Understanding the risk and company evaluation Part 1

Don’t you hate it when you just can’t work out what an announcement means? And doesn’t it just drive you nuts when you’re buying while the rest of the market is selling? Or just as bad you are selling when the rest of the market is buying. And what the hell does a flow-rate of X amount mean to the stock price anyway.
Well you’re not alone and with ERH about to hopefully unveil some cracking results (fingers, toes and eyes crossed) I thought that this would be the perfect time to cover some basic valuation methods so you don’t make those same old mistakes that have seen some great profits go straight down the drain in the past.

The major problem we will run into at the moment is in the current market you can all but throw the text books out the window as a common sense approach to valuation of companies has been over taken by blind panic. But for the patient investor that does his homework these are times of great opportunity. But , yes the enviable “BUT” we all need to be conscious of the risks we are taking with our investing and I can’t express this strongly enough, if you don’t have the time or the skill sets to evaluate the risks of your investments then please, please seek professional advice. For those that are interested I can help put you in contact with some excellent brokers.

Risk evaluation should be the first port of call for all new investments and the things to look for are as follows.
- you have to look at solvency (i.e. debt)
- cash on hand
- how well established it is
- is it threatened by competition
- patents
- management
- other factors that may impact earnings
- sovereign risk
- war/politically unstable
- isolation
- so on and so on and so on...
Of course I am going to use ERH as the case study for this post and some maybe blown away by the results but the thing to remember here is to be honest with it an especially when you’re playing in the speculative end of the market, it’s always best to err on the side of caution.
So that being the case I am going to use a DCF model (discount cash flow) and use a discount rate of 16% as my risk factor.

The beauty of using a DCF is that you can calculate future growth in not only production rates but also say the increase in the oil price or the decrease (it really is a flexible tool when doing your valuations).

So only based on what we know for sure I will do this calculation and show you how to create a spread sheet. After you have done this once it should then become easier to set one up for your next company.

What is a DCF model (discount cash flow)
To show how discounted cash flow analysis is performed, consider the following simplified example.
John Doe buys a house for $100,000. Three years later, he expects to be able to sell this house for $150,000.
Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 − $100,000 = $50,000, or 50%. If that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 14.5%. Looking at those figures, he might be justified in thinking that the purchase looked like a good idea.
1.1453 x 100000 = 150000 approximately.
However, since three years have passed between the purchase and the sale, any cash flow from the sale must be discounted accordingly. At the time John Doe buys the house, the 3-year US Treasury Note rate is 5% per annum. Treasury Notes are generally considered to be inherently less risky than real estate, since the value of the Note is guaranteed by the US Government and there is a liquid market for the purchase and sale of T-Notes. If he hadn't put his money into buying the house, he could have invested it in the relatively safe T-Notes instead. This 5% per annum can therefore be regarded as the risk-free interest rate for the relevant period (3 years).
Using the DPV formula above, that means that the value of $150,000 received in three years actually has a present value of $129,576 (rounded off). Those future dollars aren't worth the same as the dollars we have now.
Subtracting the purchase price of the house ($100,000) from the present value results in the net present value of the whole transaction, which would be $29,576 or a little more than 29% of the purchase price.
Another way of looking at the deal as the excess return achieved (over the risk-free rate) is (14.5%-5.0%)/(100%+5%) or approximately 9.0% (still very respectable). (As a check, 1.050 x 1.090 = 1.145 approximately.)
But what about risk?
We assume that the $150,000 is John's best estimate of the sale price that he will be able to achieve in 3 years time (after deducting all expenses, of course). There is of course a lot of uncertainty about house prices, and the outturn may end up higher or lower than this estimate.
(The house John is buying is in a "good neighborhood", but market values have been rising quite a lot lately and the real estate market analysts in the media are talking about a slow-down and higher interest rates. There is a probability that John might not be able to get the full $150,000 he is expecting in three years due to a slowing of price appreciation, or that loss of liquidity in the real estate market might make it very hard for him to sell at all.)
Under normal circumstances, people entering into such transactions are risk-averse, that is to say that they are prepared to accept a lower expected return for the sake of avoiding risk. See Capital asset pricing model for a further discussion of this. For the sake of the example (and this is a gross simplification), let's assume that he values this particular risk at 5% per annum (we could perform a more precise probabilistic analysis of the risk, but that is beyond the scope of this article). Therefore, allowing for this risk, his expected return is now 9.0% per annum (the arithmetic is the same as above).
And the excess return over the risk-free rate is now (9.0%-5.0%)/(100% + 5%) which comes to approximately 3.8% per annum.
That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a good one: it produces enough profit to compensate for tying up capital and incurring risk with a little extra left over. When investors and managers perform DCF analysis, the important thing is that the net present value of the decision after discounting all future cash flows at least be positive (more than zero). If it is negative, that means that the investment decision would actually lose money even if it appears to generate a nominal profit. For instance, if the expected sale price of John Doe's house in the example above was not $150,000 in three years, but $130,000 in three years or $150,000 in five years, then on the above assumptions buying the house would actually cause John to lose money in present-value terms (about $3,000 in the first case, and about $8,000 in the second). Similarly, if the house was located in an undesirable neighborhood and the Federal Reserve Bank was about to raise interest rates by five percentage points, then the risk factor would be a lot higher than 5%: it might not be possible for him to make a profit in discounted terms even if he could sell the house for $200,000 in three years.
In this example, only one future cash flow was considered. For a decision which generates multiple cash flows in multiple time periods, all the cash flows must be discounted and then summed into a single net present value.
The above was taking from Discounted cash flow - Wikipedia, the free encyclopedia