In this week’s edition of DDDD (Data-Driven DD), we’ll be exploring the most common way that investors calculate what a stock’s actually worth, and then why this valuation method no longer anymore. Also, apparently mods disabled image uploads, so this post is going to be a bit hard to read since I rely a lot on visuals in them; please direct all your complaints to them.
Disclaimer – This is not financial advice, and a lot of the content below is my personal opinion. In fact, the numbers, facts, or explanations presented below could be wrong and be made up. Don’t buy random options because some person on the internet says so; look at what happened to all the SPY 220p 4/17 bag holders. Do your own research and come to your own conclusions on what you should do with your own money, and how levered you want to be based on your personal risk tolerance.
The Discounted Cash Flow Model
The DCF model is the most common model for valuing companies in finance, and hence the fair value of a stock. It’s based on one simple principle: the value of a company is based on the ability of that company to generate cash flows in the future. This principle is used in virtually every other financial instruments, like bonds, and is also used to help aid capital expenditure decisions. This method of valuing a company became popular after the 1929 stock market crash, once the “stonks only go up” mentality broke and investors started investing in equities based on value and returns rather than speculation, which drove much of the stock market in the 1920s, but this idea has been used as far back as ancient Egypt.
Time Value of Money
Before looking into the math behind the DCF model, another principle needs to be understood – Time Value of Money. This is the principle that money today, or the Present Value, is worth more than money in the future, or Future Value. The difference in worth can be caused by many things, such as inflation, the interest rate of Treasuries (i.e. risk free rate), and risk of default. This difference of worth is calculated to some interest rate, r, which is then used to calculate the Present Value of some future cash flow.
Cost of Capital
In the case of valuing a company, what would this rate be? Typically, the Weighted Average Cost of Capital, or WACC is used for this percentage.
WACC in simple terms is the rate of return typically required to be paid by the company to shareholders and bondholders to raise capital from them. In this formula,
E is the market capitalization of all equity in the company
D is the value of all debt in the company
V = E+D
Tc is the tax rate paid by the company
Rd is the cost of debt, for simplicity let’s say this is the average interest rate paid by the company for its outstanding debts
Re is the cost of equity. The most common way of calculating this is the Capital Asset Pricing Model (CAPM), with the formula below
In this formula,
Rf is the risk free rate, which is the interest rate an investor can receive when investing in some risk free asset, like a US treasury
β represents the volatility of a company’s stock on the stock market; this value has its own complicated formula but this value can be usually found in most stock trading platforms
Rm is the long-term return of equity markets. Hence (Rm – Rf) is typically seen as the equity risk premium, which is the excess returns given by the stock market for taking on the risk of investing in equities rather than treasuries
Free Cash Flow
Free cash flow is typically reported as part of a public company’s financial statements and hence can easily be discovered. Intuitively, it’s the company’s ability to generate cash from operations to pay back stock and bond holders, and is calculated by adding non-cash expenses (i.e. depreciation, amortization), subtracting capital expenditures, and adding increases in current assets – liabilities to the post-tax EBIT, or Earnings before Interest and Taxes.
Putting it all together
With all of these in mind, let’s use them to calculate the Enterprise Value of a company. This is done by adding the sums of all future cash flows generated by the company, and discounting it by the weighted average cost of capital. Since a company can have a potentially perpetual stream of cash flows, and future cash flows beyond a few years becomes very unpredictable, we would instead only do this calculation for the first five years, and then add some “Terminal Value” of the company to represent how much the company would be worth by the end of that period, and discount that as well.
To calculate this Terminal Value, we’ll need to have some rate, g, which represents the “growth rate” of the company once it’s mature and no longer growing rapidly (i.e. taking market share).
Once you add all of the discounted near-term cash flows and discounted Terminal Value, you now have the Enterprise Value. Once you have that, figuring out the fair value of all the equity in a company, or the market cap, is easy.
Fair Market Cap = Enterprise Value – Total Debt + Cash
Where we are right now
Let’s see how recent events have changed the equation for equity valuations today compared to in January for the stock market overall.
Cost of Equity
Risk Free Rate – Looking at US Treasuries, this is this most obvious and well-known change in this equation, with yields plummeting from 1.5% from the start of the year to near 0% today.
Market Risk Premium – This one is a bit complicated because it can’t really be immediately calculated and is based largely on investor sentiment. Historically, market risk premium has been between 5% to 6% for the US stock market. This can easily change, however, based on economic and financial conditions. Right now, let’s assume this has remained unchanged, but we’ll get back to this later.
Cost of Capital
Debt – Corporate debt this year has exploded, with an additional $1 Trillion raised by companies so far, more than double from last year at the same time of the year
Equity – SPY started at this year at $325; As of time of writing, it’s within 2% of this number
Cost of Debt – Despite skyrocketing bond yields in March as the economy experienced a liquidity crisis, bond yields have since stabilized, aided by the Fed backstop, and bonds yields are now at about the same levels as it was at the start of the year.
So assuming the risk premium being the same, compared to the start of the year, we have a slightly lower cost of equity from a lower risk free rate, roughly the same cost of debt, and having increased corporate debt, making the debt weigh more proportionally than before in our WACC. Since the cost of debt is usually slightly lower than the cost of equity, this provides a slight downwards pressure towards WACC as well. Thus, WACC has decreased by a small amount since January, due to increased debt levels and decreased risk free rates.
Free Cash Flow
For most non-tech companies, the lockdown has severely hurt their cash flows, with many industries such as airlines burning billions of dollars per month. It’s pretty hard to find up-to-date metrics of what free cash flow is for the S&P500, so instead, I’ll just use earnings as a proxy to make a very rough estimate of what it might look like. According to one source I found, Q1 saw the YoY decline of 14.6%, with an estimated 36% decline in earnings for Q2.
What free cash flow looks like for the remainder of the year, and future years depends on two very fundamental questions.
First, will there be a second wave of lockdowns later in the year? On one side of this, based on the history of similar pandemics and what most medical experts are saying, a second spike of cases is extremely likely to occur in the fall. On the other hand, the US population seemed to have stopped caring about the virus, and is currently distracted by other problems. It’s unclear whether or not the US population will care enough to lock down the country once again when the second wave hits after being desensitized with the first wave. In fact the first wave never really stopped; the US just started pretending that the pandemic is over and it’s time to go back to business as usual.
The second question, assuming the answer to the first question is “No”, is what kind of recovery the US economy will see. According to one source, “V”-shaped recovery will see earnings going back to normal as early as 2021. A “U”-shaped recovery, which will represent a recession, could see it take up until 2022 to return back to pre-COVID output levels. If we do see a second wave of lockdowns, then what might be seen is a “W”-shaped recovery, where we’ll see a second steep decline in GDP, and prolong the recession and make it tougher to get towards a recovery as more businesses go bankrupt.
Missing from this model is an “L”-shaped recovery, similar to what happened in Japan in the 1990s, and the US in the 1930s, which would represent a decade-long depression. This is what I personally believe would look like in my long-term thesis, along with some of the most famous investors in the financial world, like Ray Dalio.
Back to the DCF Model; we have an additional $1 Trillion of corporate debt. With a total market cap of $32 Trillion, the effect of this on the fair value of equities are negligible. With nearly the same market cap as in the beginning of the year, this would mean the market is pricing in the same Enterprise Value for the market as the start of the year. This implies either one of two things, based on the factors explained about
- The stock market has priced in a “V”-shaped recovery for earnings, with earnings and free cash flow beyond 2020 to remain unimpaired.
- The stock market has priced in a “U”-shaped recovery, but this is offset by a lower WACC as the market risk premium has significantly lowered. This can be caused by a few things, such as decreased perceived risk by investors of companies due to fiscal and monetary stimulus, and inflows of cash that was previously waiting in the sidelines (eg. retail investors), large international funds (eg. Saudi and Norway’s sovereign wealth funds), and yield-seeking institutions as Treasury yields drop to 0%, with no prospect of a rate increase anytime soon.
Why Fundamentals Might Not Matter Anymore
There’s another thing that can explain the recent stock market movements other the reasons explained above of what the stock market was pricing in – a stock market bubble. This happens when speculation in the market overpowers fundamentals, and the money in the market is no longer investing for long-term, earnings-based gains, but rather trying to get short-term gains through speculation. In other words people throwing their money in the stock market aren’t investing because they legitimately think the company has good fundamentals and will give a good return on their investment through earnings in the long term, but because they believe that stocks only go up, and hence they can make a quick buck by throwing some money in it and cashing out later and making money through capital gains. This is how every asset bubble starts, from the Dutch tulip-mania bubble, the English South Sea bubble, the 1920s stock market bubble, the dot com stock market bubble, and the real estate bubble in the 2000s.
To give an example to illustrate what’s happening, let’s look at one of the first major bankruptcies to have happened during the stock market crash – Whiting Petroleum (WLL). I’ve previously covered WLL, but the most interesting part of it is the dislocation of the valuation of its stock and bonds.
WLL reached a bankruptcy agreement with some of its key creditors on April 23. To be clear, this agreement has not been agreed upon with all its creditors and has yet to be approved by the court, and represents the best-case outcome for existing WLL shareholders; the court or creditors and reject this and demand better terms, or even worse, request to change the bankruptcy to a Chapter 7 and liquidate all the assets. The agreement was to restructure the corporation such that the bondholder will receive 97% of the restructured company’s equity, and the remaining 3% will be given to existing shareholders and management.
As of this writing, the price for WLL bonds were all between $15 – $16.50.
Using this, we can calculate what the bond market is pricing the restructured WLL at; multiplying the market value of all the outstanding bonds by 97% would give you the implied price of it. From the most recent 10-Q, the face value of all notes involved in the bankruptcy agreement is $2.4B. Using the highest bond price of $16.5, or 0.165% of face value, the implied market cap of the restructured WLL would be $2.4B * 0.165% * 97% = $384M.
With 91M shares outstanding, this would mean the fair value of the old WLL shares would be $384M * 3% / 91M = $0.13. As of writing, the current share price is more than 10 times higher than this, at $1.38.
How could this be possible? It’s because absolutely no one speculates with bonds, and bond prices are usually entirely grounded in fundamentals; people buying bonds buy it to hold onto it and not to sell it later at a higher price. The opposite is clearly happening with WLL stocks. Noone is buying WLL to receive a small stake in the reorganized corporation once the bankruptcy agreement clears in the best case; if an institution really wanted it, they would have just bought the bonds. Instead, people are buying these shares because they believe they can sell it shortly after for a higher price. This is what’s going on in the stock market right now, which is how bubbles form.
Making Tendies in a Bubble
Okay, so you now believe, like me, that the stock market is now in a bubble, and has been in a longer-term bubble for the last decade. Does this mean that I should sell all my long positions, buy puts, and short the market? Absolutely not. Never short a bubble. The whole idea of a bubble is that asset prices no longer reflect its intrinsic value, but is based on sentiment and speculation. Just because it’s overvalued now doesn’t mean it will immediately crash, and there’s nothing stopping it from being even more overvalued in the near future; fundamentals aren’t stopping it anymore. This has been the most clear the past week, with the first wave of COVID-19 cases never actually ending, bad vaccine news, and most US cities literally on fire, yet the stock market is skyrocketing for no apparent reason.
Instead, my personal strategy is to play into this bubble, while holding a substantial amount of VIX calls as a hedge for when the stock market bubble eventually pops. I’m holding VIX calls of multiple strike prices and expiry dates, mostly in Fall, since I personally believe the stock market will go back towards reality once more companies become insolvent (i.e. Fed can no longer help them), and a second spike in cases forces countries around the world to a second wave of lockdowns, as warned by most medical experts.
In the meanwhile, I’ll be using Technical Analysis, which is most useful for markets on assets with no fundamentals and driven by pure sentiment, to drive my short-term and medium-term strategies. Some of you who have been following me for the past few weeks may know that my previous thesis revolved around SPY never breaking above 293 (+2%), which looked like it was going to happen until it didn’t. This is because according to historical precedents, breaking above this level will bring SPY above the 62% retracement, and 200D EMA, and cause a 1W MACD crossover, which always resulted in a V-shaped recovery and new ATHs soon after. Of course, back then I believed fundamentals still mattered a bit and that this would not happen, but I was clearly wrong and it became clear we’re in a short-term super-bubble within the longer-term bubble; SPY will be hitting new ATHs within the next few weeks.
My personal strategy for playing the bubble is the same as previous weeks, for those that have been following me – if the market is pricing in a V-shaped recovery, go long on the weakest and most beaten-down stocks that are not currently in bankruptcy, since those will be skyrocketing within the next few weeks as we see a rotation of capital from strong stocks like FAANG that have retraced back to their ATHs towards weak stocks, such as airlines, cruises, and banks. In other words, I’m literally inversing my strategy from a few months ago. Two weeks ago, some of these positions included CCL, JPM, and BA, which I entered into as soon as I saw their 1W MACD crossover, and have been doing phenomenally well last week. However, I have since exited BA and JPM and taken profit and rolled them into M, GE, WFC, and DAL, among other positions.
My strategy for these tickers are simple – enter long positions (i.e. calls) as soon as they break the 24% retracement, which acted as a resistance for these industries until recently, and hence means that their stock price will skyrocket once it breaks it, and exit at the 50% retracements. BA and JPM have since hit these marks, so I exited. This week, I’m holding calls from CCL, DAL, WFC, and GE, which has yet to have broken these levels. The market will probably need to consolidate next week because we’ve had a lot of green days in a row, and it’s getting pretty overbought, so I’m not expecting these to print immediately. As I exit all of these positions and take profit, I’ll be rolling half of the profits over towards more VIX calls for more hedging.
As always, I’ll be posting some thoughts throughout the next few days in this thread below for people interested.
6/7 8PM – Futures very green, especially /RTY, maybe the market is just gonna go for a 5th green day in a row with strong bullish momentum
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.