A discounted cash-flow process is your best friend.
Not only does it allow you to identify the substance of a company’s balance sheet, what it owns (similar to what you have in your own savings account less all debt), but it also encourages a focus on the future free cash flow stream of the entity (much like your salary after expenses, for example). Intrinsic value estimation provides the backbone behind the conviction that an investor gains in either sticking with an idea or throwing in the cards. You can perform discounted cash flow analysis, too.
Let’s walk through a few examples to help explain this concept.
In mid-September, shares of Alibaba (BABA) had been in a tailspin, with investors growing concerned about the health of the Chinese economy and the impact on consumer spending. Relatively cautious comments by management also served to punish the Chinese e-commerce giant’s shares, all the way down to the high-$50s per share. It wasn’t looking good for shareholders.
But while others were calling for the company to fall another 50% from depressed levels, those that applied sound fundamental analysis backed by a discounted cash flow process were able to shrug such concerns off. In mid-September, Valuentum addressed “The Puzzling Attack on Alibaba,” walking through five distinct reasons why Alibaba shares would be resilient:
- Alibaba is significantly free cash flow positive.
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Alibaba’s valuation is not stretched.
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Why no long-term focus?
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Why is precision important?
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Businesses are their future free cash flow streams.
From the time a large publisher ran a negative article on Alibaba in mid-September, shares have rallied 30%+, and we point to the conviction gained by employing a discounted cash-flow process as to why we weren’t spooked at all. Though no stock is a perpetual “buy” and we could look to remove shares of Alibaba from the Best Ideas Newsletter portfolio in the future, we continue to value the company north of $100 per share. Investing is not about precision within a discounted cash flow process – it’s about identifying large mispricings, considering companies that are trading at 50 cents on the dollar, for example.
The discounted cash flow process helps in opposite cases, too.
Valuentum’s President Brian Nelson’s work on Kinder Morgan (KMI) continues to receive attention, and with shares of the energy giant now dipping into the high teens per share, Mr. Nelson encourages investors to stick with the Valuentum process to prevent falling into value traps, stocks that look cheap but really aren’t. For example, Valuentum would only grow interested in Kinder Morgan’s shares when a bottom has firmly been established, and frankly that could take a while, or not. It really doesn’t matter. The point is that we’re not trying to pick bottoms, but instead, we’re letting the market tell us when it’s time to own Kinder Morgan.
For example, trying to catch a bottom at $30, $25, and $20 has only left more investors with losses in the energy giant’s shares. Investors that continue to demand stocks with both good value and good momentum characteristics are improving their odds of finding winners while avoiding losers. At the moment, Kinder Morgan’s shares are starting to look cheap, but by no means can we be certain that all of those running for the exit are not out of the stock. Prudence always prevails, and KMI is not a Valuentum stock on the long side, at least not yet.
Not all cases have to be tragic to employ a rigorous discounted cash flow process either.
For one, Valuentum’s $540 per share fair value estimate of Chipotle (CMG) is looking really good right now. Shares have dropped from the mid-$700s to ~$560 since October, as the fast-casual burrito-making giant deals with slowing comps and bad press related to E.coli scares. We have been warning for some time that any slip up in same-store sales momentum or an exogenous shock at the restaurant could send shares reeling, and we’re seeing some of the aftermath now.
Where Alibaba’s shares are underpriced, Chipotle’s shares aren’t, and we’d only grow interested in Chipotle near the low end of our fair value estimate range. That may be a long way off from today’s levels, but it is a vital consideration of the Valuenutum process. The stock must first be cheap on a discounted cash flow basis.
If you are interested in viewing our DCF models, please be sure to contact us at info@valuentum.com.