“Price is what you pay, Value is what you get.” Warren Buffett
For many of us who are beginners in stock analysis, valuing a business can be a bewildering task.
There are so many ways to value a stock and there is so much information written about it. Calculating intrinsic value of a stock is very subjective, and what is seen as value investment to me might not be the same for you. Calculating intrinsic value often requires the input of assumptions on future expectations and required rate of return, this is why ‘value’ is never a fixed number.
You can calculate ‘value’ from a company’s assets or company’s potential earnings. Let me illustrate this in layman for you…
Meet John, he bought a $1 million condo and have paid $600k thus far, still owes the bank $400k (let’s assume interest payments are included in this calculations for simplicity sake). After years of savings, he has accumulated $200k of cash at bank for emergency purpose and owns an investment portfolio worth $400k. Now, his estimated net worth will be the sum these; Cash at bank + investment portfolio + total amount paid for condo = 200k + 400k + 600k = $1.2 million. As shown below, when valuing a company, we can use a similar approach to calculate the current value of the company’s assets.
Second method to value a company is from its potential earnings, using John again to illustrate, assume John earns $200k yearly and expects zero to little salary increments over the next 6 years. If all things remain the same, John expects to earn $1.2 million in total earned income over the next 6 years. In this context, to value a company from its potential earnings refers to forecasting its future growth rates and revenue over the next few years and then discounting back to present value.
Now that we’ve understood the basic concepts, I’d like to share some simple techniques to help you calculate the value of a stock and how you can include it in your investment framework.
Balance sheet valuation
Examples: Net Current Asset Value, Net Working Capital Value and Price to Tangible Book Value, Negative Enterprise Value
- Net Current Asset Value = Current Assets – Total Liabilities – Minority Interest
- Net Working Capital Value = (Cash and Cash Equivalent + 0.75 * Receivables + 0.5 * Inventories) – Total Liabilities – Minority Interest
- Price to Tangible Book Value = ((Cash + Land/Building + Investment Properties + Short and Long-term Investments) – Total Liabilities – Minority Interest)/ Market Capitalization
- Enterprise Value = Market cap + Total Liabilities + Minority Interest – Total Cash and Cash Equivalents.
Types: Asset heavy in industries (Real Estate, Construction, Engineering, Manufacturing, etc)
Balance sheet valuation often focuses on the good assets of the business while putting less emphasis on earnings. Good assets are cash, cash equivalents, short and long-term investments, deposits, trade receivables, inventories, investment properties, land/building, strategic investments in other companies and subsidiaries. The key to prudent balance sheet valuation is to apply appropriate discounts on certain items. For example, if a business manufactures CDs, I would aggressively discount its inventories in valuation for a simple fact that global demand for CDs is very low. So if the value of its inventories is worth $100 mil, I will mark down its value by a minimum of 50%. This is to illustrate a fire sale if ever the business needs to be liquidated. Other assets in the balance sheet should be given appropriate discounts given the nature of the business.
Discounted Cash Flow
Variations: Discounted Cash Flow on EBITDA, EBIT, Net Profit or Free Cash Flow.
Types: Mature companies with stable cash flows (Telco, Utilities, Public Transportation and Healthcare)
Calculating Discounted Cash Flow can be complex and subjective, assigning values for cash flows and discount rate are just assumptions of the future. However, the purpose of DCF analysis is to estimate the cash flow an investor receives on an investment adjusted for time value for money. DCF analysis can be a reliable tool for valuation if the inputs are estimated conservatively, however, a slight misjudgment of inputs can cause huge deviations in expected value. Personally, I prefer not to use DCF analysis but exceptions will be businesses with very PREDICTABLE cash flows and stable business environment.
Earnings Multiple Valuation
Variations: Price to Earnings, Enterprise Value to EBITDA/EBIT/Free Cash Flow, Price to Sales
Types: All Types
A versatile method, simple yet reliable tool for valuation. This method allows investors to assess a business in a similar perspective of a private owner. Assume a business valued at EV to Free Cash flow of 5, if cash flows remain consistent over the past 5 years and conditions to remain stable going forward this suggests that an owner will receive 20% return annually. Earnings multiples can also be compared to similar stocks within an industry, this can help you find undervalued gems in sectors. However, these metrics should not be used as a stand-alone. Investors must consider the nature of a business and consistency of its cash flows.
Valuation is an important part of an investment process, however, it is not the only part of the process. Valuation is an art, there’s no such thing as a one size fits all valuation tool. Customizing valuation methods for different businesses takes experience and qualitative ideas. It is just silly to value a stock blindly while ignoring business climate, quality of business and financial health of a business.
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