A simulation-based valuation of DXC Technology (DXC): May 2021

Summary

- DXC Technology (DXC) is a technology consulting and services company headquartered in Tysons, Virginia ().

- Launched in April of 2017, DXC was created from the merger of Computer Sciences Corporation (CSC) and the Enterprise Services division of Hewlett Packard Enterprise (HPE).

- In this post we provide a simulation-based (sim-based) valuation () of DXC.

- Our results suggest the following fair values – stock price: $70.21, and price-to-earnings ratio: 7.65.

- DXC currently trades at $36.86, so it appears to be undervalued, with a potential upside of 90.48%.

DXC Technology (DXC)

DXC Technology (DXC) is a technology consulting and services company headquartered in Tysons, Virginia. Launched on April 3, 2017, DXC was created from the merger of Computer Sciences Corporation (CSC) and the Enterprise Services division of Hewlett Packard Enterprise (HPE).

The company operates in more than 70 countries, and counts among its customers several federal and regional government agencies. In many ways DXC is similar to Accenture (ACN). In fact, DXC has had since September 2019 a new CEO, Mike Salvino, who previously served as group CEO for Accenture Operations.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of DXC.

At the time of this writing the company had a negative net profit margin of -15.67% and a price-to-sales ratio of 0.48. The company has great growth potential, as long as it transitions from legacy technology services to more modern and narrow offerings (e.g., cloud applications, security consulting). This transition seems to be a major focus of the new CEO.

To be somewhat conservative, we will use recent numbers from Accenture to set our sim-based estimated earnings growth rate for the next 5 years (1.24%) and net profit margin (11.95%). We believe this to be a conservative approach because DXC is much smaller than Accenture; e.g., DXC’s revenues are less than half of Accenture’s.

Another reason why we believe the above is a conservative approach is that it is quite possible that in the near future earnings growth will be much higher than it is now. Sales are likely to go up, and so should earnings – the latter at a faster pace, leading to higher margins for many of DXC’s services (the same goes for Accenture).

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $70.21, and price-to-earnings ratio: 7.65. At the time of this writing, DXC trades at $36.86, so it appears to be undervalued, with a potential upside of 90.48%. In fact, the company seems to be quite undervalued at the moment, even though its shares gained more than 100% in value in the last 12 months.

Note that we assumed a positive net profit margin of 11.95% for a company that actually has a net profit margin of -15.67%. This type of assumption is useful in valuing growing companies that have a negative profit margin, which is often the case with companies that have been experiencing problems and are turning around; as well as high-growth companies that have been publicly-traded for only a few years.

Other pluses and minuses

About a year ago, DXC paid an attractive dividend of 5.11%, significantly higher than the average S&P 500 dividend at the time. We thought then that the dividend was relatively safe, but the COVID recession proved us wrong. That dividend was cut to zero in response to the recession, and still no dividend was being paid at the time of this writing.

While somewhat leveraged, DXC has a reasonably attractive balance sheet, with EBITDA in the neighborhood of $2.53 billion. This, added to its cash position of $3.92 billion, is fairly close to its $7.80 billion dollar debt. So, DXC is leveraged, but much less so than many other companies with much higher valuations.

Disclosure

The author owns DXC shares at the time of this writing.

Cash hedging with high-dividend securities: A look at the AGNC, ORC, OXLC and SRET (April 2021)

Summary

- The cash hedging strategy discussed in this post is one in which an investor raises cash, to protect against a severe correction, but maintains a high-dividend allocation that is calculated as a proportion of the cash position.

- Let us assume that the investor has $20,000 and wants to have 50% of her portfolio in cash, as protection against a severe market correction.

- We show that, if the investor wants the equivalent of a 2.50% return on the cash, before taxes, she needs to invest only a fraction of the cash in a high-dividend security.

- Often over 80% of her cash is protected. The portion at risk generates the desired yield.

Cash hedging

The cash hedging strategy discussed in this post is one in which an investor raises cash, to protect against a severe correction, but maintains a high-dividend allocation that is calculated as a proportion of the cash position. Cash is raised as investment gains grow together with the perception that the market is overvalued. We assume that interest on “pure” cash is negligible, as it is at the time of this writing.

The high-dividend allocation is calculated as follows: (desired cash allocation) times (desired yield on cash) divided by (high-dividend security yield). The remainder is the actual cash allocation, which is “safe”. The high-dividend allocation is the portion at risk, which earns the equivalent of the desired yield on the entire desired cash allocation.

Let us assume that the investor has $20,000 in a portfolio and wants to have 50% of that in cash, as protection against a severe market correction. The table below assumes that she wants a 2.50% return on the cash portion, before taxes. For that, she invests $1,785.71 in a high-dividend security with a yield of 14%. In this example, over 82% of her cash is protected. The portion at risk generates the desired yield.

AGNC, ORC, OXLC and SRET

Investors may consider using one or more of the following high-dividend securities to implement our cash hedging strategy. These securities pay dividends regularly, typically on a monthly basis.
- AGNC Investment Corp. (AGNC, ), a mortgage real estate investment trust (REIT) with an 8.59% yield (at the time of this writing).
- Orchid Island Capital, Inc. (ORC, ), another mortgage REIT, this one with a 12.98% yield.
- Oxford Lane Capital Corp. (OXLC, ), a collateralized loan obligation (CLO) fund with a 12.86% yield.
- Global X SuperDividend REIT ETF (SRET, ), a high-turnover fund of REITs with an 8.01% yield.

How much cash at risk?

The table below shows how much money would be needed across various high-dividend yield options ranging from 14% to 8%. They cover all of the funds above, in terms of yield. For example, if one were to use SRET, a little over 30% of the cash would have to be invested (i.e., put at risk) to yield the equivalent of a return of 2.5% on the full $10,000.

Final thoughts

Generally speaking, the higher the yield, the higher the risk. Often this is due to leverage being used by the security to generate the outsized yields. Nevertheless, it tends to be safer for an investor to buy a leveraged security (e.g., the ORC) than to borrow money to implement leverage directly. For example, one could get a return on a 4%-yielding security that is significantly higher than the 4% yield by borrowing to buy more of the security – a debt that has to be paid back, with interest.

Many investors like to employ protection strategies other than increasing their cash allocation. A favorite is the use of “put” options. The reality is that these strategies are highly specialized and require much better timing than holding cash – e.g., “put” options are “timed” bets, since they expire at a certain date. Because of these and other constraints, they tend to be less successful.

Would growth underperform value at 5% inflation: A simulation-based approach

Summary

- We often hear from experts on business media outlets that inflation has a much more pernicious effect on growth stocks than value stocks.

- In this post we provide a simulation-based (sim-based) assessment () of this assumption.

- Our results suggest that growth stocks may do better under relatively high inflation than value stocks.

The nonlinear relationship between the PE ratio and earnings growth

In a previous post () we have shown that there is a nonlinear relationship between the price/earnings (PE) and the price/earnings to growth (PEG) ratios, which are widely used measures of company valuation. The PE divided by the PEG yields the expected growth in earnings, usually for the following 5 years.

Value stock

For the purposes of our discussion, we will consider a fictitious “value” company with a stock price of $100 and expected earnings growth of 10% (real growth of 5%). The PE ratio is 11.89 (see: ), which is considered fair assuming that there is no inflation. (An equivalent assumption, with slightly different simulation parameters, would be that the rate of inflation is covered by the company’s dividend.)

The table below summarizes our sim-based estimation of the fair value of this value company at 5% inflation. As you can see, it is $77.76. The reduction (from $100) accounts for the yearly loss of 5% in real terms.

Growth stock

We will also consider a fictitious “growth” company with a stock price of also $100 and expected earnings growth of 75% (real growth of 70%). The PE ratio is 260.47, which is considered fair, again, assuming that there is no inflation (see: ).

The table below summarizes our sim-based estimation of the fair value of this value company at 5% inflation. As you can see, it is $80.58. Analogously to what happened with the value company, here the reduction (from $100) accounts for the yearly loss of 5% in real terms.

Comparative performance

The table below summarizes a comparison of the two sim-based estimations for the value and growth stocks. Note that in neither case we assume that the company can pass on the inflation to its customers. As you can see, the growth stock does better under relatively high inflation than the value stock.

What we often hear from experts on business media outlets is that inflation has a much more dramatic negative effect on growth stocks than value stocks. That is not what our simulation suggests.

Final thoughts

Both value and growth stocks should be affected by the expectation of future inflation. If that expectation proves to be incorrect, then an upward adjustment should ensue.

Generally speaking, inflation should be particularly problematic for companies that sell tangible items via influential retailers, because usually the companies have to wait for the items to be sold to get paid.

The above scenario is normally seen in the manufacturing sector, which is usually where value companies are.

If you go back to the sim-based results on the two similar tables, you will notice that at year 10 both value and growth stocks approximately triple in nominal terms – this is what we assume in our algorithms to set our fair values; going “backwards”, so to speak.

But if you look at years 11 and 12, growth significantly outperforms value.

A simulation-based valuation of ViacomCBS Inc. (VIAC): February 2020

Summary

- ViacomCBS (VIAC) is a multinational mass media conglomerate headquartered in New York City. It was formed as a result of the merger of CBS Corporation and Viacom in late 2019 ().

- In this post we provide a simulation-based (sim-based) valuation () of VIAC.

- We set our sim-based estimated earnings growth rate for the next 5 years to be 30%. This is approximately twice the consensus among sell-side analysts, which we see as conservative.

- Our results suggest the following fair values – stock price: $69.76, and price-to-earnings ratio: 32.45.

- VIAC trades at about $62.69 at the time of this writing, so it appears to be undervalued, with a potential upside of a little more than 11.27%.

- If earnings growth rate for the next 5 years turns out to be 35% (instead of the 30% we used), our simulation suggests the following fair values – stock price: $89.09, and price-to-earnings ratio: 41.44.

ViacomCBS (VIAC)

ViacomCBS is a multinational mass media conglomerate headquartered in New York City (). It was formed as a result of the merger of CBS Corporation and Viacom in late 2019. The company owns, among other highly valuable properties, the film studio Paramount Pictures, CBS Television Studios, CBS Television Stations, MTV, Nickelodeon, BET, Comedy Central, and Showtime. Valuable sports rights owned include the NFL, the NCAA's March Madness, and college football.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of VIAC.

At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 29.16. The trailing twelve months price-to-cash flow ratio was 13.60. Earnings growth trends have been remarkably positive recently. We will set our sim-based estimated earnings growth rate for the next 5 years to be 30%. This is approximately twice the consensus among sell-side analysts, which we see as conservative.

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $69.76, and price-to-earnings ratio: 32.45. VIAC trades at about $62.69 at the time of this writing, so it appears to be undervalued, with a potential upside of a little more than 11.27%.

Final thoughts

Discovery, Inc. (DISCA), which will soon report earnings, is very similar to VIAC in terms of balance sheet and growth prospects. Nevertheless, DISCA’s price-to-sales ratio is about twice the one for VIAC.

One could argue that sell-side analysts are underestimating the potential impact on earnings of the COVID reopening with respect to the NFL, the NCAA's March Madness, and college football. If earnings growth rate for the next 5 years turns out to be 35% (instead of the 30% we used), our simulation suggests the following fair values – stock price: $89.09, and price-to-earnings ratio: 41.44.

Disclosure

The author owns VIAC shares at the time of this writing.

Reflation or inflation? A look at 12-month commodity trends in January 2021

Summary

- The term “reflation” is used in this post to refer to an increase in certain commodity prices due to the expectation of increased economic activity.

- The term “inflation” refers to an increase in certain commodity prices due to currency devaluation.

- When we look at the past 12-month period, copper has been increasingly outperforming silver, and silver outperforming gold.

- The patterns above suggest reflation, which is generally bullish for equities going forward.

Reflation versus inflation

The term “reflation” is used in this post to refer to an increase in certain commodity prices due to the expectation of increased economic activity. The term “inflation” refers to an increase in certain commodity prices due to currency devaluation. Generally speaking, reflation would be bullish for equities, and inflation would not.

12-month commodity trends: Copper, silver, and gold

A sign of reflation would be a 12-month trend characterized by copper outperforming silver, and silver outperforming gold – in terms of price. Inflation, on the other hand, would be characterized by gold outperforming silver, and silver outperforming copper.

The figure below shows the past 12-month performances, in terms of price increases, for the following commodity funds: SPDR Gold Shares (GLD), iShares Silver Trust (SLV), and United States Copper Index Fund, LP (CPER). The performances are measured by percentage increases in prices for the past 12 months, 6 months, and 3 months.

As you can see, the trend for the past 12 months has been one of copper increasingly outperforming silver, and silver outperforming gold. Silver has actually done better than copper when we consider the entire 12-month period, but copper has been significantly outperforming silver more recently – in the past 6 and 3 months.

The patterns above suggest reflation, which is generally bullish for equities going forward. These patterns are particularly bullish for “banks and tanks” equities, and also for commodities in general – more so for commodities that have an industrial use.

A simulation-based valuation of Alliance Data Systems Corporation (ADS): December 2020

Summary

- Alliance Data Systems Corporation (ADS) is a marketing and loyalty programs provider headquartered in Columbus, Ohio ().

- In this post we provide a simulation-based (sim-based) valuation () of ADS.

- Our results suggest the following fair values – stock price: $156.13, and price-to-earnings ratio: 18.16.

- ADS trades at $77 at the time of this writing, so it appears to be undervalued, with a potential upside of a little more than 100%.

Alliance Data Systems Corporation (ADS)

Alliance Data Systems Corporation (ADS) is a marketing and loyalty programs provider headquartered in Columbus, Ohio. Among other things, the company provides private label credit and debit cards, which allows them to also add value to their clients by developing and executing data-driven marketing initiatives. Recently ADS announced the upcoming acquisition of Bread, a digital payments company.

The company operates in two main segments: Card Services and LoyaltyOne. Card Services makes up about 80% of the company’s revenues; it involves transaction processing and customer collections services. LoyaltyOne generates approximately 20% of the revenues, and involves data-driven marketing initiatives. Financial services providers, grocers, drug stores, and specialty retailers are among the company’s main clients.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of ADS.

At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 11.63. The trailing twelve months price-to-cash flow ratio was 5.57. Earnings growth trends have been remarkably positive recently. We will set our sim-based estimated earnings growth rate for the next 5 years to be the group average, at 18.39% - to be somewhat conservative.

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $156.13, and price-to-earnings ratio: 18.16. ADS trades at about $77 at the time of this writing, so it appears to be undervalued, with a potential upside of a little more than 100%.

Final thoughts

Like many companies that extend credit to customers (e.g., car and equipment manufacturers), ADS is often presented as having a very high debt load. This can be misleading, because the company does not have to pay interest on debt that others owe to it. In fact, this type of debt generates a significant amount of interest income. The problem is the risk of default, which is countered by data-driven credit analyses prior to lending approval.

The expectation of growth in the short term is way above the group average of 18.39%. Still, the company is currently valued as if there will be little to no growth going forward. The reason for this is that some of the retailers that ADS works with are having serious problems, even though ADS also has partnerships with retailers that are doing quite well. With the synergistic acquisition of Bread, it is quite possible that ADS will experience above-average growth in the next 5 years.

Disclosure

The author owns ADS shares at the time of this writing.

Understanding the price of bitcoin: Data from early 2019 to mid-2020

Summary

- We conducted a multivariate analysis of the price of bitcoin with financial data from early 2019 to mid-2020.

- Our main conclusion is that bitcoin should do well in what we could call a “nervous bull market”.

- In this scenario, we would see the market generally going up, with some expectation of inflation in the future, all of this against a bearish backdrop.

The analysis

We used WarpPLS () to create several second-order indices (as composites of first-order index funds) and link them in an exploratory model to help us understand what has been driving the price of bitcoin from early 2019 to mid-2020.

The period from early 2019 to mid-2020 was used because prior to it bitcoin was generally perceived as a cash-like currency that could be used for day-to-day transactions among individuals and organizations. From early 2019 onwards, the perception shifted to one of a store of value; something akin to “digital gold”.

We collected and analyzed daily data from various funds. More specifically, the price of one share of each fund at each day’s close was used. In terms of WarpPLS settings, the outer model analysis algorithm used was “PLS Regression”, and the default inner model analysis algorithm was “Linear”. The composite variables were made up of the following funds.

- FIN, reflecting a bullish view of financial institutions, was made up of the iShares U.S. Regional Banks ETF (IAT), and the Financial Select Sector SPDR Fund (XLF).

- HDG, reflecting a bearish view of the market (intention to hedge), was made up of the iShares Silver Trust (SLV), the SPDR Gold Shares (GLD), and the iShares 20+ Year Treasury Bond ETF (TLT).

- MKT, reflecting a bullish view of the market, was made up of the SPDR S&P 500 ETF Trust (SPY), and the Invesco QQQ Trust (QQQ).

- GBTC, reflecting the price of bitcoin, was measured through a single indicator, namely the Grayscale Bitcoin Trust (GBTC).

The Grayscale Bitcoin Trust (GBTC) provides one of the most straightforward ways for investors to own bitcoin. It is generally available to retail investors through various online brokers.

The results

The figure below shows our model with the main results. The iGBTC variable is an instrumental variable that controls for the effect of “time” on the results; to account for autoregression, or the fact that the variable GBTC is influenced by its own values back in time. The instrument used was a numeric variable generated based on the date associated with each data point. In a previous analysis published on this blog, based on the same data, we did not employ this type of control, which led to slightly different results.

The path coefficients (indicated as beta coefficients) reflect the strength of the relationships; they are a bit like standard univariate (or Pearson) correlation coefficients, except that they take into consideration multivariate relationships (they control for competing effects). A positive beta means that an increase in a variable is associated with an increase in the variable that it points to.

The P values indicate the statistical significance of the relationship; a P lower than 0.05 means a significant relationship (95 percent or higher likelihood that the relationship is “real”). The R-squared value reflects the percentage of explained variance for the variable in question; the higher it is, the better the model fit with the data.

I should note that the P values have been calculated using a nonparametric technique, which does not require the assumption that the data is normally distributed to be met. This is good, because I checked the data, and it does not look like it is normally distributed. 

So, what does the model above tell us? It tells us that: 

- As a bullish view of financial institutions (FIN) increases, the price of bitcoin (GBTC) also increases, in a statistically significant way (beta=0.13; P below .01). This is not normally what one would expect, if we assume that bitcoin’s success means the failure of financial institutions.

- As a bearish view of the market (HDG) increases, the price of bitcoin (GBTC) also increases, in a statistically significant way (beta=0.42; P below .01). This is what one would expect, if we assume that bitcoin is used as a hedge against a drop in the market. Note that this effect is the strongest in the model, by far.

- As a bullish view of the market (MKT) increases, the price of bitcoin (GBTC) also increases, in a statistically significant way (beta=0.17; P below .01). Again, this is not normally what one would expect, if we assume that bitcoin’s success means that a bear market is under way.

The three predictors above (i.e., FIN, HDG, and MKT) explain 33 percent of the variance in the variable GBTC (R-squared=0.33). This essentially means that the model is incomplete, although it does explain enough of the variance in GBTC to be useful in an exploration of major influences on the price of bitcoin.

Main conclusion

While the results above may look contradictory, they in fact suggest that bitcoin should do well in what we could call a “nervous bull market”. Here we would see the market generally going up, with some expectation of inflation in the future (which tends to be good for financials), all of this against a generally bearish backdrop.

Disclosure

The author does not own bitcoin at the time of this writing.