Discounted Cash Flow models have to be future
In a post-covid world, the fair value of a stock can and should be determined solely based on its fundamentals and discounted cash flow models seem to be the ideal solution.
The unprecedented lock-down that the world is facing is understandably leading to a market meltdown. The stock-markets world over have crashed by 25%-30% in about a month, as investors fret about what could perhaps be the sharpest recession that the world has ever faced. In India, the Nifty 50 Index peaked at around 12,000 levels in late February, and since then has declined by about 27% to about 8750.
The question that every investor is grappling with is whether the fall is justified (and perhaps only the beginning of a long winter) or over-done. Here, an investor is defined as someone who buys a stock or business to produce returns in the future from the business itself, rather than on profiting from price movements in the stock market, as a speculator would do. Traditional market approaches to valuation, which are based on valuing stocks with reference to a profitability multiple, like a P-E ratio or an EV/EBITDA multiple, do not work in cases of extreme slowdown. Firstly, the earnings collapse in the immediate term implies that there are no earnings to benchmark. Further, given that there is extreme uncertainty as to how long the impact of this slowdown will last given the widely held view that a vaccine is at least a few quarters away, even a one or two year forward earning estimate may have a significant degree of error. Last but not the least, it is difficult to decide what level of multiples signal an under-valuation or a fair valuation in a scenario where the historical multiples or comparative multiples stop being a reliable benchmark.
In such times of extreme uncertainty, discounted cash flow models provide a more robust basis to analyse valuations. A free cash flow model principally aligns better with the investor’s framework of earning returns from the business itself (obviating the need to consider a sale at some point of time to calculate value). It permits valuations considering various scenarios by altering the underlying assumptions. Finally, pandemics and other crisis create extreme uncertainty in the short to medium term, but the impact peters off over a period of time, and free cash flow models are best templates to model the impacts.
To answer the question raised in the title, we created high level cash flow models for Nifty, encapsulating pre-Covid and post-Covid assumptions under various scenarios, and tested the difference in values between the two.
Just before the Corona virus crisis crept into investor conscience (about two months after it started in China), Nifty had an EPS expectation of about 500 for March 2020 (excluding exceptionals like large telecom/auto losses), which is considered the starting levels for the financial modelling While earnings are not free cash flow, and one needs to adjust for items like depreciation, capital expenditure, changes in working capital, and in debt flows to derive free cash flows, for the purpose of this high level modelling, the earnings measure is considered synonymous to the free cash flow to equity estimate. (The assumption being that capex will equal debt, and the working capital increase will be funded by an equivalent debt increase).
A 10 year model is considered. Nominal growth forecast for the country prepared by Oxford Economics was the base forecast (See Table 1). This was available till CY2026, and the same growth rates were considered for the balance three years of the forecast. The Nifty growth premium over the country growth rate was taken at 2%. The growth rate in perpetuity post 10 years was considered at 5% p.a. The discounting rate was assumed at 13.5%, representing 6.5% long-term risk free rate and a market risk premium of 7%.
These assumptions lead to a fair value of around 12,000, which was the average level of Nifty in February, prior to the current mayhem. We commence the analysis with the assumption that Nifty was fairly valued, though we discuss the implications of it being over-valued in the later paragraphs.
Post Covid Scenarios
With the economic activity significantly frozen throughout the world, it is clear that there will be a huge fall in sales of companies. Initial estimates of fall range from 25% to 40% decline in industrial production and sales for the immediate quarter. Many companies will experience minimal sales but will have to bear overheads. In all the post Covid scenarios modelled here, it has been assumed that the Nifty companies would, in aggregate, make a loss in the first two quarters (a conservative starting estimate), with the extent and timing of recovery being different in different scenarios
In Scenario 1, it is assumed that Nifty Companies would, in H1CY20 make an aggregate loss of 50% of the level of profits they would have expected to earn, followed by zero profitability in H2CY20. Thereafter, it is assumed that the profitability will come back to pre-Covid levels in Year 3, with companies earning 50% and 75% of their pre-Covid level profits in the two halfs of the second year. This is a classic V-shaped recovery model. With similar discounting rates and perpetuity growth rate, the value in Scenario 1 is only about 7% lower than pre-Covid levels.
Emboldened by the result in Scenario 1, in Scenario 2 we assume a far greater destruction of profitability in the near term, and the destruction to last longer. Thus, here we expect Nifty companies to lose as much as they were expected to make in the first half of the year (i.e. losses equivalent to 100% of expected profits), with losses extending in the second half to 50% of the profitability expected. In the second year, the climb-back is expected to be slower, with profits at 25% and 50% of the pre-Covid expectations. The slowdown continues in the third year, with profits at 75% and 90% of the pre-Covid levels in the two halves. Profits are expected to be normal from the fourth year onwards. This is a U shaped recovery. Such a scenario leads to a value for Nifty lower by about 10.6%.
Scenarios 1 and 2 assume that the Covid pandemic will not have any long-term negative impact on the profit growth beyond the first few years. What if the crisis leads to a lasting impact on the long term profitability, and an L shaped recovery. In Scenario 3, we assumed first three year earnings to be as modelled for Scenario 2, but the earnings thereafter to be 10% lower the pre-Covid scenario. Thus, the crisis leaves a permanent poke-mark on the health of the companies. In this scenario, the value loss is 19%.
To cause a 25% value loss, the earnings would have to decline by about 16% permanently.
So what conclusions can we draw from such a cash flow modelling exercise. Let us start with the caveats and the limitations.
Firstly, such a high-level modelling cannot capture all the complexities and nuances of an economic crisis, and a more detailed model would be required when valuing sector and companies. Especially for companies facing a heightened insolvency risk, an option pricing or a probabilistic cash flow model may be more appropriate.
Further, the starting assumption of the analysis is that pre-Covid Nifty was at a fair level. Considering this requires a strong double-digit growth in Nifty over the next 10 years (and atleast 200 basis points higher than the nominal GDP growth), and that Nifty earnings over the last five years were rather flat, these do seem somewhat optimistic (in hind-sight, perhaps). In the pre-Covid scenario, if the reasonable Nifty earnings growth is considered equivalent to GDP growth, and not higher, the fair level of Nifty is about 14% lower. In such a case, the current melt-down is partly correcting the previous over valuation and partly factoring the new normal of short-term earnings decline.
However, if the initial Nifty levels were reasonable, then one has to believe in a sustained long-term negative impact of this pandemic on corporate profitability to justify the current market valuations.
Whatever may be your assumptions and beliefs, it is clear that any investment, whether pertaining to an acquisition in an M&A or of acquiring a few shares in the stock market, would require the acquirer to look at the business closely and to diligently develop longer term models.
Table: Nominal GDP Growth forecast (pre-Covid) Oxford Economics
2020 - 7.3%
2021 - 9.4%
2022 - 10.8%
2023 - 11.7%
2024 - 12.6%
2025 - 13.0%
2026 - 13.3%