What You’ll Learn
- Why I’m Using EPS as a form of cash flow in the DCF
- Where I get my growth rates
- How to think about discount rates
- Whether EPS is wrong in a DCF
- Extra words on valuation and extra reading
- Download a preloaded MSFT example spreadsheet
Click on the download button below to get the sample spreadsheet mentioned above.
With the release of the updated OSV Analyzer, a big change that took place was including the use of EPS as a form of “cash flow” into the DCF.
I’ll get to why, but first things first.
The other big changes that took place are:
- The data provider has been switched over from Morningstar to EdgarOnline to provide more accuracy and quicker updates.
- There’s 3x more data and even more detail to help you speed up research and make better decisions
- All the valuation models have been enhanced to provide better forward looking valuations
Previously I mentioned that I’m now using a new method to calculate growth rates.
Until now, I was using historical data to project forward, but the problem is that this method ignores forward looking scenarios.
If a company had great growth the past 5 or 10 years, the models would assume that it would continue.
I gave the example that it was like walking backwards, whereas the new growth method lets me to walk forwards.
That’s why a company like Apple (AAPL) was defaulting to a growth rate of 38% as it was only looking in the past.
Now, AAPL defaults to a growth rate of 12.6% because it looks at
- Next Year Growth
- Next 5 Year Growth
- Industry Long Term Rate
to determine the growth rate input in the DCF.
Understanding and Overcoming the Downsides of a DCF
This brings me to the idea of including EPS as the input for the DCF.
Buffett and Munger have stated that they don’t use DCFs, spreadsheets or calculators when assessing and valuing businesses.
Bruce Greenwald expressed his dislike for DCF because the future inputs required which are guesses at best.
On the other hand, Professor Aswath Damodaran has shown how it is possible to value any stock with a DCF as long as you do the detailed work.
If I boiled it down to a few common issues, it’s like this:
- future growth rates are impossible to estimate
- discount rates are difficult to estimate because it’s different for every company and industry
- FCF is very lumpy across most companies and industries
There’s nothing you can do about point 1 because investing requires speculation about what the future will bring.
With point 2, it’s not a good idea to constantly play with discount rates to make your valuations match the stock price. However, it is important to adjust the discount rate depending on the company.
A low risk investment like a AAA bond isn’t going to be valued using a 10% discount rate.
The discount rate for Microsoft is going to be much lower than a junior metal miner.
It’s easy to oversimplify the discount rate as a single number, but when I use 9% for large caps, it’s made up of a risk free rate of 2.5 to 3% and a market risk premium rate of 5 to 6%.
= Risk Free Rate (10 Year Us Treasury Bill)
+ Market Risk Premium (my minimum desired return for risking my money in the market)
Discount Rate = 2.5% + 5% or 3% + 6% = 7.5% to 9%.
For small and “risky” stocks, I want a higher return on the money so my risk premium goes up to 8-9%.
It’s the same concept as a bank. For people with bad credit, a bank may charge 10% interest on a loan compared to 6% for a person with good credit.
Now how do you handle point 3?
First, you need to think about why you are valuing stocks in the first place.
Valuation exists purely so that you and I know how much we should pay for an asset. If you don’t have any money in the market, your stance on valuation may be on making sure that the inputs are absolutely correct.
But I’d rather profit, than be a prophet.
What that means is that even if I’m right only 40%, I can make profit from my ideas.
My goal isn’t to have a 100% accuracy rate. That would be awesome, but impossible.
I want to be approximately right and profit by having a good range of intrinsic values and then apply discipline and margin of safety rules.
Using EPS in a DCF
Over the years of performing various valuation techniques across hundreds of companies, DCF only works a handful of the time when using an automated calculator.
Most investors don’t know – and won’t be able to do it manually – by going through the SEC reports directly and breaking down every detail.
Unless you’re a full time investment banker where it’s your job, it’s not possible for the majority of investors.
With FCF being so lumpy, it creates intrinsic values that are way off.
Here are a few examples of using a standard DCF with FCF vs EPS.
3 stocks displayed here are a tiny sample size for sure. And most likely I’ve subconsciously cherry picked these three stocks for the article.
Nevertheless, if you use the OSV Analyzer, you will definitely notice a more consistent valuation range and how it’s now more applicable to a wider range of stocks.
Evidence that Stock Prices Follow EPS
Gurufocus beat me to it and tested the use of EPS in a DCF. The test isn’t perfect but it’s a good one which I recommend you to read.
Also back in 1994, a paper titled “Accounting earnings and cash flows as measures of firm performance: the role of accounting accruals” was published in the Journal of Accounting and Economics.
The author provides evidence that supports the idea that stock prices follow earnings than other forms of cash flow measurements because of the noise in cash flows. Things like accounting accruals, cash related transactions, changes in working capital and the ever changing needs of capex.
Keep in mind that if you go in to any experiment set to prove your assumption, there’s always a way to make the data fit your assumption. I mention this because there are just as many papers and books discussing how FCF should be the only cash flow used in a DCF.
However, what I’m really after is a practical use of DCF for valuing stocks.
The textbooks and papers are great. They are spot on.
But sometimes, what works in theory doesn’t work in the real world.
In theory, the markets are 100% efficient and intrinsic value is a single value accurate to two decimal places.
In the real world, the markets have pockets of inefficient areas and intrinsic value is a range because the future can never be modeled or predicted with accuracy by people.
If you look at the chart above of Chevron, I find it difficult to believe that CVX is worth a negative value based on a standard DCF with FCF.
I also don’t see how the market is inefficient with AAPL for more than 10 years when FCF is used. These are clear practical signs where FCF is an imprecise method of valuation.
But EPS Is NOT a Cash Flow Figure
Here’s the best table I found comparing the differences.
EPS (or net income) is defined as profit after taxes, the impact of capital structure (interest), AND non-core business activities.
It’s not discretionary cash flow a company generates.
Buffett said that the true value of a business is;
the discounted value of the cash that can be taken out of a business during its remaining life.
– Warren Buffett
Yet we (sort of) know that Buffett also likes to use simple EV/EBIT multiples to judge the value of a business. And at the same time, you know from experience the difficulty with trying to predict reasonable cash flows.
But what if the FCF or operating income is negative?
Here’s an answer from a site that helps people gets jobs on Wall Street.
A: Then you really shouldn’t be using a DCF to value the company – or you need to project the company over a much longer period until it starts generating positive Operating Income or Free Cash Flow (i.e. for a pharmaceuticals company where it might take 10-20 years to generate revenue).
This pretty much confirms what Seth Klarman says about DCF.
When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present-value analysis an imprecise and difficult task.
– Seth Klarman
Seth Klarman is one of the best investors there are, but he’s saying that he doesn’t like DCFs that much.
So who’s right?
Buffett or Klarman?
The answer is that they are both not wrong. The same train of thought applies to EPS or FCF.
EPS may not be the best, but it’s also not wrong.
FCF may not be the best (theoretically it’s the best), but it’s also not wrong.
The key is to understand that DCF and any form of valuation is an art.
What I believe with certainty is that;
In the short run, the market is a voting machine but in the long run, it is a weighing machine.
– Ben Graham
So again, I come full circle back to the point of why I’m using EPS.
Because I want to profit off my stocks and it provides an adequate intrinsic value range for a variety of stocks I look at.
My goal is to profit from stocks. Not to be a prophet of stocks.
Word on Business Valuation
The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to protect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.
– Ben Graham & David Dodd
Graham and Dodd understood that valuation is an art.
Markets exist because of differences of opinion among investors. If securities could be valued precisely, there would be many fewer differences of opinion; market prices would fluctuate less frequently, and trading activity would diminish.
– Seth Klarman
With that, here’s a sample file of the OSV analyzer preloaded with MSFT. Go to the DCF section to see the values as it has recent data for MSFT.
So what are your thoughts on using EPS in a DCF?
Yes or no?