This analysis is for sharing of knowledge. It is not a buy or a sell call. Please do your own analysis before buying or selling.

“There are many areas in valuation where there is room for disagreement, including how to estimate true value and how long it will take for prices to adjust to true value. But there is one point on which there can be no disagreement. Asset prices cannot be justified merely by using the argument that there will be other investors around willing to pay a higher price in the future.”       Aswath Damodaran, Investment Valuation

Seth Klarman, in his book, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor,” emphasizes that while the net present value, or discounted cash flows analysis can give a wide range of results, it is still an essential valuation methods which should be thoughtfully considered in any business valuation for investors.

In my previous articles, I have attempted on valuation of Perstima and Padini using the dividends discount model (DDM) as their dividend pay-outs are quite predictable with consistent growing earnings and free cash flows and substantial cash in their balance sheets.

http://klse.i3investor.com/blogs/kcchongnz/85379.jsp

http://klse.i3investor.com/blogs/kcchongnz/85828.jsp

What if the company doesn't pay a dividend, or its dividend pay-out is way below its free cash flow (FCF), or the dividend pattern is irregular?

In this case, I can still carry out the same discount cash flow analysis but instead of using dividends as the future cash flows to investors, I can use FCF available to equity shareholders, or to the firm.

FCF is whatever cash is left after all operating expenses, including capital expenses for growth. FCF is like the end all goal of companies. The point is to do so well that you make so much money that even after all the checks written to expand the business you still have a lot of cash. Cash is pretty much the most important thing, and FCF is the most flexible kind of cash there is. With this FCF a company can pay out dividend consistently, buy back its shares when they are selling cheap, pare down loans, or invest in other profitable ventures, all done without assuming more debts, or issuing more shares.

The big advantage of using FCF in DCFM is that it can be used with a wide variety of firms that don't pay dividends, and even for companies that do pay dividends, such as Padini in the previous example.

In this article, I will do precisely that; to value what is Padini worth with the discounted free cash flows model (DCFM), using a two-stage DCFM.

Similar to DDM, we require two important inputs in this DCFM; the discount rate and the future FCF.

The discount rate

As similar to the previous DDM for Padini, I will use a discount rate of 10%, a risk premium of 6% over the bank fixed deposit rate. This rate has been articulated in the previous article.

http://klse.i3investor.com/blogs/kcchongnz/85828.jsp

Estimating future free cash flows

In this analysis, the FCF are forecasted for ten years for the equity shareholders (not the firm FCF) as Padini’s debts is minimal, and then a terminal value is calculated to account for all the FCF beyond the forecast period.

Table 1 in the Appendix shows Padini has consistent positive FCF over the last 7 years, with an average FCF of RM72m. Last year, FCF was excellent at RM150m.

In this model, we will use the average, or a normalized FCF of RM72m as the base and assuming this FCF will grow at 8%, less than its compounded annual growth rate of FCF of 17% over the last 7 years. This rate is also half its growth in cash flows from operations of 16%.

Discounted Free Cash Flows Analysis

Table 2 in the appendix show the data and assumptions and the two-stage DCFM computed using FCF on a spreadsheet. The present value of all future FCF attributed to the equity shareholders from the ordinary business using this method is shown to be RM1.535b. Adding the total cash and cash equivalent of RM246m, the total present value attributed to equity shareholders is RM1.781b, or RM2.70 per share.

This present value, or intrinsic value of the stock represents a margin of safety (MOS) of 39% investing in Padini at today’s price of RM1.65 on 13^th November 2015.

For a company like Padini, a MOS of more than 30% is what I am looking for as an investment.

Reverse Discount Cash Flow Analysis (RDCFA) for Padini

Projecting future cash flow of the business is an art. There is simply too many uncertainties when trying to forecast this future cash flow.  A small error can result in a drastic change in the value. Rather than starting your analysis with an unknown, a company's future free cash flows, and trying to arrive at a target stock valuation, start instead with what you do know with certainty about the stock: its current market valuation.

By working backwards, or reverse-engineering the DCFM from its stock price, we can work out the amount of cash that the company will have to produce to justify that price. If the current price assumes more free cash flows than what the company can realistically produce, then we can conclude that the stock is overvalued; if the opposite is the case, and the market's expectations fall short of what the company can deliver, then we should conclude that it is undervalued.

Basing on the market price of RM1.65 for Padini, the RDCFA shows that the market is expecting its business to grow at a compounded annual rate of just 1% for the rest of its economic life from now on. Do you think this is a reasonable growth expectation for Padini, after taking into consideration of its recent past performance and that the inflation rate and GDP growth is about 3%-4%?

Conclusion

The discount cash flow analysis basing on a growth rate of its FCF of 8% for the next 10 years and 3% subsequently estimated the intrinsic value of Padini to be RM2.70. There is a margin of safety of 39% at its market price of RM1.65.

The reverse DCFA shows at RM1.65, the market is expecting its growth rate from now on for the rest of its economic life to be about 1%.  One has to judge if this expected growth rate is realistic.

Well like what Joel Greenblatt said,

“The secret to successful investing is to figure out the value of something-and then pay a lot less.”

Do you think it is good to know how to figure out the value of a share and then pay a lot less in order to be successful in your investing experience?

Feel free to contact me for online investing course for a small fee at

ckc14training2@gmail.com

K C Chong (15^th November 2015)

Appendix

Table 1: Cash flows of Padini

Table 2: Discounted free cash flows analysis of Padini