Buying Quality Using Discounted Cash Flows

Valuation matters to me.  In fact, I’m particularly fond of one of the many aphorisms coined by Warren Buffett:  “Price is what you pay, value is what you get”.  With that in mind, I read an article this week in Barron’s suggesting Under Armour could double from its current price (thanks to @chriswmayer).  Eye catching for sure.  The company has been beaten down recently, and isn’t particularly expensive, but this wasn’t always the case:

“Under Armour must have been overvalued back in 2005, when it sold at a P/E of 90 and had a price-to-sales multiple of 6.3. Despite what looked like a crazy valuation, it is up nearly 500% since 2005, even after the huge pullback in the past year.”

I’d have struggled to buy at 90 times earnings and over 6 times sales, but are there circumstances in which I would pay a higher price?  Yes.  I’d pay a higher price for perceived higher value, and one way to determine value is through free cash flows.

Quality

When screening for stocks, I tend to rely on certain criteria.  And truth be told, in this instance I haven’t changed very much.  All I have done is relax restrictions on the valuation metrics whilst retaining determiners of ‘quality’.  With that in mind, I’m looking at the following:

  • Average 5 year ROE above 20%
  • Average 5 year ROCE above 20%
  • Current ratio above 1.5
  • Long term debt-to-equity less than 1
  • 5 year net income growth rate above 10%

I’m looking for growing companies who generate high levels of free cash flow, who are able to reinvest cash at a high rate of return.  Companies who’s assets comfortably cover liabilities, both current and long-term.  Running a screen on Google Finance returns 20 stocks (scroll across to view data):

Company name Market cap P/E ratio Price to sales Price to book Current ratio LT debt/equity (Recent yr) (%) Return on investment (5 yr avg) (%) Return on equity (5 yr avg) (%) 5y net income growth rate
Ab Dynamics PLC  115.94M33.135.456.185.04025.4625.6150.56
Bioventix PLC  113.85M27.1417.9913.5115.03042.7542.8331.63
Cellcast plc  3.98M5.340.311.592.43033.3145.5317.14
Craneware plc  345.76M39.118.278.351.7021.0321.3911.95
Dotdigital Group plc  214.74M35.677.328.935.19027.8228.4112.06
FDM Group (Holdings) PLC  986.90M33.384.4718.441.97045.1651.6525.09
Games Workshop Group PLC  539.56M17.793.438.641.91029.9930.5815.73
Gamma Communications PLC  600.58M34.152.797.32.09025.1426.4127.23
Hargreaves Lansdown PLC  6,502.34M30.6716.7521.051.65-74.7474.6313.39
Howden Joinery Group Plc  2,642.93M14.751.986.692.33035.8252.4617.81
Kentz Corporation Limited  1,121.96M25.251.125.571.690.3525.3126.7825.04
Moneysupermarket.Com Group PLC  1,716.11M22.995.289.341.53025.4130.2634.37
Mortgage Advice Bureau (Holdings) PLC  247.37M19.512.7516.71.64065.1370.3257.93
Nichols plc  684.66M275.497.933.27028.631.3313.84
Plus500 Ltd  1,042.53M8.233.79.88.060100.53100.8446.87
Polar Capital Holdings plc  404.72M25.945.325.633.69027.7528.0917.88
Quartix Holdings PLC  167.76M27.887.269.171.66030.1533.8238.05
Taptica International Ltd  227.44M17.832.255.491.59028.7130.7342.29
TRIAD GROUP PLC  8.85M6.170.32.581.77038.1754.3750.15
XLMedia PLC  265.62M13.763.293.282.42031.142925.89

Some familiar names in there, including current darlings Games Workshop and Bioventix.  As well as this, a few holdings in my portfolio, Taptica, Plus500, AB Dynamics and Howden Joinery.

Beyond this, however, I need to weed out those without consistent levels of free cash generation or net income to enable me to look at a DCF valuation range for those that remain.  Out go Triad Group, Cellcast and Polar Capital Holdings.

Today I’m going to look at three from the list that remain.  Quartix Holdings, Moneysupermarket.com and Nichols.

Valuations

Quartix Holdings

Quality
Google Finance

Quartix Holdings’ current valuation metrics:

  • Price/Earnings: 28
  • Forward P/E: 30
  • PEG: 1.35
  • Price/Sales: 7.2
  • Price/Book: 9.17
  • Price/Cash Flow: 30
  • Yield: 1.9%
  • Five Year Average ROIC: 30.15%

The discount cash flow valuation. Here are the calculations:

  • Free cash flow has grown steadily over the last five years, at a compound rate of over 43%.  Last year, the company generated £6m free cash.  I’ll be conservative and input £4m.
  • Net income has grown at the same rate.  For conservatism’s sake I’ll drop this from 43% p/a to 20% p/a for the next ten years.
  • As I usually do, I assume growth slows to 3% after these ten years to reflect an implied average inflation rate.
  • I will also use a discount rate of 10%, to reflect my required return.

Based on this calculation this gives a potential intrinsic value of £4.68, against a current valuation of £3.53.  A potential discount to intrinsic value of 32.5%.

Using free cash flow of £6m, a growth rate of 40% for five years, followed by growth at 3% thereafter gives an intrinsic value of £9.38.  A discount to intrinsic value of 166%.  FCF of £4m, growth of 20% for five years, followed by growth thereafter of 5% gives an intrinsic value of £3.57.

All in all, a lot of upside with reasonable downside protection in my view.


Moneysupermarket.com

Quality
Google Finance

Moneysupermarket.com’s current valuation metrics:

  • Price/Earnings: 23
  • Forward P/E: 17.6
  • PEG: 1.44
  • Price/Sales: 5.28
  • Price/Book: 9.34
  • Price/Cash Flow: 16.5
  • Yield: 3.1%
  • Five Year Average ROIC: 25.41%

The discount cash flow valuation. Here are the calculations:

  • Free cash flow has been somewhat lumpy over the past ten years, however it has always been positive and the trend has been upward.  Most recently it has generated £82m in free cash.  I’ll be conservative and use £50m.
  • Net income has grown at a compounded rate of 23.78% in the past ten years.  Growth has actually accelerated in the past five so I’ll leave it at 23.78%.
  • As I usually do, I assume growth slows to 3% after these ten years to reflect an implied average inflation rate.
  • I will also use a discount rate of 10%, to reflect my required return.

Based on this calculation this gives a potential intrinsic value of £7.01, against a current valuation of £3.19.  A potential discount to intrinsic value of 120%.

Using free cash flow of £80m, a growth rate of 23.78% for five years, followed by growth at 3% thereafter gives an intrinsic value of £5.52.  A discount to intrinsic value of 73%.  FCF of £80m, growth of 15% for five years, followed by growth thereafter of 5% gives an intrinsic value of £4.93.  A discount of 54.5%.

Another company with reasonable downside protection and the potential for a large upside.


Nichols

Quality
Google Finance

Nichols’ current valuation metrics:

  • Price/Earnings: 27
  • Forward P/E: 23
  • PEG: 1.82
  • Price/Sales: 5.5
  • Price/Book: 8
  • Price/Cash Flow: 42
  • Yield: 1.66%
  • Five Year Average ROIC: 28.6%

The discount cash flow valuation. Here are the calculations:

  • Free cash flow has also been bumpy for Nichols.  Whilst revenues and net income have been growing however, free cash flow has hovered between £5m and £18m.  For this calculation I will use a ten year average of £12.4m.
  • Net income has grown at a compounded rate of 17.18% in the past ten years.  Growth has slowed in the past five to 14% however, so I’ll go with that for the next ten.
  • As I usually do, I assume growth slows to 3% after these ten years to reflect an implied average inflation rate.
  • I will also use a discount rate of 10%, to reflect my required return.

Based on this calculation this gives a potential intrinsic value of £11.72, against a current valuation of £18.52.  A potential premium to intrinsic value of 36.7%.

If Nichols can pick growth back up to 17.18%, intrinsic value rises to £15.11.  The current valuation subsequently sits at a premium of 18.4%.

Fair to say there is limited upside to Nichols based on these calculations.  The growth in net income is not reflected in increased levels of free cash flow, impacting the valuation.

Conclusion

Fair to say not all quality companies are created equal.  On a free cash flow basis, larger potential premiums are allocated to those who are able to generate increasing levels of cash.  There is most definitely a tilt towards smaller, faster growing companies, and in fact this does limit the extent to which a discounted cash flow valuation method can be applied.  However, it is also useful in identifying those ‘no brainer’ stocks whose valuations are, based on cash flows, clearly trading at a discount to intrinsic value.  Buffett always says it should be clear when a stock is undervalued, and I can sort of understand what he means.

One Last Thing…

One major difficulty in holding growing companies is living with declines in value, which for some may be hard to stomach.  For example, Quartix has risen 143% in just under three years, or 38.06% compounded annually.  However it has also had peak to trough draw downs of 21%, and 38%, and is currently experiencing a decline of 12.7%.

Moneysupermarket.com has grown by 102% in ten years, or 7.05% compounded annually.  But there have been many draw downs.  82% in 2008, 34.9% in 2013 and 32.1% in 2016.

Nichols has experienced remarkable growth since 1999, up 1,194%, or 14.3% annually.  Growth has been pretty steady, however there were still a few fairly hefty declines of 27.8%, and 21.5% during this period.

Quality
Source: The Irrelevant Investor

I’m always keen to share the above graph representing peak-to-trough draw downs.  Whilst it is fair to say this is an outlier, this graph belongs to Netflix, which has gained 12,300% since IPO for a compounded annual growth rate of 38% per year.

The point is, hang in there.

 

Happy investing!

 

Leave a comment below, or find me on Twitter @BritishInvestor.

Disclosure: Taptica, Howden Joinery, Plus500 and AB Dynamics are constituents of the portfolio.

1 thought on “Buying Quality Using Discounted Cash Flows”

  1. I’m not sure I’d trust Taptica – it’s an Israeli company Listed on AIM and its projected figures are a little too good.

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