ER is dead so I'll try this forum...need some guidance regarding splitting weight for DCF/Comps valuation

TL;DR - tried tweaking DCF to make it more optimistic but cannot honestly justify tweaks. Resorting to arriving at target share price with DCF/Comps weight - don't know how to justify/explain my decision for 60% DCF 40% Comps. Need some guidance.

Disclaimer: I'm creating an equity research/stock pitch report and I'm also heavily debating between sticking with a contrarian view or "staying in line" with the street. If I use my DCF, I'll be contrarion. With the split, I'll be "in line". Would it be wise just to "stay in line" when I'm presenting this report to potential recruiters/employers?

I've built a thorough DCF and comps model from scratch. The company I'm covering is split between two sectors, and has multiple revenue streams where there are some instances of publicly traded companies specializing in just that one stream.

The sector(s) in which this company is traded in has over the last two years seen dramatic upside price swings. On top of that, there have been transactions above average premium levels. With rates rising, tensions between China growing, and the U.S economy soon to becoming the longest bull run in U.S history, I believe that I am not alone that overall valuations have been teetering on the high side for some time now, and that it's hard to find a bargain these days.

I've taken careful precaution in to monitoring my growth assumptions and the inputs with my company.

The difference in the model is pretty start. The comps multiple average is about 20% above where the stock is trading, and the DCF (perpetuity) produces a share price 22% below the current share price, with sensitivity ranging 30% and 8% below the current price, respectively.

I've tried to adjust inputs like the long term growth rate, but I cannot rationally justify it being greater than the current emerging markets forecasted growth rate (4.7%). I also tried playing with the WACC to make it lower, but the driving input there is the equity market premium, which I cannot also justify being any lower than it is (or else I'm basically saying that this company has the same risk profile as a company that derives most of its revenues from the U.S - which it does not).

So, I've come to the conclusion that the best course of action is to arrive at a share price that gives weight to both the DCF and comps model. I believe that 60% DCF, 40% comps is fair - the only thing that I'm worried about is having to justify this split, and being able to write about it which at this point I'm not sure how.

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Comments (22)

Oct 29, 2018

Sorry I can't help but I'd be interested in any insight someone has to give as well.

Oct 29, 2018

cricket

Oct 29, 2018

You are missing the forest from the trees. If your recommendation comes down to some random weighting, which will swing it one way or another, then it means that it's not a very strong idea.

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Oct 29, 2018

Let's just say that I'm cautiously optimistic. Which would make me want to incorporate the weight of the comps, since the peer group implicitly has a high growth rate driving their valuations. The problem with this is that I cannot rely on my DCF no matter which way I've tweaked it (to a reasonable extent).

I'm also trying to be smart here by not butchering the pitch to an analyst who might cover the stock and I'm telling him to go against his own rating.

Funniest
Oct 31, 2018

weird flex but ok

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Oct 30, 2018

May be obvious but confirm the company doesn't have any characteristics that make comps less relevant. Alternatively, do some supporting work to demonstrate that the company is a good candidate for a DCF.

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Oct 30, 2018

Sounds like a shit show. That said, in general, you apply greater weight to a DCF if the operations of the entity make it difficult to find true/good comps. Technically speaking, you can adjust multiples for differences in growth rate, profitability, etc (between comp set and entity) but not for differences in operations.

Oct 31, 2018

I dunno. I once valued Humana using a similar method and was satisfied with my results.

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Oct 30, 2018

Why assume that the street is correct? I'd stick with you contrarian view which you have a lot of data to support. Then I'd mention the only way to get to the Street forecast is to use a comp multiple (which again supports your contrarian view since you think the comps are overvalued).You will be more respected by having a firm point of view.

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Most Helpful
Oct 29, 2018

If you see my first post I was hesitant to say anything as I don't believe it would have been value-add. But my initial thought was the same as yours.

OP:
How come you are worried about whether or not your valuation is in line with the street? Listen, I get the whole "I don't want to be THAT guy that thinks he's smarter than all the professionals with industry experience" but if you pitched the stock with a contrarian view and explained it "hey, this is my valuation, I see it is not in-line with the market, these are the assumptions I made and this is why I made said assumptions" I would find it difficult for anyone to hold that against you. They may make counterpoints, correct your work, explain their own perspectives but that will only help you grow.

At the end of the day nobody wants a "yes man". If every analyst just fudged their assumptions to stay in line with the market then their jobs really wouldn't be producing ANY value at all. Don't just disagree for the sake of disagreeing, but that doesn't seem to be the case here.

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Oct 29, 2018
FinancelsWacc:

OP:
How come you are worried about whether or not your valuation is in line with the street? Listen, I get the whole "I don't want to be THAT guy that thinks he's smarter than all the professionals with industry experience"

Answer in bold, pretty much. I just want to make the smart play. On one had I got a couple of people on this forum here telling me that I should stick with my contrarion conviction (if I can back it up). On the other hand, I have a friend who worked ER at CS and he's telling me to stay with street.

The thing is, I'm not going to be showing this ONLY to ER folk. Some boutique IB/PE people will also be looking at it - so in aggregate perhaps it might be better if I stick with my contrarian opinion? Gah, I'm so conflicted.

Thanks for the insight, however.

Oct 31, 2018

Couple of quick thoughts...have you tried an exit EBITDA multiple instead of a perpetual growth on your DCF? That could create a more in-line valuation. Or what about a SOTP valuation using comps, where you model the two business segments independently using comps and then sum the two together?

Oct 31, 2018

100% agree to also use and exit EBITDA multiple as well...tbh perpetuity is mainly for academics, most use exit multiples

Oct 31, 2018

Perpetual is useful when it can't be reasonably assumed that EBITDA will be flat or expected to grow indefinitely, e.g. a company in an industry that is facing secular decline.

Oct 31, 2018

Do yourself a favor: delete your price target output, put in all of your absolute best assumptions and use the weightings that make the most sense to you, then create your price target output and THAT'S your view. If there doesn't end up being enough upside/downside to pitch, then find a better idea.

Oct 31, 2018

This bull run is fairly short.
The only reason it ends is because Powell decides to cause a recession.

Australia and China haven't had a recession in 30 years. If you start pricing thing like a recession will never happen again you will get much different valuations.

Also I have no problems finding bargains in this market. Is 20 times on google expensive? And I'm one of the biggest bears on their regulatory risks. Or fb at 16 times next years earnings. Alibaba at an 18 times pe and maybe the best tam in the world.. these aren't your deep value guy depressed valuations but the entire market looks fairly cheap to me. Citigroup at 8-9 pe with the best global banking franchise.

Array
Nov 1, 2018

Known your audience.

If you're pitching to the sell side, keep it somewhat in line. If you're pitching to the buy side, deviate from consensus if you have reason to.

Nov 1, 2018

In the real world you tend to value a company using a number of valuation models so as to sense check your work. If you find that your DCF derived valuation is significantly different from your comps derived valuation then there is either a problem with your DCF assumptions or you are using the wrong comps. Ideally you run a DCF, look at comps, and maybe do a sum-of-parts model if there are different segments to the business. All 3 methods should get to a similar price target.

Now, in your situation it seems that your DCF model is leading to a lower valuation than what the comps suggest. It may be the case that comparable companies have better growth or margin prospects than the company you are trying to value and, hence, warrant higher multiples. You need to better understand the comps before you can derive anything from the multiples they trade at. For example, a company that is expected to grow EPS or DPS faster than the industry may trade at a higher P/E multiple than the industry.

If you want to grab someones attention come up with a buy or sell idea. Nothing wrong with a hold but generally people want to read reports with conviction....and then tear apart your thesis to see how you react under pressure.