunities. Many people have become very wealthy with a huge concentration of income in a single company that they expected to see growing over the years. Investing in those types of securities is very complicated for a non-initiated investor because of many cases of fraud, risk aversion or industry collapse. But for people who are willing to make advanced searching and dig a little deeper than the average person, penny stocks can actually make you some money. Reduction of financial portfolio risk is not only applied by diversification of the nature and amount of securities but also by acquiring more knowledge about the company, its industry, products, clients and strategy. Especially in our ultra-informed society. 

A penny stock is primarily characterized as a security whose price is less than 5$ per share (SEC, 2006). They are usually quoted over-the-counter but the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and the National Association of Securities Dealers Automated Quotation (NASDAQ) have a large portion of penny stocks. Companies having this type of stock are usually small and highly speculative since they don’t have any historical record to back up anyone’s investment (Andrew Black, 2016). But it appears very frequently in the markets that penny stocks are not only small size companies. Amazon, Crown Holdings, Starbucks or Monster Beverage are examples of stocks priced at less than 5$ while having billions in annual sales written on the first line of their income statements. Apple was a Penny Stock from 1980 until 2005, so during more than 25 years! If you had invested 50 000 euros just 22 years after Apple entered the stock market, you would have more than 5 200 000 euros today in your bank account. After 2007, we saw companies like Ford, CBS and Bank of America (the second financial institution of the US at that time) being priced at less than 5$.

Many of us think that we can’t compete against the Market. The reasons for scaring us are quiet fair: better tools, more time for researching, a lot of professional analysts and engineers and huge amounts of money to be invested. It supports the theory of the efficient market that suggests that prices written on the markets are reflecting the real value of any given asset meaning then that we can’t beat the market. The reality is different. Of course, most of the stocks priced on the market are being fairly valued, and obviously, there are very smart people out there, but mispricing is very common. And it has more to do with our emotions, misinterpretation or myopia than any other quantitative model built by mathematicians. 

Traditional stock investment focuses on stocks priced at more than 5US dollar. They are being considered as more mature and safe companies since the high price would unconsciously suggest high quality. The most frequently used criterion for investing in one company is the quality of the latter and the risk associated with the investment. However, it is not always true. The market is well known for gathering many sheep that follow the crowd and some wolfs that lead the masses. It underlines the problem of self-decision of investors, especially when we deal with penny stocks. The usually developed variables that explain the variations of penny stocks – liquidity, firm size or price to book - are not sufficient when we look at the penny stocks that trade on national exchange. 

Non-professional investors do not have to worry about investing in penny stocks. With a serious analysis and hard work, they can find some great companies. Obviously, blue-chip stocks like IBM or Amazon are big companies, and thus may sound less riskier, but small companies can sometimes hide high quality penny stocks. Even better, sometimes we find big companies striving in a sector that experiences some difficulties: it is now the case in the retail industry for example. Time to buy some stocks?

Xinyuan Real Estate, a very attractive stock

The company

Xinyuan real estate (NYSE: XIN) is a Chinese company specialised in residential real estate. It develops and manages real estate in China and abroad. The company is in business since 2006. As of today, the stock price of the company is at $ 4.66 per share. The market seems to ignore the stock because Chinese companies listed in the NYSE usually have a reputation of being fraudulent. A lot of investors lost huge amount of money because of that. 

However, Xinyuan is different. It doesn't seem that the company is fraudulent. Several reasons lead us to think that. First of all, the company is giving dividends since 2011 and buys back its shares. It is a clear signal of confidence sent to investors. Usually, fraudulent companies do not give dividends. Also, the company is being audited by Ernst & Young Hua Ming LLP which is a member firm of Ernst & Young, China. This shows that the financial data provided by the firm is correct and that investors can be confident with their financial analysis. Finally, the company is being led by very smart managers. Among them, Thomas Gurnee - formerly CFO of Sohu.com (NASDAQ: SOHU) and member of the board of directors of Xinyuan - obtained his bachelors degree from Stanford University.

The industry

It is mainly said that there is a bubble about to burst in the Chinese real estate industry. It is maybe right when we speak about the first tier of the main cities because they saw their prices quadruple. But Xinyuan is protected from that because the company mainly invests in the suburbs of the towns. They build and manage residential properties for middle class workers in second tier areas. Also, the company started diversifying their locations because it recently invested in the New-York (Brooklyn) area. 

After all, we've all heard our parents telling us that land and stone are the best investments because they are not risky. 

The valuation

Why is the stock undervalued? 

Regarding the Tangible Book Value, the company has $900M in total equity, nothing in intangibles and nothing in preferred stock. The number of shares outstanding being equal to 69M, we get a tangible book value of $13.04 per share.

If we value the company using the Net Current Asset Value, we find that Xinyuan has $3931M in current assets, $3320M in total liabilities, no preferred stock and 69M shares outstanding. We get then a value of $8.85 per share.

Now, if we try to value the firm based on the Graham Number, we need too important data used by Ben Graham in his book "Security Analysis". First, the tangible book value per share that equals $13.04 as calculated earlier and the earnings per share (EPS) that equals $1.06 in December 2016. We end up with a value of $17,63.

The Dividend Discount Model (DDM) confirms that the stock is undervalued. As stated before, the dividend per share in 2016 was $1.06. Since 2011, the dividend increased on average by 27%. However, we assumed in our calculations that for the next years, we will see an increase of only 7%. For a discount rate of 15% we get a value of $13.25 per share while we get an amazing value of 35.33 if we use a discount rate of 10%.

Furthermore, the Discounted Cash Flow (DCF) method suggests that the company has a value situated somewhere between $9 per share (for a discount rate of 15%) and $15 per share (for a discount rate of 10%). We think that the capital expenditures will decrease over the next years because the company wants to strengthen its balance sheet by reducing its debt. We did not include the change in working capital in our DCF because we considered that it was not necessary because the change in working capital has not impact on the capacity of the company to keep its competitive advantage (while the capex does). 

At the end, we clearly see that the stock is way undervalued. We estimate its value to be between $8 and $17 per share. Also, with a p/e of 4.5, a current ratio near 2X, a very good price to book ratio and an attractive yield, we estimate the stock to be of good value.

Please make your own research, and do not take this article as being an investment recommendation.