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Does this make sense?


WeiChiLoh
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I had just finished working on my financial model when I noticed something quite peculiar.

 

The company I am working has high ROIC and is operating in an industry that I believe is in its early growth stage (~20% growth rate for ~5 years, followed by mid-high single digits growth rate). It is also useful to note that I calculate ROIC as Change in EBIT/ CAPEX+Change in NWC. So, from the data that I stated, this company should be at least an interesting company to look at, considering EV/EBIT is rather low.

 

HOWEVER, after doing a DCF, the value of the company is only 10-15% of the current market capitalization, which doesnt really make sense to me considering the company have such high ROIC and high growth opportunity. Apparently, the projected 5 years DCF value is even slightly negative. After playing around the the numbers, it seems that the company is actually losing value in growth. 0% growth rate value > 20% growth rate. How is this possible considering the high ROIC?

 

Link : https://www.dropbox.com/sh/montt2kejcmx2in/AADPtdCatMxg5cc5mmuNugmga?dl=0

 

 

 

I have only recently started my journey on financial modeling so some advice from the veterans would be helpful!

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Its entirely possible for a business to lose value from growth. If say the base business earns a 15% ROIC and reinvests the retained capital at 5%.

 

However here it just sounds like you have a mechanical issue in your model. 

 

basically impossible to troubleshoot w/o seeing the model

 

Would it be possible if I send you my model?

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Think about the steady state - in your terminal year, D&A still greatly exceeds capex. I would just use the D&A as a proxy for capex and not count the actual capex. When you do that, it should be much closer to the current market cap.

 

I would amplify this by saying all of the capex should not be subtracted.  Capex is made up of maintenance capex + growth capex.  Only maintenance capex should be deducted, and this is frequently approximated by D&A expense.  The hard part is estimating how much of total capex is really growth capex, and most companies do not explicitly break this down for us.

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I tend to think PP&E/Sales is a better metric to focus on than absolute capex level.

 

I also find that most managements definitions of maintenance vs expansion capex is closer to "keep the machines running" as opposed to "adequately support organic growth"

 

So in the context of your model - I assume capital intensity approximates that - and yet it goes from 11% ish, to 16% today, to 18% - and your marginal capital intensity is even higher.

 

So if you like those assumptions, then its totally plausible there is no equity value on their current business model, or somewhere better 11 and 16 is sustainable and you've understated their ability to generate cash.

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I tend to think PP&E/Sales is a better metric to focus on than absolute capex level.

 

I also find that most managements definitions of maintenance vs expansion capex is closer to "keep the machines running" as opposed to "adequately support organic growth"

 

So in the context of your model - I assume capital intensity approximates that - and yet it goes from 11% ish, to 16% today, to 18% - and your marginal capital intensity is even higher.

 

So if you like those assumptions, then its totally plausible there is no equity value on their current business model, or somewhere better 11 and 16 is sustainable and you've understated their ability to generate cash.

 

Hi top,

 

I dont really understand your point of capital intensity and equity value. Would you mind explaining that?

 

Thanks!

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First thing I'd say is that you have way, way too much stuff in this model. You have 12 tabs and most of them don't seem to feed in to anything. I also can't really tell if you're going for a FCFE or FCFF model here, because you take all the trouble to forecast out interset expense by year but then use EBIT as the jumping-off point for your DCF.

 

That's cool, whatever, but then I notice it seems like you're not accounting for the debt anywhere on your DCF page. It's possible I've missed it on one of these tabs somewhere, but assumign the "Discounted Value" tab is the DCF tab, I don't see it. You'll need to account for that one way or another, if you haven't.

 

I'd suggest taking the model out at least five more years. Your terminal growth rate is really high, and as a result of that you're just dumping your value there, but it doesn't really mean anything as it probably hasn't really been thought through. I agree with everyone else about how CapEx won't substantially exceed D&A forever, so you really do need to get that right in your terminal period or you'll get a valuation that's way too low.

 

Also, I wouldn't just forecast recent results out willy-nilly. Think about why and how those line items are going to develop. Is this a business that will benefit from any operating leverage over time, even if it hasn't yet? You need to account for that, if so. Right now you have pretty much flat EBIT margins going in to forever. Not saying you're wrong about that, just something to think about.

 

I'm not going to dig in to your various formulas right now, but I'd check those too to make sure you're doing everything "by the book," so to speak. You can easily botch a valuation by screwing up the order of operations or just not accounting for something. I may come back to this later, if time permits. I also may not.

 

 

Think about the steady state - in your terminal year, D&A still greatly exceeds capex. I would just use the D&A as a proxy for capex and not count the actual capex. When you do that, it should be much closer to the current market cap.

 

I would amplify this by saying all of the capex should not be subtracted.  Capex is made up of maintenance capex + growth capex.  Only maintenance capex should be deducted, and this is frequently approximated by D&A expense.  The hard part is estimating how much of total capex is really growth capex, and most companies do not explicitly break this down for us.

 

This is inaccurate. If you're forecasting growth but don't deduct growth CapEx from your FCF, then how are you going to get that growth? In most businesses, you need to "spend money to make money," as they say, and if you spend that money on CapEx you can't exactly dividend it out to shareholders.

 

That's about it for a five minute look over. I may come back with a more thorough take later, but feel free to point out anything I've missed if you think I inaccurately described your model.

 

Best wishes,

 

Scott

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