This is a cash flow stock valuation piece for the stocks of Advanced Micro Devices (NASDAQ:AMD), Amazon.com (NASDAQ:AMZN), Facebook (NASDAQ:FB), General Electric (NYSE:GE), International Business Machines (NYSE:IBM), Intel (NASDAQ:INTC), Microsoft (NASDAQ:MSFT), NVIDIA (NASDAQ:NVDA), and Qualcomm (NASDAQ:QCOM).
Why Cash Flow Valuation Is Better
We all seem to have an unusual fascination with earnings. A company’s earnings, measured under specific accounting standards and tax laws, are arbitrary at best, whereas cash flow, like the balance in a checking account, is an actual number and subject to little interpretation. Earnings are opinion and cash is a fact. BlackRock CEO Larry Fink’s recent letter to 500 chief executives, urging them for the first time to stop providing quarterly earnings estimates, is yet another plea for long-term value creation. Today, many companies are expected to execute corporate policies that reflect short-term earnings growth, thus forcing investors to rely mainly on what a stock is worth. When company forecasts are heavily based on earnings, one of the biggest problems is that they have been known to be overly optimistic.
Let’s not to forget what happened to the stock market after 2001?
Corporate shortsightedness is manifested by firms’ practice of providing short-term earnings guidance. However, firms that frequently issue quarterly earnings guidance also behave myopically. Further exacerbating this problem is the fact that managers are typically evaluated and compensated based on earnings goals, providing a perverse incentive to focus on producing short-term results. Moreover, if stock prices react to short-term earnings, managers can argue that they are doing their jobs in the name of “maximizing shareholders’ wealth.”
Since 2002, there has been a new movement led by the CEOs of top blue-chip companies such as GE, Microsoft, and Intel, to voluntarily stop providing earnings guidance. The intention was to relieve managers from being boxed into hitting short-term targets, and investors from being misguided. Similarly, in his 2002 annual meeting, Warren Buffett said:
“We’ll never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Wal-Mart, GE, and Microsoft. The fraudsters are trying to con you or they’re trying to con themselves.”
The easiest example of such a wide spread in using earnings in a quick valuation can be demonstrated by the wide spread use of the price (earnings) ratios in valuing stocks. We are often tempted to value a stock future price movement by simply comparing a stock’s current price ratio to that of its benchmark.
In Table 1, an example for such practice is shown for nine of the most widely held tech stocks. The relative valuation for each stock is demonstrated by comparing its price ratios with the industry average in order to determine if each stock is fairly valued. Using this common practice, both earnings-based approach (PE) and cash flow-based approach (P/CF) reach the same conclusion that INTC, IBM, MSFT, and QCOM are undervalued while AMD, NVDA, and AMZN are overvalued. On the other hand, GE and FB are overvalued by future earnings, yet, undervalued by future cash flow.
Clearly, the simple index model is over-simplified. It is not forward looking, and it fails to incorporate the different risk level of each company/stock. A stock’s price ratio is supposed to be higher (lower) than the industry’s if the company has a lower (higher) risk. The fair value of a stock should reflect the forward-looking fundamental and adjusted for the corresponding risk level.
The Financial Modeling Process
To further improve the fairness of the fair value estimates, I use a more elegant and complex approach to resolve the shortcomings of the simple approach.
(A) Estimating Future Growth Rates
The most pivotal factor in any valuation model is the future growth rate of the underlying fundamentals, albeit revenue, earnings, or cash flow. The understanding of the product portfolio and the overall business model and strategies shall be translated into numerical estimate future growth rates which are used to derive a numerical fair value of the stock. For each company, the pro forma top-line (revenue) growth rate, margins, and bottom-line (earnings) growth rates are estimated by using the information drawn from the following sources: (1) The technical product portfolio; (2) historical growth rates; (3) sustainable growth rates; (4) management guidance (5) analyst estimates; (6) acquisition growth and organic growth rates; and (7) the growth rates embedded in the market prices.
(B) The Risk-Adjusted Discount Rate
The financial modeling process will result in a “distribution” of estimates for the underlying fundamentals, including future revenue, earnings, free cash flow, dividend and book value. The probability distribution of each growth rate estimate reflects the risk of the fundamental forecasted fundamentals. So the operational issue is how to convert the subjective risk estimates into numerical risk premium. This is usually achieved by reflecting the associated risk in the discount rate or required rate of return for shareholders as follows:
k = Risk-free rate + risk premium
Where k is the required rate of return which is used to discount future fundamentals. The subjectively determined “risk premium” is the percentage of return that is required by investors to be compensated for the individual risk taken to own the company/stock. Both the pro forma growth rate estimates and risk-adjusted discount rate become the inputs to the following complex valuation models.
Using Earnings to Value Stocks
Especially for tech stocks, investors love to look at the future earnings rather than the cash flow dividend they will receive. For that reason and for the nine tech stocks we examine, the Incremental P/E Model can be used to identify mispricing of stocks based on the difference between the return on equity and the required rate of return. If the return on equity exceeds the rate of return that investors require given the investment’s risk characteristics, the company’s growth potential might be mispriced. The construct of the model below assumes that the extra return that the company produces above the required rate of return will continue forever. However, in the long run, the extra return should diminish and eventually become zero. If the excess return becomes zero, the fair price to earnings ratio should equal one divided by the required rate of return.
The reasoning here is that the zero growth company should distribute all of its earnings to its investors. If the company is able to invest these earnings at a superior rate, at a greater rate than the required rate of return, it is going to add extra value to its shareholders. The Incremental P/E Model is trying to capture the company’s ability to reinvest its earnings at the superior rate.
Using Cash Flow to Value Stocks
“We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life.”
Traditionally, the Street has been overly fascinated by the quarterly earnings growth rates. However, when earnings volatility becomes so extreme, say to triple digits, even the most die-hard fans of the company should realize it is not sustainable. When the most recent earnings growths are not expected to continue, shareholders should always come back to the basics, i.e., “discounting future free cash flow of the company.” Specifically, the long-term outlook on stock values may be looked upon based on the free cash flow (cash flow, net capital expenditure) to the equity holders. To them, the stock valuation is “the discounted value of future free cash flow.” As most tech firms invest heavily in capital expenditure of the next-generation technology that will produce exponentially high future cash flow, it is reasonable to assume, at a minimum, a two-stage free cash flow growth pattern. In the equation below, the construct of the model is to discount the next three years’ free cash flow at one growth rate and a terminal f cash flow at a normal growth rate forever by using a normal price multiplier.
For the sake of brevity, the reasoning of arriving at the actual growth and discount rate inputs for each of the nine stocks is not discussed here.
The results of the complex models are summarized in Table 2. For the nine stocks being examined, the conclusion from the earnings model is almost always at odd with that from the free cash flow model. However, the Street analysts’ estimates are closer to the valuations from the cash flow model. Both the Street and cash flow approach agree that FB, INTC, GE, and QCOM are undervalued, AMD is overvalued, and IBM is fairly valued. As AMZN just turned profitable two years ago, the typical earnings-based model will easily conclude an overvaluation. As a result, AMZN is more likely fairly priced per the cash flow model. As QCOM and MSFT are established companies, the cash flow model conclusion that indicates an undervalued QCOM and a fairly priced MSFT seems more creditable.
When to Use Earnings Vs. Cash Flow Valuation?
Given the often conflicting valuation conclusion from earnings and cash flow approach, the real question is, under what circumstances should cash flow valuation be used over earnings valuation? Although stock prices are on average, affected by short-term earnings, cash flow pricing is used primarily to price what we classify as “negative” stocks – stocks that are generally characterized as illiquid, mispriced, or having a shorter trading history, negative earnings, or negative market performance.
(1) If you disagree with the conclusion due to the inputs I used, feel free to plug in your own estimates of the growth rates and the discount rates.
(2) If you disagree with my choice of cash flow over earnings valuation, then repeat (1) using the earnings approach.
(3) If you disagree with using quantitative approach to value stocks, or, you simply don’t like the conclusion on a particular stock, sorry to waste your time.