“Excellence is a continuous process and not an accident.” 
 
                                                                                   -    A. P. J. Abdul Kalam 

“Business, more than any other occupation, is a continual dealing with the future; it is a continual calculation, an instinctive exercise in foresight.”
 
                                                                                  -   Henry R. Luce 

In this second of a three-part series, I walk readers through some of the functional elements of my valuation tool set and their role in calculating intrinsic value.
 
Successful investing is as much a failure-prevention process as it is looking for undervalued growth opportunities. Henry Petroski once said, “Failure is central to engineering. Every single calculation that an engineer makes is a failure calculation. Successful engineering is all about understanding how things break or fail.”[1] Value investing is no different. Great investors avoid failure (most of the time!) by understanding the elements that often lead to failure.
 
My discounted cash flow (DCF) spreadsheet tool is used to answer the five questions mentioned in Part 1. These were:

1.  Are managers great allocators of capital? Do they use assets to drive future growth (hopefully highly profitable) over the long-term?
2. Does the company have the financial strength to shake off even the most severe economic or financial challenges?
3. Does the company have the ability to earn a return on capital greater than its weighted cost of capital over a 10 - 20 year time horizon?
4. Does the company have the ability to beat competitors over the same time horizon?
5. Calculate whether the share price is indicative of an adequate margin of safety to purchase, hold, or sell.

 
To answer these questions, I’ve selected some of the major categories in the tool set I find helpful in calculating intrinsic value. These aren’t a complete list. A full description of the total functionality of the tool would take a small book that would – with all likelihood – be a bestseller at the “American Society of Chronic Sleeplessness” annual meetings.
 
Rate of Return
 
By way of illustration, in this column we will do a calculation to see which is a better deal – a 10-year US Treasury note (risk free, in all probability), or the potential investment. I use two measures as modeled by Warren Buffett – rate of return by P/E ratio and rate of return by earnings growth. Both methods of this approach allow an investor to make a reasonable projection of value going forward if the company has a competitive moat and steady earnings growth. I should point out this method is less effective with companies that have extremely lumpy earnings or no competitive moat. Both numbers should be significantly higher than the current yield on the 10-year Treasury. I look for a company that I expect to achieve 20% or greater in both rates of return.
 
Balance Sheet Strength
 
A strong balance sheet allows a company both offensive and defensive options. In the case of a significant downturn the company can rely on cash on the balance sheet to fund operations (defensive) or acquire undervalued competitors (offensive). I use three measures: Cash as a percent of assets, cash as a percent of liabilities, and cash used as reduction of P/E. Generally, I look for companies that have 50% or more of assets in cash and 100% or more of liabilities. This process protects me on the downside from potential blow ups that can lead to permanent capital impairment for my investors.
 
Free Cash Flow Yield
 
Free cash flow yield is another simple calculation that tells you the general value (and risk) of your potential investment again a 10 treasury. You can do two different measures dependent your own personal values. Some use a free cash flow variant while others use an earnings variant. I happen to use both and look for the free cash and earnings yield to be at 15 - 20% or greater than the yield on a 10 Treasury.
 
Return on Invested Capital
 
The difference between return on invested capital (ROIC) and return on allocated capital (ROAC) is that the latter tells us more about management while the former tells us more about the business’ characteristics. Return on invested capital can be calculated in hundreds of ways. The formula I prefer to use is the following:

​This calculation removes some of the numbers that can skew ROIC numbers. Companies with large goodwill or cash on the balance sheet can see ROIC be highly inflated or deflated in a manner that means very little as to the company’s return on invested capital.
 
Return on Allocated Capital
 
Return on allocated capital is measured quite differently from return on invested capital. Here I’m looking to see how good management’s skill is in allocating retained earnings. There is no more important job for management than allocation of capital. It’s very difficult to see long-term profitable growth if your investment’s managers unwisely use retained earnings and cash to grow (or shrink!) the business. The formula used in this case:

Using both ROIC and ROAC gives a varied look at the profitability of your investment (along with others such as free cash flow yield). Combined with these measures is return on equity (ROE) and return on assets (ROA). For ROIC and ROAC I look for 25% or greater and 15% or greater for ROE and ROA.  
 
Cash Return
 
The cash return formula measures how efficiently the business is using its capital -- both equity and debt -- to generate free cash flow. The formula is free cash flow + net interest expense divided by enterprise value.   I generally look for a cash return of 7% or greater.
 
IRR Treasury Review (or Buffett’s “Equity Bond”)
 
This is a wonderful tool used by Warren Buffett to quickly size up your expected internal rate of return (IRR) in a stock versus the IRR of a 10-year US Treasury. By utilizing the last 10 years earnings, an investor can identify what price is necessary to meet the Treasury’s return. This is another great tool to assess the risk premium you are being paying versus a risk-free asset.
 
Discounted Free Cash Flow (Intrinsic Value)
 
A discounted free cash (DCF) model uses future free cash flow projections and discounts them - using a required annual rate - to arrive at present value estimates. That present value estimate is then used to evaluate the potential for investment. There are several things that impact a DCF model – the current share price, the number of shares, current free cash flow, estimated 10-year FCF growth rate, perpetuity growth rate, and discount rate. The first three need no description but the final three can be quite subjective. For an estimated free cash flow growth rate, I generally start by looking at the last 10 years rate, halving it, then sometimes halving it again. I vary this discount depending on my level of uncertainty but generally discount it by 50 – 85%. In almost all case I attempt to break my investment case by halving the 10 year rate and then halving it again. As an investor, the level of discount is really dependent upon your comfort level of your estimate. My suggestion is that whaever number you finally come up with halve it. That’s what’s called a margin of safety!
​
Always assume the worst and build from there. For a perpetuity growth rate some use 4% but I think this is too aggressive; I use 3% on average. Finally, to calculate the discount rate I start with current 10-year Treasury rate and then add on for company size, financial leverage, cyclicality, management governance, economic moat, complexity of business and its previous weighted average cost of capital (WACC). Dependent on these factors, a discount rate can range from 7% - 13%. As I’ve stressed before, the use of a DCF model should give an estimated intrinsic value – not an exact intrinsic value. It should also demonstrate whether the current price provides an adequate margin of safety.
 
As an aside, you can pull up companies either in my portfolios or watch lists by creating the following screen on Gurufocus.
 
Debt-to-Equity                                 0%
Return on Assets (10 Year)             >15%
Return on Equity (10 Year)             >15%
Return on Capital (10 Year)            >15%
 
This screen will generally get you to about 150 companies or less.
 
Part 3 in this series will utilize a case study of a company on my watch list and former holding in the Nintai Charitable Trust.
 
As always, I look forward to your thoughts and comments. 

​[1] Petroski is a professor of civil engineering and history at Duke University. His “To Engineer is Human: The Role of Failure in Successful Design” (Vintage Press, 1985) is considered a classic and I recommend everyone read it at least once in their investing career. 

“Earnings are only a means to an end and the means should not be mistaken for the end. Therefore, we must say that a stock derives its value from its dividends, not its earnings.”

                                                                                   - John Burr Williams 

“In ‘The Theory of Investment Value’, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond, or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset.” 

                                                                                  - Warren Buffett 

After I wrote a recent article (“Value Investing and Relativity” August 2017), many individuals asked if I could write about the proprietary discounted free cash valuation model I used at Nintai Partners and still use at Dorfman Value Investments. The amount of content required for a sufficient explanation is enough to break this into three articles – definitions of free cash flow (FCF) and model pros and cons (Part 1), describing FCF model steps (Part 2), and a working example of the FCF tool in a corporate valuation (Part 3).   
 
Some Definitions and Background
 
Free cash flow represents the cash that a company is able to generate after spending the money required to run operations and spend adequately for future growth. Free cash flow is simply operating cash flow less capital expenditures. Capex is a vital step in growing many businesses and it is - after all - paid in cash, so its use in corporate FCF valuation is essential. FCF is calculated by the following formula.
 
          EBIT + Depreciation + Amortization - Change in Net Working Capital - CapEx
 
Of all the numbers used to calculate valuation, free cash flow is arguably the hardest number to manipulate. Sometimes earnings aren’t what they appear to be, but cash is cash. When my investment partners’ hard-earned savings are at work, I look to use many tools to reduce downside risk. By basing my valuation models on cash, I believe I’m using the most solid measurement available to an investment manager.
 
Pros and Cons of DCF Modeling
As with any valuation tool, a discounted FCF model has both its positives and negatives. Dependent on your strategy, investment style, and valuation proclivities, a discounted FCF model can make sense or not. Let’s start with the negatives.
 

1. Discounted FCF can give an investor a false sense of security in the establishing a company’s intrinsic value. Getting the estimate to within a penny can often lead investors to think valuation is more a science than an art.
2. The smallest changes in growth rates or average cost of capital can make an enormous difference in your final value. I wrote about this earlier in “Moats and Terminal Value” (October 2017). Estimates must reflect the most reasonable – and conservative - numbers available to the investor.
3. Discounted free cash flow valuations are the least static of valuation models. They should be constantly updated as new information becomes available. I generally update mine after the release of each 10-Q. If I’ve done my job well, valuations rarely jump significantly but are tweaked as necessary.
4. DCF models take an awful lot of time to research and get the numbers right. One should have a detailed understanding of the company, its markets, and its chief competitors. Achieving valuable insights in DCF calculations means you become very comfortable with every aspect of your portfolio holdings. For me, this means keeping the total number of stocks in the portfolio down to only 15-20 stocks.

 
Not everything about DCF models are negative. I’ve found over time the positives far outweigh the negatives.
 

1. Free cash flow is the hardest of numbers to cheat on when reporting financials. Financial reporting today means earnings might be earnings, but cash is still cash. Basing your valuation on the soundest basis will cut down on the inevitable blow ups that happen every now and then on Wall Street.
2. DCF models scrub out short-term trends and general market conditions that play little role in calculating long-term value of a potential holding. If an investor’s decision to hold is based on each quarter’s earnings report, then they are not investing, but speculating. A good DCF model keeps an eagle eye on the long-term trends in free cash flow and guides long-term decision making.
3. A DCF model generally makes an investor to focus on several areas critical to a company’s long-term performance. Weighted average cost of capital (WACC) and free cash flow growth rates should be supported by such numbers as return on capital, cash return, and IRR versus Treasury bills. All of these will begin to nail down the company’s breadth and depth of their competitive moat, their strength in the marketplace, and management’s ability to allocate capital. Understanding these are essential to provide estimates on long-term value creation.

 
A Process not a Solution
 
For all the benefits of a vigorous DCF valuation model, investors should be crystal clear this is a process – not a solution – in attempting to come up with a reasonable intrinsic value for their investment. Nothing in the DCF model will give an investor a definitive answer. In the parlance of Wall Street, the process should add some “color” to your knowledge base. As an investor works through their model, the process should answer some general – but vital - questions.
 

1. Are managers great allocators of capital? Do they use assets to drive future growth (hopefully highly profitable) over the long-term?
2. Does the company have the financial strength to shake off even the most severe economic or financial challenges?
3. Does the company have the ability to earn a return on capital greater than its weighted cost of capital over a 10 - 20 year time horizon?
4. Does the company have the ability to beat competitors over the same time horizon?
5. Calculate whether the share price is indicative of an adequate margin of safety to purchase, hold, or sell.

 
The DCF calculations aren’t the only step in answering these questions. I look to develop a better understanding of the company by other calculations. These include cash return, return on capital, gross/net margins, IRR vs risk free return (equity premium), rate of return, etc (I will discuss these in much greater detail in Part 2). All of this data is loaded into one spreadsheet with the ability to tinker with the numbers as needed. Behind all this data is in-depth research on the markets, competitors, regulatory, and other issues which drive company performance at a macro level.
 
Conclusions
 
Any valuation tool should try to scrub out information that can skew results from subjective or fuzzy thinking. Hunter Thompson once said the only objective reporting was the horse race ticker. This tool – though somewhat more subjective than the latest Pimlico results - forces me to review new data and trends as they appear not how I want them to appear. There is much research that doesn’t get plugged into the spreadsheet. These will be layered on top of some calculations or integrated into specific calculations. Is this process perfect? Not at all. But it forces me to use data to come up with my best shot at what I think an individual share is worth.
 
Part 2 of this series will cover the major components of my valuation spreadsheet functionality.
 
As always I look forward to your thoughts and comments.
 
Disclosure: Dorfman Value Investments currently has no interest in stocks mentioned in this article.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

“You think your facts are more valuable than my feelings. I’m tired of being told facts. Sometimes facts just don’t matter. Sometimes facts are not facts”. 

-    Bobbie Sanders, (Inaugural Attendee)

One attendee said, “I think stock picking abilities are overrated. I’ve beaten the stock market for something like 6 years in a row. People in index funds are driving a VW while I’m in a Porsche”. When asked how his returns fared versus the S&P500 Index, the investor said he really didn’t track numbers like that. 

-    Shaun Rodriguez

The view from the top of bull markets is remarkably like that from the top of the Matterhorn. What begins in a slow ascent at the base becomes a near vertical cliff for the last quarter. Sitting at the apex one might be inclined to puff up a little bit about their climbing abilities. One things climbers will tell you on a regular basis is that disaster usually happens when you lose that sense of risk. Studies show that 60-70% of accidents happen to climbers on the way down not on the way up. It’s often referred to as “hikers’ letdown” . While the view from the top is great, the danger lies in getting cocky at the height of the climb. 

Market Bubbles

I bring all this up because many investors are sitting smugly on top of their own investment Matterhorn – serenely looking down at those numbers that seem so small down below. If we follow our hiker’s advice, now is the time to utilize the most caution and avoid the 1000-foot fall into a market crevasse. Put another way, Ieyasu Tokugawa always said that after a victory one must tighten the helmet strap.

The funny things about market bubbles is you can’t put your finger on exactly when they start or even if you are in one at the time. Knowing you have been in one is a heckuva of a lot clearer. But I would proffer that in the later stages of a bubble there are some events that take place that really aren’t seen in less exuberant times. For instance:

1. At the height of the Japanese asset bubble in 1989, the value of the land underneath the Imperial Palace in Tokyo (roughly 280 acres) was worth the same as the entire acreage of California (roughly 100,000,000 acres). 
2.  Near the height of the technology bubble in 1999, there were 457 IPOs of which nearly 80% were technology companies. Of those, 117 doubled in price on their first day of trading. 
​3.  In 1999, thirty of the top 50 stocks (by market size) on the Nasdaq exchange had prices that reflected estimated growth to be 35% for the next 50 years. 

Cryptocurrencies: The Symptom or the Disease?

We all generally look back and wonder how we couldn’t see the bubble at the time. With 20/20 hindsight it looks so obvious. But we shouldn’t be so smug to think we can’t be fooled again. Take a look at some of the latest news surrounding cryptocurrencies.

•    Ripple (which owns XRP, a digital currency) rose to nearly $4 per share. This made its majority shareholder and CEO Chris Larsen’s net worth jump to roughly $60B – placing him number four on the Forbes 500 richest. The vast majority of this wealth has been generated over a period of roughly 180 days. 
•    SkyPeople Juice International, a company that makes – wait for it, juice – renamed itself Future Fintech Group and saw its stock jump by 280%. 
•    Not to be outdone, Long Island Ice Tea company changed its name to Long Blockchain and saw its share price jump by 600%. More than 15 million shares changed hands the day the name change was announced, compared with average daily volume of about 170,00 shares over the prior three months.
•    CNBC reports an ever-increasing amount of people are utilizing debt to purchase cryptocurrencies. In an interview Josh Fairfield says “People are maxing out their credit cards because they think it's going to make them a lot of money," said Fairfield. "They've been right enough that people are now making ever more risky investments in cryptocurrencies."
•    Software developer Rishab Hegde launched a cryptocurrency he called Ponzicoin. The company described its offering as “the world’s first legitimate Ponzi scheme” and encouraged people to buy and then “shill this coin heavily to your family and friends like a fucking sociopath”. Owners of the company had to shut the site down after “things got crazy out of hand”. 
Watching the cryptocurrency craze sweep over Wall Street, Ben Carson wrote on his wonderful blog A Wealth of Common Sense, “Hundreds of billions of dollars in a currency have been created basically out of thin air over the past few months. This doesn’t seem normal.”

Indeed. It definitely doesn’t seem normal. Most of the aforementioned events lead me believe there is a great deal more speculation than investing in cryptocurrencies. But I’m not sure it stops there. With the major indices trading at levels not seen since the mid-1920s (!), one has to think long and hard whether stocks are currently in a bubble or not.  Only one thing is certain: panics in cryptocurrencies, stocks, or tulip bulbs pop because of a lack of confidence. David Preiser says “Until 2008, people thought debt problems were confined to specific sectors. But when the bubble burst, ¬trouble popped up in unexpected areas.” Financial complexity brings prosperity but also increased fragility. Since the Lehman collapse it’s been a long and slow recovery. But the underlying problem remains: The entire edifice is built on confidence, and that can evaporate pretty quickly. The next global crisis will stem from failure of confidence somewhere.” The recent drop in Bitcoin values would suggest many investors have lost confidence in their investments. 

Conclusions

When I began writing this article, the town of Zermatt at the base of the Matterhorn was attempting to evacuate 13,000 tourists. The mountain received nearly 12 feet of snow in a matter of days triggering avalanche warnings. The obvious fear was the town would be swept away in an extraordinarily large avalanche. Thankfully it didn’t happen, but that didn’t mean officials didn’t take it seriously and prepare for the worst. If you are sitting atop your own investing Matterhorn be prepared for a bumpy descent down. Remember climbers die on the way down not the way up. Ask any investor in technology stocks in 2000-2002 or financial stocks in 2007-2009 and most remember the ride down not the ride up. It is truly time to tighten the helmet strap.  

As always I look forward to your thoughts and comments.