The Discounted Cash Flow Terminal Value Model As an Investment Strategy
173 Pages Posted: 17 Jun 2019
Date Written: May 15, 2019
To determine a company’s intrinsic value, equity analysts make forecasts several years into the future, although the value generated in the explicit forecast period only represents a small part of the total valuation. Instead, most of a company’s value is determined in the terminal period - a perpetuity that includes all years after the explicit forecast. The literature states that the forecasts of analysts are too optimistic, and their assumptions in the terminal period does not reflect a normalized level in the company’s business cycle.
This thesis develops several investment strategies based on estimates of the terminal value by using past financials with the goal of eliminating optimism and bias. Our valuations utilize the Gordon Growth and value driver formulas – both of which are commonly used in discounted cash flow models. We present several variations to estimate the fundamental components in the two formulas and test whether these variations are robust. The strategies are applied to the 727 non-financial stocks that have been a part of the S&P 500 index from 2003 to 2018. The results are benchmarked against the index and the performance of stock recommendations from Morningstar’s independent equity analysts.
By investing in stocks trading below their terminal value, the strategies produce average annualized returns between 12.6% and 17.6% in excess of the risk-free rate, while the S&P 500 index excluding financials has generated 12.5% annualized. A portfolio of 4- and 5-star rated stocks gave 13.1% yearly but with a relatively higher risk.
The Gordon Growth and value driver strategies have similar returns and risk, but an important finding is that they invest in stocks with very different characteristics. The Gordon Growth strategy invests in stocks that appear cheap on price multiples and have higher debt, lower margins, and lower returns on invested capital. In contrast, the value driver strategy invests in cheap stocks with higher quality on these parameters. Both strategies favour stocks in the healthcare and consumer defensive sectors but often find technology stocks to be overvalued. If the strategies are used to both buy cheap and short-sell expensive stocks, they continue to deliver strong risk-adjusted returns, but the different variations of the strategies are less consistent – particularly the value driver strategies.
The results are robust across many variations of the Gordon Growth and value driver strategies, but if the assumptions to growth and discount rates become too conservative, the amount of undervalued stocks is reduced, which makes the strategies more concentrated and riskier. The discount rate also has significant influence on which sectors appear most attractive.
The results indicate, that our strategies represent a better alternative to the traditional quantitative value factor of Fama & French that evaluates stocks on their book-to-market ratios. The value factor has performed poorly in the past decade and appear redundant in the face of more recent factors of profitability and investment.
Keywords: terminal value, quantitative, value, valuation, Morningstar
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