Discounted Earnings Model

By Stella Goh – Market Data Analyst | 23 January 2019

We had covered the topic of the Discounted Cash Flow Model last time, today we will focus on the next valuation calculation method, Discounted Earnings Model.

Also known as Discounted Future Earnings, this model is to forecast the earnings value of a firm and firm’s estimated terminal value at a future date. Terminal value represents all future cash flows that will reflect the returns occurred in future which they are nearly impossible to forecast.

The future earnings and then will be used to discount it back to the present value by using the appropriate discount rate. The sum of the discounted future earnings will be equal to the estimated value of the firm. By using this model, investors must make sure that the earning of the company is always positive. If it is negative, this model cannot be applied.

Note: We can use Adjusted Earnings per Share or Historical Earnings per Share of the company based on investor’s perspective and determination.

Let us look at How to fill Up the Figures in ShareInvestor WebPro to get the intrinsic value for Nestlé Berhad by using Discounted Earnings Model as an example.

1.Earnings per Share (RM)

Earnings per Share (EPS) is a financial ratio that used to measure or indicate the profitability of a company. To get Earnings per share, the total earnings of a company available to common shareholders will divide by the total number of common shares outstanding. In other words, this is the amount of money each of the shares will receive if all of the profits distributed to the outstanding shares at the end of the year.

ShareInvestor WebPro does provide an automatic calculation of Earnings Per Share for you as shown as the picture below:

Based on the photo above, insert 2.75392 to the Earnings per Share column.

Note: You have to right-click the stock and choose financial, then you can found Earnings Per Share in the part of Per Share Data (Adjusted).

2. EPS Growth Rate (%)

For EPS Growth Rate, we can use the industry average EPS growth rate of the company in the model provided, or we can use the average EPS growth rate for the company based on selected years.

We will use Nestlé Berhad as an example this time; we will choose the industry EPS average growth rate which has been providing as shown below:-

3. Years Of Growth

A company CEO may project the years of growth and announce it to the investors during AGM ( Annual General Meeting). Sometimes, we also can saw some news from the newspaper regarding the years of growth for a particular company. The other ways are looking into the past industry growth cycle. If the industry cycle usually tends to continue to grow for 10 years, you can take this number as a reference.

Let us assume that the years of growth for Nestlé Berhad is 10 years.

Therefore, insert 10 years into years of growth column

4. Discount Rate (%)

As we have discussed in the previous Article of “Understanding Discounted Cash Flow Model (DCF)to find intrinsic value”,  we know that Discount rate is the required rate of return for investors. The rate of return would be applied to the future earnings or cash flow to discount it back to the present value. It could be the risk-free rate of yields such as government treasury bonds or the expected rate of return.

We will use the Capital Asset Pricing Model (CAPM) as below to find the Discount rate for Nestlé Berhad based on its own risks level.

The formula of Capital Asset Pricing Model is as follow:-

Risk Free Rate (R_f) = 0.041

We will obtain the risk-free rate from 10 years of Malaysia Government Bond by Google it which is 4.10% equivalent to 0.041 as shown as the picture below:-Beta (β) = 0.40

Beta is a measure of stock’s volatility which will use to analyse how much returns will fluctuate about the overall market return. Beta equal to 1 indicates that the stock price moves together with the market. The beta of less than 1 means the stock is less volatile than the market. A beta which is greater than one means the stock price is more volatile than the market.

We will obtain the beta for Nestlé Berhad from the Factsheet of ShareInvestor WebPro which is 0.40 on 16Jan2019 as the picture below. The beta that I have selected is beta (500days). There is no right or wrong choosing beta (75days) or beta (500days).

Note: Select particular stock and select FactSheet, and you will found Beta (500days) at the vital statistic part.

Expected Market Return E(R_m) = 0.067

To find the expected market return of the stock, we can use the Compound Annual Growth Rate (CAGR).

Compound Annual Growth Rate is a useful tool which uses to determine the annual growth rate of an investment which the values have fluctuated widely from one period to another.

The Formula of Compound Annual Growth Rate (CAGR) as follow:-

I will take 10 years of the stock to measure the expected market return from the Year 2009 to the Year 2019 for FBMKLCI.

Beginning Value for FBMKLCI in the Year 2009 = 878.30

Ending Value for FBMKLCI in the Year 2019 = 1673.08 (On 16 Jan 2019)

The period from the Year 2009 to the Year 2019 = 10 years

We calculate the CAGR after we have all the beginning value, ending value and number of years in the FBMKLCI. The expected market return that we have is 0.06657. After we got all the figures as above, we can use it to calculate Capital Asset Pricing Model to get the Discount Rate. The discount rate we will get is 5.14%. Therefore, I will round off and insert it as 5% into the Discount Rate column.

5. Terminal Growth Rate (%)

Terminal Growth Rate will be used to estimate the company’s growth beyond the projection period to calculate the terminal value of a company that will expand its future income beyond the initial few years’ projections.

Note: the terminal growth rate used must always be lower than the discount rate. There is no right or wrong to use Real Gross Domestic Product (GDP) or Global Gross Domestic Product (GDP).

I will use Growth Rate of Global Gross Domestic Product (GDP) for this year 2019 which is 3% equivalent to 0.03.

After we have all the info, we can key into our ShareInvestor WebPro to get the intrinsic value of Nestlé Berhad. The intrinsic value for Nestlé Berhad is RM 169.37

Now we know that Nestlé Berhad has an intrinsic value of RM169.37. The current market value of Nestlé Berhad is RM147.30 (Based 16 January 2019). Based on the Discounted Earnings Model, it shows that Nestlé Berhad currently is in fair value due to the margin value of the stock is not much.