EPS or FCFE for DCF analysis?

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Teslaphil

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Hi all,
1) I need a tutor to help me pass Level I. Requirements are: provide explanations to questions I may have via email or text or phone depending on the level of complexity. I can offer up to fair market value for this service provided that FMV isn’t cost prohibitive for me. I don’t estimate there will be too many questions - just every once in a while. In fact I’ve gone through 90% of the material and EOC questions and only have 2 or 3 off the top of my head.
2) What are the advantages and disadvantages of using 10yr averages of EPS vs FCFE when using DCF to determine intrinsic value? Since EPS also flows to shareholders and EPS history is readily available online, would it not be better to use EPS over FCFE? In other words, please give me a reason(s) why I should prefer to use FCFE over EPS when doing a DCR. Is FCFE simply more “robust” or comprehensive b/c it includes dividend paying capacity and/or the ability to adjust other items such as operating margins?
Thank you!
 
Teslaphil wrote:Hi all,
1) I need a tutor to help me pass Level I. Requirements are: provide explanations to questions I may have via email or text or phone depending on the level of complexity. I can offer up to fair market value for this service provided that FMV isn’t cost prohibitive for me. I don’t estimate there will be too many questions - just every once in a while. In fact I’ve gone through 90% of the material and EOC questions and only have 2 or 3 off the top of my head.
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I tutor all three levels of the CFA exams: http://financialexamhelp123.com/services/.
Teslaphil wrote:2) What are the advantages and disadvantages of using 10yr averages of EPS vs FCFE when using DCF to determine intrinsic value? Since EPS also flows to shareholders and EPS history is readily available online, would it not be better to use EPS over FCFE? In other words, please give me a reason(s) why I should prefer to use FCFE over EPS when doing a DCR. Is FCFE simply more “robust” or comprehensive b/c it includes dividend paying capacity and/or the ability to adjust other items such as operating margins?
Thank you!
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EPS isn’t cash flow, so it’s not appropriate for a DCF model. If a company pays a dividend, then DPS would be appropriate. If the company doesn’t pay a dividend, FCFE would be appropriate.
 
Thank you. Makes perfect sense.
However, now the flip side: as a quick and dirty way to determine intrinsic value using DCF, would it be alright to use readily-available EPS history, determine its geometric mean over 10 yrs, and use this mean as the company’s assumed growth rate? How “wrong” would this be compared to using forcasted FCFE?
(Thank you I will look up your website later today!)
 
Assuming you adjust the EPS data for changes in WACSO, the growth rate you get from EPS over 10 years is likely to be quite close to the growth rate of FCFE. You’ll get differences because of accrual accounting and different capital expenditures year to year, but over time they’ll even out. I suspect that 10 years is probably enough time for them to do so, but 20 years would be better.
 
^ I somwhat agree with this, although it certainly depends on the quality of earnings for the company.
If the company has growth in receivables that is consistently higher than growth in revenue, then I would suspect that FCFE growth would differ significantly from EPS grwoth. This could be a way for management to expidite earnings when there isn’t any cash flow. The could be the result of poor credit quality, poor collection services and result in write offs and dampen future earnings.
(Level II topic)
 
I agree that it’s a quality of earnings issue, which is the reason that I said that 20 years of data would be better than 10: eventually, the differences will net to (nearly) zero.
 
These answers are exactly what I was looking for and more/less what I was suspecting, and I thank you both for helping a Level I dude out!
 
S2000magician wrote:EPS isn’t cash flow, so it’s not appropriate for a DCF model. If a company pays a dividend, then DPS would be appropriate. If the company doesn’t pay a dividend, FCFE would be appropriate.
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I tend to think that the use of DDM is getting obsolete for equity valuation. It tends to underestimate equity value most of the time.
Even when adjusted for buybacks, it’s not very a very sustainable model, and less flexible to account for fundamental changes. It might be less flawed for mature companies growing at stable rates with a long history of dividend payout policies, but even then it fails to account for capital appreciation.
Teslaphil wrote:
Thank you. Makes perfect sense.
However, now the flip side: as a quick and dirty way to determine intrinsic value using DCF, would it be alright to use readily-available EPS history, determine its geometric mean over 10 yrs, and use this mean as the company’s assumed growth rate? How “wrong” would this be compared to using forcasted FCFE?
(Thank you I will look up your website later today!)
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You’d want a smoothed out EPS (earnings accounting for changes in capital structure particularly) dataset if you want to caluclate the geometric mean (OLS in this case). Because the geometric mean fails to take into account trends and cyclicality, since it’s only input is the beginning and end point.
It would not differ at all in theory if the firm is in steady state, net income smooths out your cash inflows to equity, but you need to assume a stable an equity reinvestment rate, and a stable capital structure. Otherwise, you’d find big differences in both, but they should eventually revert to simillar growth as the firm becomes a stalwart, consistent with the previous assumptions
dwheaton wrote:
^ I somwhat agree with this, although it certainly depends on the quality of earnings for the company.
If the company has growth in receivables that is consistently higher than growth in revenue, then I would suspect that FCFE growth would differ significantly from EPS grwoth. This could be a way for management to expidite earnings when there isn’t any cash flow. The could be the result of poor credit quality, poor collection services and result in write offs and dampen future earnings.
(Level II topic)
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That does not make sense, if we assume that recivables are growing faster than revenue, then they will eventually exceed revenue. The change in working capital should smooth out over the years and hold constant, thereby bringing FCFE on terms with NI.
 
dwheaton wrote:
^ and what accounting rule says receivables cannot exceed revenue?
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It’s a rare occurence that signals a red flag, but possible. However, it’s not sustainable in perpetuity to have A/R growth exceeding revenues.
 
And I was simply pointing out why growth in earnings is not always a suitable metric for growth in FCFE.
Thank you for clarifying.
 
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