My first CAPS post - My use of the capital asset pricing model for the valuation of equities.
This is my first CAPS posting. I have been posting on Yahoo for 10 years, and I must be honest - I have become quite upset with the overall quality of other Yahoo posters. The Yahoo message boards is now just a free for all of nasty, illiterate, bashers, or dumb permabulls, or spammers...I started my CAPs about a week ago, and have blogged a bit. I am impressed with the overall quality of CAPS, and fool. If anyone out there can give me advice on CAPS game, that would be appreciated. The questions I have are: How many equities should I manage?, When should I close out positions - Are the gains of more the 5% significant? Can I close out losers if they are less then 5%, and not get my rating dinged?? Just a quick blurb about me. I am an economist and software developer. I spent many years developing econometric models, while getting my masters in economic and finance. My focus was on linear modeling using matrix algebra, probability theory, and simulation programming. I used APL, & SAS as the main programming languages(this dates me). My actual thesis was a proof of the Efficient Market Hypothesis, using the equities market, and interest rate movements..Then for about 10 years I was a portfolio manager for large leasing firms - I manage large portfolio of computer equipment, and large commercial aircraft's..I currently manage my own hedge fund, and use my proprietary DCF model to help analyze equities. For many of you, the use of DCF's to value equities is old news, so if I coma across preachy, it just that I am very enthusiastic about this topic. I use various types of cash flow in my model - free cash flow, operating cash flow, clean cash flow(NI + depr + adj), etc...This model has been very good at predicting performance. over the past 3 years, 4 out of the top ten in my list have been bought out at huge premiums...DCF is a tricky metric though. I break all the numbers into current and future cash flow yields, so when stocks crash there yields soar. So you have to be careful your not just catching falling knives. My goal is to come up with a spreadsheet of about 100 equities for evaluation. I have personally not found a good cash flow screener on the net - If anyone has, please provide a link. So my first step is to perform a stock screener based on low PE stocks. You can filter these low PE stocks with other variables. Then you will get a more manageable list.. I had to analyze about 500 equities after my filters... Some variables to consider for additional filtering:
1)P/B below 2
2)OP margin above 10%
3)ROE above 15%
4)Market cap above 500M
5)D/E below 50%
6)NI growth rate above 10% Of course you could be filtering out some very good stocks, but you need a manageable number to start with. Keep in mind, as well, that discounted cash flow analysis is just the beginning of the due diligence process. Creating a DCF list of equities does take some time. I massage the data also. Here are some steps I use.
1) Cleanse the cash flow data. I look for large one time gains that may inflate the cash flows. This is important since I add back in the NI adj's for some of my cash flow data. but I weight Maintenance cash flows more. This is (NI + depr + NI adj's) - maintenance capex(minimum capex to keep the firm running). Then I just divide by the market cap of the equity to get the current cash yield for the equity.
2)I analyze the net asset value of the equity. If the cash flow is growing, but the NAV is not, I get very suspicious. NAV must be growing with cash flow growth, for me to buy..
3)Research the industry. This is difficult work. I like to read and listen to the CC's of the firm, and its competition. I like to do this for current Q and up to one year back. I am trying to glean the next 12 months of future cash flow...My models heavily weight the next 12 months of cash flows.
4)Set benchmark metrics. P/B under 2, OP margins > 10, ROE > 20, D/E < 50, NAV growth > 8%, cash on hand > 10% of NAV, etc... These metrics are helpful when comparing firms within the same industry. Comparing OP margins in different industries can be difficult. As an example, the food industry has very low OP margins, while energy equipment(drillers) firms have very high OP margins. This does not mean that NBR's is better than let say SAFM just because NBR's op margin is much higher...
5)Go to the equities web site. Read all the investor presentations for the past 3 years, and see how accurate these past report were. Is the firm always overly optimistic in it presentations? Read the past Q reports with the same critical eye.
After this due diligence the list of 100 top DCF stocks should to trimmed to about 50..From here I sort this cash flow yield spreadsheet by current, and future yields, with obviously the highest yield at the top. Then I research the top 20 for my purchase decisions.
Any thoughts, comments on this process is welcomed...I will be posting my top 20 for 2008, once I have all the Q4 data for my equities...