The art and science of valuing stocks

<p><strong>Glenn Freeman</strong>: Just to pick out a couple of the key points from your presentation; one of the things that's proved particularly interesting to the audience there was around the discounting of cash flows. And you were talking about why discounting is important. Now, can you just talk us through some of that?</p> <p><strong>Adam Fleck</strong>: Sure. Absolutely, Glenn. Discounting cash flows and the discounted cash flow model is how we value all the companies we cover at Morningstar. So, we walked a bit in the presentation last week about how we forecast a company's future cash flow and how we ultimately then bring that future value back to today. Afterall, a dollar tomorrow is worth less to me as an investor today than any dollars I have in pocket. Think about it this way. If you had $100 in a bank account earning 2 per cent a year, in 10 years you'd have $122. Well, that $122 10 years from now can be reversed, that's worth $100 today. So, it's really important as we put together our future cash flow projections that we think about what the present value is, because that's what we are getting today for our investments in the stock market. So, we talked a lot about how to discount on top of, of course, the fact that we think the company's valuation is its future cash flows.</p> <p><strong>Freeman</strong>: Free cash flow is another aspect that your analysts spend quite a bit of time talking about in their reports and you described a bit about that at the conference, too. What is free cash flow and how do you calculate that?</p> <p><strong>Fleck</strong>: Free cash flow is something that is near and dear to our heart. It's different than a company's net profit after-tax or their operating income or even their EBITDA. Free cash flow is ultimately what can be used to reinvest into the business, it's used to pay down debt, it's used to do things that we as shareholders are most concerned with, buy back shares, pay dividends. So, free cash flow is when you take the company's operating earnings adjusted for tax and then adjusted for other cash investments. So, you think about the company's capital expenditures, for instance, or its investments in working capital. We will ultimately want to get to how much cash is actually moving in and out of the business, not just the reported impact on the P&amp;L which can be subject to different accounting rules, management assumptions and other manipulation.</p> <p><strong>Freeman</strong>: The company that you pulled out as a case study there was a2 Milk. Why was that company selected and what kind of made it interesting within the context of these methodologies you are describing?</p> <p><strong>Fleck</strong>: We talked about a2 Milk because it's a company we recently initiated on. It's a very interesting company and it's one that is on our best ideas list. It's a 4-Star stock right now. We think it trades at a substantial discount to our valuation. It also is one that has a very high exposure to one geography and one product in particular. Infant formula sales in China is really the key driver for a2. So, it makes for a perfect example of digging into different geographic level assumptions and growth forecasts, both from a top-down and bottom-up perspective, as well as digging into product-level margin discussion and profitability discussion.</p> <p><strong>Freeman</strong>: And another thing that you discussed during your presentation was around terminal value. What are we talking about there and how do you arrive at that method?</p> <p><strong>Fleck</strong>: I think a lot of analysts and investors think about building a discounted cash flow model and are really concerned about next year, maybe the next 5 or 10 years. But companies last for a really long time past that or at least they should. Whenever we are investing, we want to think about the long-term, but we don't want to go out and build a 200-year discounted cash flow model. So, the terminal value, or you may have seen it called the perpetuity value, is a formula that helps us estimate the value of all those cash flows past our discrete 5 or 10-year forecast period. It's really important. It often makes up more than half of the value of a company. But it can be easy to overlook because we are so focused on what's going to happen in the next 5 or 10 year period.</p> <p><strong>Freeman</strong>: You also discussed ultimately how you arrive at a fair value estimate, at a valuation for a company. How do you ultimately arrive at that, at that FVE?</p> <p><strong>Fleck</strong>: The fair value estimate is a product of that discounted cash flow model that we are doing for each company we cover. It's really made up of four key parts and we focused last week at the presentation on the first two. The discrete forecast period where we were really digging deeply into understanding the future revenue, future costs, future cash investment needs of a business to come up with a present value of the next, in the case of a2, 10 years. From there, we also talked about the terminal value, which is a formula that's helpful to estimate the value of all the cash flows past the next 10 years. The other two key parts are anything we haven't counted yet that is already sitting on the company's balance sheet. That would be the cash it has, less the debt it owes to its creditors; we as equity holders, of course, don't have access to that value; as well as any other adjustments we need to make. For the case of a2, they own shares in Synlait, another New Zealand-listed company. The fourth part is really easy. Divide by the share count. And ultimately, we get to the fair value estimate.</p> <p><strong>Freeman</strong>: Excellent. Thank you very much for your time today, Adam.</p> <p><strong>Fleck</strong>: Thanks for having me.</p>