Blog 1 - The real role of DCF in Investing by 2Point2 Capital
Please find below our key excerpts of yet again a decent blogpost from team of 2point2 capital. (Emphasis Ours)
Warren Buffett gave a simple summary of the DCF formula in his 1992 Berkshire Hathaway shareholder letter – “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”.
DCF has had its fair share of critics:
a) The criticism has been the loudest when the markets are exuberant and when many stocks trade at exorbitant valuations that cannot be justified by DCF.
b) criticism of DCF stems from its complexity and its sensitivity to assumptions
A DCF valuation requires two critical inputs – a forecast of cash flows (in perpetuity) and a discount rate. The DCF’s sensitivity to assumptions means that it can be fairly unforgiving of any mistakes in estimating the inputs.
There can be a 9x difference in value if growth rate changes from 8% to 20% and discount rate from 14% to 10%. Even when the changes are smaller, the differences are quite large.
DCF results in widely varying estimates of value because small changes in assumptions do have large effects on the intrinsic value of a business. .
Most of the value of a business lies far away in an uncertain and unpredictable future or what investors call Terminal Value.
If a business has predictable cash flows, it is easy to calculate its intrinsic value. As the cash flows become more uncertain and further out into the future, it becomes difficult to come up with a reasonable estimate of intrinsic value.
Alternative methods like valuations multiples (P/E, P/S, EV/EBITDA, etc.) have become popular because they seem easier and intuitive compared to the DCF. But it is important to remember that these metrics are just derivatives of the DCF model and not independent valuation methods. The underlying assumptions of a DCF model are explicit and transparent but those of other valuation multiples are implicit and hidden.
NOTE: Please read our Valuation series Post 5 to Post 10 to get a hang of Drivers of business valuations. Also read this fantastic research paper by none other than Michael J. Mauboussin on factors affecting valuation multiples:
It uses the market price to back-calculate the implied assumptions. The analyst can then evaluate whether the implied assumptions are reasonable or not. If the implied assumptions seem aggressive/unrealistic, the stock is potentially overvalued.
Case Study: Asian Paints
As of now, Asian Paints has a market cap of US $ 39 bn.
For Asian Paints to have an intrinsic worth of 40 bn $s, it would need to deliver 20% EPS CAGR(!!) for the next 20 years. Also after 20 years terminal growth rate has been kept at 6% and ROE has been constant at 27% with cost of capital as 11%.
We can analyse whether this is a reasonable expectation or an improbable one (For comparison – Asian Paints EPS CAGR over the last 10 and 20 years was just 14.1% and 18.5% respectively). Based on such analysis, we can then conclude whether the current stock price undervalues or overvalues Asian Paints.
Blog 2 - STRUCTURAL WHEN CHEMICALS, CYCLICAL WHEN ALUMINIUM?
Read Our Key excerpts from the below blogpost explaining origins of China+1 and similarity between shift happening in chemical space and aluminum industry. (Emphasis Ours)
On an average, over the past decade, Chemical companies have catapulted 50x. Their historical earnings during the same period have jumped 5x, implying meaningful expansion in valuations.
And the story, you would say, is straight forward, right? Chemicals is a polluting industry; China did whatever it had to do over the past 2 decades and is now incrementally focused on environment. Plus, post-Covid, the world is tired of the supply chain hassle and wants ‘China plus one’ procurement. Indian companies are well placed in simple as well as complex (or multi-step) chemistry. Plus, managements speak decent English to converse with buyers, labor cost is low, law of the land holds, currency is broadly stable and companies are free to pollute their way to growth. A minuscule move away from China would double revenues of Indian companies.
But what if I were to tell you that the exact same story is playing out in aluminium, and whereas all of us see the chemicals story as “structural”, we view the aluminium price move as “cyclical”.
That is to mean that good chemical companies deserve a 30x PE multiple, but metal companies are something of a fad and hence deserve a single digit PE multiple and are generally not worthy of a place in our portfolios for the long term.
Aluminium is a reasonably new metal. Unlike steel’s history of thousands of years, aluminium’s history dates back only to early 19th century, when it was considered ‘holier than thou’ (Napoleon III, the first president of the French Republic, served his state dinners on aluminium plates while the rank and file were served on plates made from gold. Yes, you read that right!).
In 1970, NAFTA and USSR accounted for 58% of global aluminium production. By 1998, aluminium production had doubled from 1970 levels, but these countries still accounted for 40% plus of global production. Here is where things started to change.
At the turn of the new millennium, aluminium was THE shiny new metal; it weighed a third of steel, was corrosion resistant, completely recyclable and had good electrical conductivity. It was the metal of the future and all countries creating infrastructure were looking at aluminium with a lot of hope. Sadly, one of those countries was China.
Broadly speaking, to make one ton of aluminium, you need two tons of alumina, four tons of bauxite and 15,000 kwh of electricity. Whereas aluminium smelters and alumina refineries can be built, bauxite and coal (traditionally the fuel for electricity) occur naturally. Historically, therefore, the largest aluminium producing countries were the ones that had access to cheap electricity and bauxite.
That was about to change. In the run-up to 2020, the global aluminium smelting capacity would nearly triple. What was more striking was that China accounted for more than 80% of the incremental capacity. That’s HUGE. For a country that imports bauxite (by my estimate, 40% of bauxite that China requires is imported) as well as coal to generate power only to export aluminium while its domestic companies incurred losses was baffling.
Now the thing we conveniently forget is that aluminum is also a highly polluting industry.
Last year, China accounted for over 56% of global aluminium production with a carbon footprint that is much larger than rest of the world (given huge transportation for bauxite and coal, plus largely coal-fired power plants). As the Chinese government started clamping down on aluminium production to curtail emissions, aluminium prices hit a decade-high this week.
Since 2000, however, whereas absolute aluminium prices are up 65%, adjusted for global inflation, they are down 25%. The three listed aluminium companies in India generated a single digit ROCE last year, and two of them are integrated with captive bauxite, and the third one has the lowest conversion cost.
Indian companies combined have the production capacity of over 4mt and they trade at single digit PEs. Over the past two months, aluminium prices have moved higher by USD300/t, resulting in an annualized increase in EBITDA by over USD1bn combined.
As many global brokerage houses start pegging next year aluminium prices at over USD3,000/t, which of the below do you think is the right question to ask? (a) should aluminium companies be a part of your portfolio; or rather (b) which aluminium company would you prefer to own?