A Walkthrough of How I Look at New Stocks (Valuations)
A disclaimer, I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand.
In my previous article I described the first half of how I perform a complete analysis on a company. In short, my process starts with opening a financial statement. I look at the self-described overview of the business first. I then look at how the company has made money. After this I look at risks and extrapolate drivers of revenue and profitability.
After understanding these factors and the way the business makes money, I tend to take a high-level view next. I tend to look generally at things like industry outlook, if the industry is cyclical, what stage of growth the industry is in, and how capital intensive the industry is. For solar power the outlook is extremely positive. With more of a focus on green energy, I only expect the industry to grow faster. That being, said the solar industry is in an early stage of development, this is evidenced by the fact that every time output is doubled, prices typically fall 20%. Manufacturing and operating solar projects, is capital intensive, which means lower competition but also means high spending is necessary to grow the business. The cashflows are not very cyclical, typically solar projects are large investments that are planned years in advance. There may be some instability in cash flows due to such few large projects accounting for a sizable portion of revenue, however. In contrast, the consumer segment likely is cyclical.
Thinking about the industry like this makes me like Canadian Solar for a few reasons. I am worried about the current level of consumer demand, but Canadian Solar is likely not very affected by this. Some projects may be delayed due to social distancing, but these projects will bring revenue to the company in the near term. Comparing Canadian Solar to the solar industry, I like what I see. Canadian Solar historically has a below average cost per watt, this means they can undercut their competition and still profit. I also like that Canadian Solar has diversified revenue streams.
Typically after generally identifying a company’s market position, and thinking about it relative to the industry, I like to compare it to similar companies. I typically compare companies’ market caps, enterprise value, and their percentage of debt financing used. This helps me get an idea of how large the company is and if it has a debt load that is something to worry about. I also compare their revenue and EBITDA to get an idea of how large of a company it is, and how profitable the company is. Finally I look at financial ratios for valuation.
The companies I compare Canadian Solar to are First Solar, Jinko Solar, Sunnova Energy Int, Vivint Solar, Enphase Energy and Vestas Wind Systems. The solar companies all manufacture solar modules or components except Vestas. And the two most comparable companies First Solar and Jinko Solar manufacture and operate solar projects just like Canadian Solar. I included Vestas as well because many of these solar companies are much smaller than Canadian Solar, so I though a similarly mature company would be a good comparison. Also, Vestas does makes wind turbines and operates wind farms in a similar (temporary) way that Canadian Solar does.
To establish a relative valuation for Canadian Solar, I took the average and the median of the following ratios from comparable companies: EV/Sales, EV/EBITDA, P/E, and P/CF. I base the comparable valuation on the median of the following ratios to avoid outliers affecting the result. P/CF is a ratio I usually like, there are a few problems with it in this case, and thus I will not use it to determine a valuation. The main reason is that many of Canadian Solar’s competitors are smaller and growing quicker, this means turning sales to cash is not a priority. Looking at the three other ratios, Canadian Solar should have an enterprise value of between $3000 million and $6600 million, likely closer to $3000 million. Based on this Canadian solar seems undervalued relative to its peers, since it is only trading at an enterprise value of $2800 million ($22 a share). Additionally, many of Canadian Solar’s ratios are more favorable than its peers, suggesting a potential mispricing. Canadian Solar has among the lowest valuation ratios, and has strong profitability, growth, as well as an excellent ability to convert sales to cash. Seeing Sunnova and Vivint trade at over 15 times sales is very strange to me and definitely requires another look. In general Canadian Solar seems cheap, and now I want to figure out if I missed a flaw, or if there is real opportunity here.
The way I choose to do this is to create a full 3-statement financial model, with a discounted cash flow valuation. By taking a very close look we can determine an intrinsic valuation range for Canadian Solar and compare it with our relative valuation.
I will explain what steps and assumptions I used to build my model in my next article, however for simplicity, I will highlight my findings. I project that Canadian Solar will go from a $379 million EBITDA in 2018 to a $470 million EBITDA in 2024. Taking the present value Canadian Solar’s future unlevered free cash flows, I got a value of $292 million. This is the value that Canadian Solar will bring from now until 2024. To get its future value we can use the exit multiple method, or the terminal value method (Again see vocab section with any questions). Using the exit multiples method we get an equity value of $48 dollars per share. Using the terminal value method, we get an equity value of $22 dollars per share. This range is extremely wide; however we can dissect it using information from the comparable ratio analysis as well.
This wide range comes from two main reasons in my opinion. One is that on a ratio basis Canadian Solar is undervalued compared to its peers. This means the average valuation ratios are higher than Canadian Solar’s ratios, thus producing a very high exit multiple valuation. The next reason is that Canadian Solar’s year by year revenues are very hard to predict. A large part of their earnings comes from a few projects, so if those projects get delayed, Canadian Solar looks like it had a bad year.
We determined that Canadian Solar is relatively undervalued on a ratio basis, and that Canadian Solar appears to be at least fair value or potentially even undervalued on an intrinsic value basis. The last step before making a determination is to find out why Canadian Solar may be undervalued.
Solar module prices have dropped about 10-15% per year, and while Canadian Solar has increased its sales on a per watt basis (around 10% per year), this aggressive decrease in prices has meant slower, if any top line growth. In addition, relying on a few large projects in their energy segment has meant unstable revenue in general. My opinion is that, what appears like modest growth has meant that Canadian Solar has been overshadowed by solar players that are more focused on manufacturing or focused in the retail space. Over the long term I like Canadian Solar’s focus on building solar projects. The fact that they are vertically integrated (manufacture components) will provide major cost saving. So with relative valuation on its side, and the largest solar project pipeline, I am bullish long term.
Looking at technicals does not provide the best picture for Canadian Solar. The RSI is not giving a signal either way. Currently on a weekly, monthly, and yearly basis, Bollinger Bands do not reveal anything. Lastly, the MACD is slightly bullish on a yearly basis but bearish over shorter terms. I like Canadian Solar, but having missed out on a 20% rally, I will wait to enter. One trade that interests me would be a pairs trade long Canadian Solar, short Jinko Solar or First Solar.
Remember this is not investment advice, I am not a financial advisor, and I just write my opinions.
Vocab
Terminal Value- The value of the busines beyond the projected cash flows.
Exit Multiples- Assuming that after the 5-year forecast period, the company is sold at public market valuations. We then use financial ratios to value to company. And we discount that sale value to present value.
EBITDA- earnings before interest, taxes, depreciation, and amortization.
Solar Module- A solar panel.
Unlevered free cash flow- EBITDA- taxes- capital expenditures – changes in working capital
Discounted cash flow- We take the value of a firm to be the present value of its future cash flows.
Present value- We take each future dollar of cash flow and we discount it so that you would be indifferent between receiving a dollar of future earnings, or that dollar discounted to the present value.
Discount rate- The discount rate is the weighted average cost of capital. A discount rate is the rate of return that you would give up by taking the discounted cash flow today, versus the full value in a year.
