Discount cash flow analysis and reversed DCFA for Elsoft Research

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.

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

Elsoft appears to be a good company with its excellent past performance as shown in my write-up here.

http://klse.i3investor.com/blogs/kcchongnz/74663.jsp

To summarize, its revenue and net profit grew by 50% and 66% a year respectively for the past five years. However, in investing, do be cynical about growth rate as many businesses are cyclic and the power of mean reverting is strong in economics. What strikes me is Elsoft has never made a single year of losses since listing in 2004. It has consistently high return on capitals, positive cash flows as well as even free cash flow, every year.

We have done some simple relative valuations as in the link below and compare Elsoft’s market valuations with some other technology companies.

http://klse.i3investor.com/blogs/kcchongnz/74842.jsp

My conclusions are Elsoft is not cheap at RM1.91 apiece. But it is also not overly expensive, in absolute term, as well as compared with the industry and other technology stocks. This is to take into considerations of its good performance metrics and its growth potential. I have promised to do a discount cash flow valuation, and here it is.

Discount cash flow analysis

Financial theory postulated by John Burr Williams in his “The theory of investment value” suggests that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. This is similar to what Seth Klarman described as the Net Present Value analysis in his book “Margin of Safety” which he said is the most appropriate method to be used to value a company of on-going concern. Arguably the best reason to like DCFA is that it produces the closest thing to an Intrinsic Value.

Putting it into a diagram, it is like this:

As you can see, we have to decide or estimate two parameters first before carrying out the discount cash flow analysis; the discount rate r, and the future free cash flow, FCF. Readers should straight away notice the art, not the science, of valuation here.

Estimating Free Cash Flow of Elsoft

Table 1 in the Appendix shows that Elsoft’s revenue and operating profit or earnings before interest and tax (EBIT) has been increasing at a high compounded annual growth rate (CAGR) of 50% and 68% for the last 5 years to RM45.1m and RM19.5m respectively in 2014. Operating margin has been steadily increasing from 25% to 43%.

We start with the estimation of future free cash flow for Elsoft from its top line revenue in 2014. We first assume Elsoft’s revenue will grow by 20% a year for the next five years and 5% subsequently. This assumption of super growth rate is about 40% of its CAGR for the last five years.

Expected Growth_EBIT g = Reinvestment Rate, RR * Return on Capital, Return on capital, ROC

ROC = Ebit * (1-tax) / Invested capital

Invested capital = Fixed assets + receivables + inventories – payable

ROC for Elsoft is obtained as 63.7%. We will take ROC as 50% for the next five years and then as 20% subsequently.

RR supernormal growth = g/ROC = 20%/50% = 40%

RR terminal growth = g’/ROC’ = 5%/20% = 25%

Elsoft has just successfully renewed its pioneer status and will enjoy tax exemption for the next 10 years until 2025. We will take the tax rate for the next 5 years as 5%, the same of that of 2014, and then 10% subsequently.

The free cash flow for Elsoft is computed and tabulated in Table 2 in the Appendix using the above assumptions.

The required return of equity for Elsoft

When we want to invest in stock, we require a return over from an alternative investment, in this case a risk free rate, say for example fixed deposit interest rate, or a long-term government bond rate. We need a risk premium for investing in this risky assets, RP, which is the risk premium of the broad market over the risk free rate. Different companies in different industry will have specific risks of themselves.

We starts from the risk premium of the broad market, RP. We use a market risk premium of 6%, being at the upper range of historical risk premium in the US.

Expected return of KLSE, Rm = Rf + RP = 4.0% + 6.0% = 10.0%

As Elsoft is in the technology industry which is quite cyclical in nature, I add one percentage point to its risk. Its past performance and the near term future prospect of its earnings visibility and cash flow stability are reasonably good, I minus half a percent point from its risk. It has a great balance sheet with excess cash, and with no debts. Hence I minus half a point from this risk.

Below is my adjustment to obtain the required return r for Elsoft to 10.0%.

Rf	MGS	4.0%
Market risk premium	KLSE	6.0%
Industry	Technology	1.0%
Stability of earnings and cash flows	Great	-0.5%
Balance sheet	Great	-0.5%
Required return, r		10.0%

I will use this required return of 10% as a discount rate for getting its intrinsic value, or the present value of all its future cash flows.

Discount Free Cash Flow Analysis of Elsoft

Table 2 in the Appendix shows the detail calculations of the intrinsic value of Elsoft. The present value of free cash flow was obtained by summing up those of first 5 years of supernormal growth value and the terminal value. After adding the excess cash and other investments, gives the intrinsic value of Elsoft at RM3.00. This represents a margin of safety of 36% with the market price of RM1.91.

Reverse Discount Cash Flow Analysis (RDCFA) for Elsoft

Projecting future cash flow of the business is an art. There is simply too much uncertainty 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 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 DCF 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 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 RM1.91 for Elsoft as before, the RDCFA shows that the market is expecting its business to grow at a compounded annual rate of about 5% for the rest of its economic life from now. Do you think this is a reasonable growth expectation for Elsoft?

Conclusion

The discount cash flow analysis basing on a growth rate of 20% for the next five years and 5% subsequently estimated the intrinsic value of Elsoft to be RM3.00. There is a margin of safety of 36% at its market price of RM1.91. The reverse DCFA shows at RM1.91, the market is expecting its growth rate from now on for the rest of its economic life to be about 5%.  One has to judge if this expected growth rate is realistic.

Well like what Joel Greenblatt said at the opening of this article,

“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?

For the last call, contact me for a fee based online investing course at

ckc15training2@gmail.com

K C Chong (17^th April 2015)

Appendix

Table 1: Historical financial performance of Elsoft

Year	2014	2013	2012	2011	2010	2009	CAGR
Revenue	45143	25218	18758	12653	11269	5880	50%
EBIT	19477	10434	6585	4348	3675	1439	68%
EBIT margin	43.1%	41.4%	35.1%	34.4%	32.6%	24.5%
Tax rate	4.9%	4.6%	0.7%	1.0%	1.9%	5.5%
NOPAT	18532	9955	6542	4304	3603	1360	69%
Net change in WC	3979	-1032	612	1873	1295	-1883
Capex	651	4363	6049	51	178	83
Reinvestments	4630	3331	6661	1924	1473	-1800
						Average
Reinvestment rate	25%	33%	102%	45%	41%	49%

Table 2: Estimating and discount free cash flow analysis for Elsoft

Year from now	0	1	2	3	4	5	Terminal
Year	2014	2015	2016	2017	2018	2019	2020
Revenue	45143	54172	65006	78007	93609	112330	117947
Ebit margin	43.1%	43.1%	43.1%	43.1%	43.1%	43.1%	43.1%
Ebit	19477	23372	28047	33656	40388	48465	50888
NOPAT	18503	22204	26645	31973	38368	46042	45799
Reinvestment		-8882	-10658	-12789	-15347	-18417	-11450
FCF		13322	15987	19184	23021	27625	34350
Terminal FCF						686991
Discount rate	10.0%
PV supernormal	$72,613
PV TV	426568
Total PV	$499,181
Less debt	0
Add cash	44742
	$543,923
No. of shares	181130
FCF per share	$3.00
Price now	1.91
MOS	36%