Learning How to Bottom-Fish, Part 1: Tracking the Cash Flow

Bottom-fishers have cast their nets far and wide, but how do they avoid bringing up old boots?

Experienced investors who have ridden the stock market's many ups and downs have a range of methods for catching beaten-up stocks while avoiding toxic junk. Now, as an economic slowdown clobbers profits across a range of sectors, they're licking their chops. For some, bear markets can provide more attractive investment opportunities than the rip-roaring rallies of recent history.

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Learning How to Bottom-Fish, Part 1: Cash Flow

Learning How to Bottom-Fish, Part 2: Buying on the Cheap

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Poorer but No Wiser, Investors Remain Captivated by Tech

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So how to navigate dark and murky waters?

Before going to different approaches, a must-read disclaimer: No money manager of consequence will stick dogmatically with one stock-picking method. Common sense, industry knowledge and gut-feeling are critical. That said, an organized approach is needed to initially identify a batch of possible investments.

Take Bob Olstein, who recently bought a range of chip stocks for his (OFAFX Quote)Olstein Financial Alert fund. He's scooped up Cypress Semiconductor (CY Quote), LSI Logic (LSI Quote) and National Semiconductor (NSM Quote), all of which have recently reduced their expectations for near-term earnings. Olstein is looking beyond these problems, however.

Olstein does this by using an analysis that is based around a discounted cash flow model. In the right hands, this method, explained in a minute, can yield helpful results. In the wrong ones, it can be manipulated to justify absurdly high stock prices, as happened during the boom in tech-stock investing.

Discounted cash flow starts with predictions of future earnings or cash generation. Over five years, Olstein's projecting that the chipmakers can notch up 10% to 15% average annual growth in free cash flow, which is most commonly described as cash flow from operations minus capital expenditures. It's just as easy to use forecast net income or cash earnings (net income excluding noncash expenses).

Next the discounting: This is when future earnings are reduced annually at a rate that is supposed to reflect the risk of investing in a given stock. Usually, this discount rate incorporates a government bond yield, since that's the risk-free, no-brainer return available to all investors. Olstein simply doubles the yield on Treasury bills. Others use the company's cost of capital, which requires a fairly complex equation to calculate.

The Best Disinfectant

What follows is a theoretical example of how a discounted cash flow model can work. Made-up company Sunshine Semiconductor makes free cash flow now of $50 million, or $5 per share, in year one. It warns that earnings growth is going to slow in the following year, causing its stock to slide from $50, or 10 times year-one cash flow, to $40, a multiple of eight.

Discounting Sunshine's Earnings
Step 1	Estimate average earnings or cash flow growth rate. In the case of Sunshine Semi, 15%.
Step 2	Multiply earnings at this rate over five years. Take starting earnings of $50 million, or $5 per share.
	Excel formula: =(50,000,000)*1.15^5
	Fifth-year earnings = $101 million
Step 3	Apply discount rate, in this case 9.46%. Over five years, 9.46% discounts $101 million to $64 million.
	Excel formula: =(101,000,000)*((1/1.0946)^5)
Step 4	Divide $64 million by shares outstanding. For Sunshine, this makes $6.40.
Step 5	Compare discounted per-share earnings with most recent earnings per share. If discounted number is higher, the stock is at least worth a closer look.
Step 6	Choose appropriate price-to-earnings multiple to get the target stock price. If Sunshine were to trade at 1.3 times its growth rate, its P/E would be 20. Twenty times $6.40 equals a target price of $128. Compare with current price to gauge potential upside.
Step 7	Play around with inputs to check one's assumptions.
	For example, with Sunshine, a five-year growth rate of 10% can make the investment moot.
	(50,000,000)*1.1^5 equals $81 million. Discounted, that equals $5.10 per share.
	Similarly, increasing the discount rate to 15% makes for an investment that won't pay off.
Source: Detox

Let's assume free cash flow actually declines markedly, but the company then goes on to post a five-year annual growth rate of 15%. In the fifth year, it makes, say, $100 million in free cash flow. Double the five-year Treasury bill rate of 4.73% to get a discount rate of 9.46%. Discount the year-five $100 million to get a present value of $64 million, or $6.40 per share.

After showing a rebound in growth, the herd flocks back to Sunshine, causing it to again trade at 10 times free cash flow -- or even higher. As the stock market is a forward-looking animal, this can happen well before year five. At 10 times $6.40, Sunshine's stock would be worth $64. At 15 times, a multiple equivalent to its growth rate, the stock would be at $96, more than double the $40 paid amid the selloff.

To be sure, there's lots of guesswork here. Some error protection is given by discounting. Yet it's easy to see how it can go wrong: 5% growth over five years yields a paltry discounted per-share free cash flow number of $4. Under that slowing scenario, the multiple at Sunshine may come down to five times free cash flow, producing a price around $20, half the buy-in price. But, if in an extraordinary bout of pessimism the market bids Sunshine's stock down to $15, that $4 starts to look attractive. The old cliche applies: Everything has a price.

Clearly, investors must know their industries intimately -- not to mention the outlook for the economy. "Semiconductor companies have cycles," Olstein notes. Understanding the wild fluctuations that some industries go through can make steep earnings declines seem a lot less dire. However, Olstein makes efforts to steer clear of firms that could run into a serious cash shortage during a decline. He's reassured if a company has positive near-term free cash flow. In that case, a company can likely meet its debts. It can also invest in new research and plant and thereby position itself with market-leading new products to take advantage of the next upswing. "It's very important for a company to have excess cash -- in case you're wrong," Olstein adds.

For Part 2, click here.