The Curious Investor

Valuation. Isn’t that something that financial geniuses do? Isn’t valuation for super-cool i-bankers and big shot investors? Doesn’t it take time and expertise that the average Joe just can’t commit? No, no, and… no. Valuation is really any technique used to determine the price you should pay for something. In the realm of stocks or equity, valuation refers to a technique which allows you to figure out how much you should pay for partial or full ownership of that company.
Truth be told, valuation is inexact at best. Two people looking at the same set of data will often come up with two completely different valuations for a company. As you may infer from this, there are many different ways to value a company. I’m not going to attempt to do justice to each and every valuation concept in this post. Instead, it’s more of a primer. Or, a sort of jumping off point for a reader to go and look for more information on the few valuation techniques that I list here. Truth be told, many valuations used to value equity aren’t necessarily useful to the average investor. After all, average investors are rarely concerned with buying 100% ownership in a company and as a result such valuations have only a sort of hypothetical significance to an investor.

Some examples of these techniques include:

Discounted Cash Flow - A technique involving taking the free cash flows of a company projected to a certain year at which one can assume that the free cash flows will grow at a constant rate. Then, taking the free cash flows in each future period and discounting them back to present value. You have to discount each subsequent period’s cash flow because, as we all know, money today is worth more than money tomorrow as a result of inflation and opportunity cost. Thus, a discounted cash flow analysis involves projecting cash flows, projecting a terminal growth rate, and using an accurate discount rate. The idea behind all this work is that a company is logically only worth the cash that it will make for its owners in the future.

Discounted Earnings - Similar to a Discounted Cash Flow but using earnings. Again, the idea behind this is that a company is ultimately worth the sum of all its earnings in the future.

Earnings Power Value - Similar to a discounted earnings calculation but instead of projecting earnings forward, we take today’s earnings and assume that they will be the same forever. Thus, the calculation is simply the geometric sum of earnings multiplied by an appropriate power of the discount rate. This is a more conservative valuation as it assumes that a company will not grow any longer but instead will just maintain its current operations.

Liquidation Value - Liquidation value is the value of a company if you were to buy all of it today and decide to sell it as quickly as possible. Essentially, it is a glorified book value. Book value, if you recall from the balance sheet post, is assets minus liabilities. This is the money a shareholder would get back from a company if it were to close the doors, sell everything off, and after it paid back whatever money the company owed. Liquidation value is simply the value of all the assets adjusted for what they should make at liquidation. Since most things will sell for less than their stated value if you were in need of selling them very quickly, liquidation value is a very conservative way to value a company.

Replacement Value - Another adjusted book value but this time taking all assets at the cost of replacement. This is coming from the hypothetical point of view that you are the owner of a similar business attempting to recreate this business by buying all the same equipment, real estate, knowledge, etc.

The above methods of valuation all involve a little bit of financial knowledge and some skill at adjusting values reported on the three sheets. Is it useful to do these on your own? First and foremost, adjusted book value valuations tend to be most difficult for the average investor because they do not have the requisite access to information or the ability to value assets. Discounted Cash Flows, Discounted Earnings, and Earnings Power Values are a bit more straight forward and are totally feasible for the average investor. They, however, take a bit of time and again don’t quite get to the crux of the issue for the typical investor who is less interested in buying a company for the potential cash that the company will generate and more interested in buying stocks which will appreciate in value. In such situations, relative valuations make a bit more sense for the average investor. The above valuations were more absolute valuations - methods intended to put an actual price tag on a stock. Relative valuations are helpful in giving an investor an idea of whether or not a company’s stock is “cheap” relative to its peers.

Knowingly or not, you probably have already done some relative valuations by using P/E or P/S or Price-to-Book ratios. In the previous post about alternative “earnings” statistics, we even examined another multiple known as EV-to-EBITDA. Using these ratios or multiples is known as multiple valuation. These multiples give an idea of what price you should pay relative to earnings or sales or book value of the company. While it is often difficult to calculate an exact multiple to determine value, comparing these multiples between like companies is a good way to get a feel for what kinds of premiums the market in general is willing to pay for a given stock. For example, if you see a tech stock with a P/E of 30 and find that the industry P/E is about 40, you would be able to tell that the market generally is willing to pay a premium of 40 times earnings for this given kind of company and that your stock with a P/E of 30 might be relatively cheap compared to the rest of the stocks that are like it.

Another method of valuation is known as comparable valuation. I guess you could say that using multiples and comparing them from one stock to another is a form of comparable valuation as you must find a comparable, or similar, company in order to properly weigh one multiple next to another. But, a more direct form of comparable valuation is known as Private Market Value. This is a technique whereby an investor interested in a particular company will look for comparable companies which have been bought out or taken over. This will give them an idea of what the company their are interested in should be worth if someone were to want to take out the company. If the stock of the company is trading at a market capitalization of much less than its private market value, this stock is likely to be a takeover target. Even if it is not, this is likely a sign that the stock is trading at a steep discount.

One final valuation method that might interest the average investor is the dividend discount model. This model follows the same logic as discounted cash flows and discounted earnings. The difference is that the dividend discount model takes the perspective of a stockholder instead of a company owner. A stockholder should realize that in the long run just about every company goes bankrupt. In the end, the only returns he will get from the stock are the dividends that he earns off of them; otherwise known as the portion of the companies earnings that were returned to the investor. Thus, a person looking to buy a stock should take this into account and quickly value the stock based on the dividend he is likely to receive. This can be done by assuming a constant dividend or projecting modest dividend growth into the future and then summing each year’s dividend’s present value. Obviously, this method is going to yield a far lower value for the stock than some of the other values listed above. Further, since no one is going to hold a stock for an infinite period of time and since most investors will be careful not to invest in a company which will go bankrupt anytime in the near future this valuation is typically much lower than what the true valuation of the company’s stock will be. That doesn’t mean that this valuation is useless. Being so conservative, one can use this valuation to have roughly good assurance that the stock that they are buying is truly being bought cheaply.

Valuation techniques are not the be all and end all of investing. With fundamental analysis, a good amount of objective work must be done confirming the health of a business and its overall prospects. The valuation part is one of the last steps of fundamental analysis which is to be used to confirm that it is indeed worthwhile to buy a business that other analysis has deemed worthwhile. The combination of multiple valuation techniques is often necessary to get a good sense of the optimistic and conservative results of an investment and as a method of anticipating both the upside potential and the downside risk of your investment. As mentioned earlier, this post is in no way meant to be instructive on valuation. Instead, it’s supposed to introduce you to the ideas of valuation and get you started on your own mission to learn a bit more about it. Good luck.

Bookmark to: