# Philippine Stock Market Research

Is it Fair to Value Stocks at Fair Value?  Part 3

July 24, 2010

Discounting future cash-flows is the third step in computing fair value.  Free cash-flow is net income plus depreciation minus working capital minus capex.  As observed in actual annual reports, the most volatile component of free cash-flow is working capital.  Free cash-flow formula, however, can do without working capital.  Fair value practitioners project five to ten years’ worth of future cash-flows.  Projections can be very detailed to general.  In our sample company JFC, we went through the process of projecting its financial statements in accordance with its local and global store expansion plans.  Projections should be conservative especially if it’s going to be long.  To make it simpler, we have three years of future cash-flows. After projecting future cash-flows, the Terminal Value is computed using the final cash-flow.

Final year’s Free Cash-flow x (one plus Perpetual Growth Rate) / (WACC – Perpetual Growth Rate) = Terminal Value

The perpetual growth rate is an assumed value ranging from one to five percent from practitioners.  In our case, we want to be conservative so we use 1%.

PHP2.7 bn x (1+1%) / (5.23% – 1%) = PHP65.5 bn = JFC Terminal Value

After getting the future cash-flows and terminal value, you discount each with the WACC as follows:

(Year 1 Free Cash-flow / (1 + WACC))^1 + (Year 2 Free Cash-flow / (1 + WACC))^2  + (Year 3 Free Cash-flow / (1 + WACC))^3 = Enterprise Value

Add them all up and you get the Enterprise Value.

(PHP891.4 mn / (1 + 5.23%))^1 + (PHP3,561.6 mn / (1 + 5.23%))^2 + (PHP65,514.1 mn / (1 + 5.23%))^3 = PHP60.3 bn

Subtracting all interest-bearing debt to this gives the fair value.

Enterprise Value – Interest-bearing Debt = Fair Value

PHP60.3 bn – PHP2.5 bn = PHP57.8 bn

Dividing this to the company’s number of shares gives the fair value per share, and this can be compared to the company’s share price to see if it has a discount to its fair value per share.

JFC Fair Value Per Share = PHP55.93

JFC Share Price (July 26, 2010) = PHP72.50

Note:  No Discount to Fair Value

Let us evaluate the risks for the investor in the computations above.  The first concern is whether the projected cash-flows are conservative enough.  The second concern is the number of years of cash-flows to use.  The terminal value is already bulk of the enterprise value.  Adding five to ten years of cash-flows just bloats the fair value.

In addition, even though the cash-flows will be discounted in the next process, do they reflect business cycles that affect a company in the long term?  The levels of these cycles are high in industries such as electronics, commodities and property.  Future cash-flows will not be on a straight line.

Below are the facts of fair value.

1. Different groups will have different fair values of stocks with different variances.
2. The terminal value is bulk of the enterprise value.
3. The number of years of discounted future cash-flows increase or decrease fair value.
4. Assumptions used for CAPM change periodically.

So is it fair to value stocks at fair value?  The answer is fair, yes, but good to excellent, no.  With the high level of variances, the investor will not know whether a stock he’s buying is undervalued or overvalued.  Fair value can also be manipulated using assumptions favorable for the stock being valued.  The stock’s financial performance is not easily reflected in this valuation method.