After entering 2024, China's economy has entered a new stage of development, and the cyclical fluctuations of the economy and corporate profits have significantly decreased. The development model that relies on real estate infrastructure to drive the credit cycle and thus drive the economic cyclical fluctuations is being replaced by the high-quality development model that relies on new quality productivity, consumption, science and technology, and external demand. In the new economic cycle stage, the investment methodology and investment strategy of A-share should also be adjusted accordingly. In the past, the core investment concept of pursuing high profit growth should gradually join the idea of pursuing the true return rate of shareholders provided by enterprises. In this context, we propose a strategy methodology based on FCF-ROE and DCF pricing models.
FCF, ROE and their internal relations. Free cash flow (FCF) is the residual amount of cash flow obtained by an enterprise from its operating activities less capital expenditure necessary to maintain and expand its asset base. Return on equity (ROE) reflects the efficiency of the company in making profits by using shareholders' equity. High ROE usually means that the company has strong profitability and capital utilization efficiency, which will be converted into stronger free cash flow. In turn, strong free cash flow also supports the company to achieve higher ROE, and improve shareholder returns through reinvestment, debt repayment and dividend payment.
In essence, the DCF pricing formula can be called the FCF-ROE strategic framework. As a classic pricing model, DCF model calculates the internal value of an enterprise by predicting the future free cash flow of the enterprise and discounting it at a certain discount rate. The premise assumption of this model is that the priced stocks should have long-term sustainable growth expectations, relatively stable cash flow, and are mostly suitable for industries or industry leaders with stable competition patterns. The four core variables based on the DCF pricing model are: free cash flow ratio (FCFR), risk-free interest rate, risk premium, and ROE. If price factors are taken into consideration, and free cash flow yield is introduced, the three most important pricing and stock selection indicators of the FCF-ROE based investment framework are: free cash flow ratio to net profit, free cash flow yield, and ROE. The representative indexes of high ROE and high FCF include 300 quality, CSI A50, performance index, etc.
Changes in FCF-ROE valuation model due to changes in the current macro environment. As China's economy and corporate profits enter the stage of high-quality growth, the three and a half year cycle of credit cycle has weakened significantly, and the profit cycle has also stabilized. At different stages of economic development, the source and mode of enterprise led growth are different. At present, when profits tend to be stable, due to the downward growth of capital expenditure, the operating cash flow of enterprises tends to improve, and free cash flow is expected to continue to improve in the next few years. In the steady growth environment, the index system based on FCF-ROE and the strategic framework of DCF pricing model will play a greater role.
In the next four years, the A-share high ROE and high FCF leading style is expected to usher in three waves of valuation repair. The inflection point of free cash flow confirmed in the 2023 annual report and the 2024 quarterly report brought the first wave of repair of high ROE and high FCF style; The subsequent rebound in profit growth in the second and third quarters is expected to bring about the second wave of repair; In the future, once the US bond yield accelerates to decline, the leading style of high ROE and high FCF will usher in the third wave of repair. Since March this year, the strongest leading style has quietly changed. The leading style and the index containing ROE and cash flow indicators, represented by 300 quality, performance of China Securities and China Securities A50, have started to lead the rise. The leading style of high ROE and high FCF has begun to rise.
A preliminary study of industry selection based on FCF-ROE. We construct the stock selection model and industry segmentation according to the three indicators of FCFR-ROE-FCF yield. If we use the 800 sample pool of CSI and consider the three indicators for ranking and scoring, the average annual growth of the 20 stocks with the highest scores is 23%, which is far higher than the average market growth. We can also select industries according to the FCFR-ROE-FCF yield indicator system.
Risk tip: The economic data is less than expected, and overseas policies are tightened more than expected.
