Stock valuation: is this good value or not?
Before you invest in any stock or share, you need to know what it’s really worth. If you don’t know what it’s worth, you can’t know if you’re paying a good price for it or not.
Valuing a company is as much art as science. There are many approaches to it, and companies are worth different amounts to different people.
The two most common approaches are:
1. Relative Valuation
2. Intrinsic Valuation
Relative valuation involves valuing a business in comparison to similar businesses – so you can see if one is relatively more expensive or cheaper than another. It typically involves some form of multiple of earnings or cash flow, the most common of which is the P/E ratio. To learn more about multiples based analysis, go here.
Pros: quick, easy, multiples are published everywhere, commonly used
Cons: inaccurate, impacted by market forces and sentiment. Eg during boom times everything is expensive and risky (think 1999 tech bubble, 2007 housing bubble) so things might look cheap ‘relative’ to other things, but that won’t protect you when they all fall….
Intrinsic valuation is valuing the company itself in isolation- determining the absolute value of that entity outside of any market forces.
Pros: much more accurate, exists outside of market sentiment and therefore provides more long term stability
Cons: requires detailed forecasting, involves calculation, the calculation is also still open to interpretation.
To be able to calculate an intrinsic value most accurately, you need to understand a technique called a Discounted Cash Flow (DCF). A DCF calculation is necessary due to the time value of money- the fact that $100 today is worth more than $100 in the future. For more on why this is the case- have a read here. A DCF works by taking all the future cash flows that are going to be available to the business and discounting them back to today’s value. By doing so, you can reach a valuation of what that business is worth to you today, based on all the money it can generate for you in the future.
The Steps of a DCF Analysis
1. Forecasting Cash Flows: Estimate the business's future cash flows for a period of time (usually 5-10 years). This involves making assumptions about revenue growth, profit margins, working capital needs, and capital expenditures. You can only do this reliably and with any confidence when you know the business and their industry well- this takes work and research and there aren’t many shortcuts.
2. Calculate Terminal Value: After the forecast period, a terminal value is calculated to estimate the cash flows beyond the forecast horizon (ie beyond the 5-10 years you’ve made explicit forecasts. This can be done using a tool such as the Gordon Growth Model (assuming a constant growth rate forever) or an exit multiple approach.
3. Discounting Cash Flows: each of your forecasted years future cash flows and also the terminal value are then discounted back to the present values using a discount rate. This rate reflects the investment's risk and the time value of money, often estimated using the Weighted Average Cost of Capital (WACC). If the company is very risky, the discount rate you use will need to be higher to account for the lower certainty of receiving those future cash flows.
4. Summing the Present Values: The present values of the forecasted cash flows and the terminal value are summed up to get the total present value of the business. This represents the business's intrinsic value.
Simple DCF example
Assumptions:
Forecast Period: 5 years
Yearly Cash Flow Growth: 10%
Initial Cash Flow (Year 1): $100,000
Discount Rate (WACC): 8%
Terminal Growth Rate: 3%
Step 1: Forecasting Cash Flows
Year 1: $100,000
Year 2: $110,000 ($100,000 * 1.10)
Year 3: $121,000 ($110,000 * 1.10)
Year 4: $133,100 ($121,000 * 1.10)
Year 5: $146,410 ($133,100 * 1.10)
Step 2: Calculating Terminal Value
Terminal Value at the end = Year 5 Terminal value * (1 + terminal growth rate) / (WACC -terminal growth rate)
Terminal Value at the end of Year 5: $146,410 * (1 + 0.03) / (0.08 - 0.03) = $3,228,620
Step 3: Discounting Cash Flows
PV of Year 1 Cash Flow: $100,000 / (1 + 0.08)^1 = $92,593
PV of Year 2 Cash Flow: $110,000 / (1 + 0.08)^2 = $94,456
PV of Terminal Value: $3,228,620 / (1 + 0.08)^5 = $2,236,667
Step 4: Summing the Present Values
Total Present Value = Sum of PV of Cash Flows + PV of Terminal Value = $92,593 + $94,456 + ... + $2,236,667 = $2,652,383 (approximately)
According to this DCF analysis, the intrinsic value of the business, based on its future cash flows and the assumptions made, is approximately $2.65 million. This is a simplified example, and in practice, DCF analyses involve more detailed forecasting and adjustments for things like debt and cash on the balance sheet.
Once we have our own estimate of what we think the company itself is worth, we can then simply look to the market and see if the stock is trading above or below the intrinsic value. If it’s below, then on your calculation you’re being offered those shares for less than they’re worth, so you might want to consider buying some. If the stock is trading at a price above its intrinsic value then you might want to wait until the price comes down before buying some, or think about selling some if you already own it.
Garbage in, garbage out
Of course, the output of any DCF will always be sensitive to your inputs. That is why it is important to get the qualitative side – or the first stage of the process right. The first stage is typically the most time intensive. To do the necessary work on a company is a complex process requiring an understanding of many factors such as the industry, management, products, competitors, etc. And its only when we know a business inside out in this way that we can even begin to even think about forecasting earnings 10 years out with any level of confidence. All the hard miles to understand the company are what make the valuation element possible.
Expected return
However a by product of this research and valuation, is that you will also effectively develop a very basic growth algorithm for each business: a slightly different approach to your investment thinking that can provide a useful yardstick. For example, say based on your work you think organic growth for the business is 4%, plus they’re going to be able to get 2% margin expansion (either higher prices or lower costs), plus you’re doing to get 1% in dividends, all that together will get you to an expected 7% total shareholder return.