🌐 𝐓𝐡𝐞 𝐥𝐢𝐭𝐭𝐥𝐞 𝐠𝐮𝐢𝐝𝐞 𝐨𝐟 𝐯𝐚𝐥𝐮𝐚𝐭𝐢𝐨𝐧 🌐
I went back and forth on whether to post this. In the end though, I promised it to many. So here it is :)
𝗜𝗻𝗵𝗮𝗹𝘁𝘀𝘃𝗲𝗿𝘇𝗲𝗶𝗰𝗵𝗻𝗶𝘀:
I. Relative evaluation
II. Intrinsic valuation
III. intermediate solution/compromise:
IV. Procedure for the assessment of growth companies
V. Conclusion
In this post, I want to introduce you to the tools and differences of the most common valuation methods. Building on my post on key ratios/value investing (https://app.getquin.com/activity/XcuRrJwmyP) for company analysis, I will now show you how to value a company. So what do you do once you've analyzed the balance sheet, P&L and cash flow statement? The ratios look great, but is the company cheap right now? I will try to explain all of this in this article. However, as usual, I would like to provide you with tools and not go into too much detail.
But before I really get started, I'll give you a few data sources right at the beginning, with which you have already achieved half the battle. Open the following two links, called "magic Link 1" and "magic Link 2". These are from Aswath Damodaran, Professor of Finance at New York University and from his book "The little book of valuation" respectively. Why am I telling you this? These links will give you explanations and Excel files that you can use to do your own analysis. You will not only get Excel based Present Value/DCF templates. You will also get various overviews of common industry multiples, common WACCs, explanations of the differences in the various stages (life cycles) of companies, sector/industry differences and how to take all this into account in the valuation. Therefore, to be considered in the valuation of companies are always:
Life Cycle of the companies:
Young Growth Companies
Growth Companies
Mature Companies
Declining and Distressed Companies
Sector Differences:
Financial Service
Commodities and Cyclicals
Intangibles Assets
The "magic links" to wealth and knowledge:
Link 1: www.wiley.com/go/littlebookofvaluation
Link 2: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html
I have summarized the most important contents of the links at the end of the post. As a supplement I would like to give you two additional links with which you can create your own DCF analyses. These are simpler than the ones shown in magic link 1, but without detailed information about common WACCs, risk betas and so on. So now you have the choice which calculator to use. But I would not work without the magic links.
DCF Calculator in the www (no guarantee about correctness of the calculation):
https://www.omnicalculator.com/finance/dcf
https://tradebrains.in/dcf-calculator/
Appreciate these links. If you have not read Damodaran's book or have not been part of his lectures at New York University, you will probably never know about it otherwise (except you now ;)). The links provide extensive Excel tools that would require payment on many sites. Partially you have also directly Youtube explanation videos of Damodaran integrated in the respective Excel Sheets. The book also gives all the tools to be able to evaluate companies. I therefore recommend it to anyone who has a certain basic knowledge of balance sheet analysis.
There are basically two approaches to valuing companies:
𝗜. 𝗥𝗲𝗹𝗮𝘁𝗶𝘃𝗲 𝗕𝗲𝘄𝗲𝗿𝘁𝘂𝗻𝗴:
Relative valuation is very simple and evaluates an asset or company based on prices for similar/same companies/assets in the market. For example, if I want to buy Coca Cola stock I might look at how Pepsi is currently valued and use this comparative information to judge whether Coca Cola is cheaper or more expensive. This is done by simple multiples like [1]:
-KGV (rule of thumb <15 favorable): Tells how many years it would take to earn back the purchase price via company profits. In relative comparison with peers, we should prefer the stock with the lowest P/E ratio. Calculation: price/earnings per share
-KUV (rule of thumb < 1 favorable): The KUV can be helpful when evaluating a company with negative earnings and/or cash flow. Calculation: Price/Sales per share
-KBV (rule of thumb <1 favorable): The share price related to the value of the equity financed portion of the assets. Calculation: Price/Equity per share
-KCV ((rule of thumb <15-18 favorable): Compared to the P/E ratio, the significant effects of differences between depreciation and actual capital expenditures and non-cash expenses are included. As a rule, the operating cash flow is used. Advantage: cash flows can be "manipulated" worse than earnings. I also refer to my post on big bath accounting for this: https://app.getquin.com/activity/Vppdunisrn?lang=de&utm_source=sharing Calculation: price/cash flow per share
-PEG (rule of thumb <1 favorable): Takes into account both current price/earnings ratio and expected earnings growth. I like to use the PEG a lot because it builds a bridge to the intrinsic valuation (DCF) and thus incorporates a growth component. Calculation: P/E ratio/projected earnings growth
Under the "magic link 1 and 2" you will find current overviews (constantly updated) of average multiples per sector. So you can already make good comparisons to expand your analysis. So you can see already now. Save these damn links!
It's also worth mentioning that the above rules of thumb for when a company seems cheap are not set in stone. They are by no means applicable to growth companies. But I will come to that later under point IV.
I see two major disadvantages with relative valuation:
-Future cash flows are not taken into account. The PEG ratio at least takes growth into account and thus covers future flows in a simple way. But again, the ratio serves as a benchmark (relatively level). Particularly in the case of growth companies with high P/E ratios, it is difficult to judge whether the company is cheap or expensive in relative terms. The values fluctuate enormously here.
-Value Trap: If the relative ratios are very low it does not necessarily mean that the company is cheap. Maybe there are reasons (high debt, miserable margins, political environment - e.g. China/Russia, bad management, etc.). You can't see all that from the ratio.
The intrinsic valuation tries to eliminate all these disadvantages.
𝗜𝗜. 𝗜𝗻𝘁𝗿𝗶𝗻𝘀𝗶𝘀𝗰𝗵𝗲 𝗕𝗲𝘄𝗲𝗿𝘁𝘂𝗻𝗴:
The intrinsic value of an asset/business is the value we determine based on the current or future cash flows generated by that asset and taking into account the investment risk (defines the cost of capital or also called WACC). For a real estate company such as Vonovia, for example, these cash flows would be defined by the net cold rents currently generated or achievable in the future. The connection is clear: the higher the rental income from a property, the more we would be willing to pay for it. [1] The most common method is the DCF model.
The difference to the relative valuation is explained quite simply: The intrinsic valuation gives me directly the share price/company value, which I have calculated based on the entered parameters. If my DCF model tells me that the fair value for Pepsi is 120€, then it would currently be too expensive (at the time of writing at 158€). In the same way, a DCF model would determine the fair purchase price of a property.
Intrinsic valuation gives a "bigger picture": by taking into account cost of capital (inflation, interest rate and risk premium for e.g. political environment or industry), growth and future cash flows, the methodology is very detailed. I ultimately discount future cash flows with projected growth rates and cost of capital to today to determine the fair value of the company for today. However, due to the many variables, 10 analysts will never have exactly the same risk assessment and thus always come to different results. Precisely because of their complexity, many mistakes can be made. Small adjustments can have a big impact. Therefore, there are situations where relative valuation gives a more realistic picture. I believe that one should find a middle ground and not ignore either method.
Advantage of Intrinsic Valuation: Intrinsic valuation is a good way to explain why stock prices usually correct in a high interest rate environment (just Growth). High interest rates make it more difficult for companies to obtain financing, making it more difficult for them to obtain favorable loans, or even higher interest charges, with variable interest rates already in place. This puts direct pressure on margins and casfhflow/profit and therefore the cost of capital or the interest rate I discount cash flows at. So you see...if you understand the intrinsic valuation and the parameters used, you also understand certain market correlations and price movements. And this closes the circle to my posts, which discuss all these risk components and which can finally be considered in a risk interest rate (WACC):
-Value Investing - Buffett
https://app.getquin.com/activity/XcuRrJwmyP
-Government debt (incl. thematization of interest and inflation):
https://app.getquin.com/activity/eGyMOcHpaC
-Goodwill
https://app.getquin.com/activity/ymidZwhlTk
It is clear that a war, an embargo or a loss of production result in price corrections or that higher interest rates are bad for most companies (banks excepted). But which parameters are affected and how analysts and investment banks judge this, respectively translate it into a number, can be understood by the DCF valuation and the parameters contained therein (cost of capital, growth rates, cash flows). A DCF valuation ultimately tells me which share price reflects the fair price, after micro- and macroeconomic adjustments (interest rate, inflation, production shortage, balance sheet structure, etc.). So not only do I know that a share price is falling, but I can better estimate the extent and when an entry point might be worthwhile.
𝘞𝘪𝘤𝘩𝘵𝘪𝘨𝘦 𝘒𝘰𝘮𝘱𝘰𝘯𝘦𝘯𝘵𝘦𝘯 𝘻𝘶𝘳 𝘉𝘦𝘳𝘦𝘤𝘩𝘯𝘶𝘯𝘨 𝘥𝘦𝘳 𝘋𝘊𝘍 𝘔𝘦𝘵𝘩𝘰𝘥𝘪𝘬:
To be able to apply the DCF calculation (I have given you a selection via the magic links and www links) I would like to give you the most important parameters in short form. They will also help you for the "magic links". But I mention explicitly that I explain everything in short form. The DCF calculation is not simple and hardly explained in one article. Therefore I would like to give you, combined with the "magic links", a wide range of tools. I will mainly deal with the entity method for DCF calculation. Basically, there are both the entity and the equity method, with different approaches and specifics. But the end result should always be the same.
1) Growth Rates:
Growth rates are used in relative valuation (PEG) but mainly in intrinsic valuation. There are different ways to define the right growth rate for the future. Using Clinuvel as an example, I have done this with the following sources:
-Future Growth:
Marketscreener is a great tool to access financial data and view forecasts or even analyst estimates.
https://de.marketscreener.com/kurs/aktie/CLINUVEL-PHARMACEUTICALS-488895/fundamentals/
-Past Growth (AQQS Score):
In the Traderfox terminal, you can find the AQQS score at the very bottom of the overview, which shows the past sales and EBIT growth on a 3-year, as well as 10-year horizon.
https://aktie.traderfox.com/visualizations/AU000000CUV3/EI/clinuvel-pharmaceuticals-ltd
In addition, the "magic Link 2" gives you historical overviews of growth rates per sector/country. Finally, you should also review the published annual report and quarterly reports, as the company's internal forecasts are often mentioned there.
All bundled together then results in the growth rate that I use in the PEG or DCF method. In my analyses I always show you an excerpt (under the heading key figures):
https://app.getquin.com/activity/MEUdUaDMjl?lang=de&utm_source=sharing
Of course, you can derive growth rates based on market forecasts or industry estimates on various platforms and show them even more accurately. In the end, it is always possible to be more exact or more complicated. Which way you choose is up to you.
-Perpetual Growth Rate: The DCF calculation still requires the Perpetual Growth Rate, with which the "infinite growth" is defined. I would use the historical inflation rate or GDP rate as a guide. If the given rate is higher than GDP, one would assume that the company will outperform economic growth "forever".
2) Cost of Capital/Discount Rate:
Cost of capital can be determined using the WACC (Weighted Average Cost of Capital) method and represents the discount rate used to discount cash flows in DCFM. Thus, the future cash flows (free cash flows) of a company are not simply summed up to determine the discounted cash flow. They are discounted with reference to their respective year of origin. Discounting means that the present value of a future payment is determined. The WACC rate distinguishes between the cost of debt (basically consisting of interest + default risk) and the cost of equity. The discount rate can be determined using the CAPM [2]. The interest rate for borrowing costs is quite simple to determine. The so-called risk-free interest rate can be derived from the interest rate of 10-year government bonds (EU or USA) or the LIBOR [3], which would correspond to a standard market interest rate. To this is added a risk premium for default risks. Depending on the balance sheet structure, the weighting of the two components is then carried out (EC vs FC). However, I do not want to go into too much detail here. The subject can seem very complex for newcomers. Basically, the following formula applies:
WACC (Cost of Capital) = E/V * ce + D/V * cd * (1-tr)
E=Equity
D=debt capital
V=E+D
ce=cost of equity
cd=cost of debt
tr=tax rate (this is taken into account because the interest on the loan is deductible from tax. Therefore the debt capital is more favorable by the tax)
Finally, to discount future cash flows, you need an interest rate (WACC), which is derived from various components and also risk factors. However, I would like to give you a shortcut here as well. It is not necessary to calculate this interest rate laboriously by yourself (just ce and cd).
A first overview of common WACCs can be found on the following page:
https://pwc-tools.de/kapitalkosten/
Of course, the magic link 2 also has great Excel files and industry/country comparisons that go into even more detail. You can see them under the heading "Costs of Capital by Industry Sector" in link 2. There you can feed the WACC nicely with data (e.g. current inflation rate or interest rate for 10 year government bonds) and the WACCs are directly linked to a formula and adjust. The Excel file is great! You don't have to do anything but add your parameters!
So you can easily pull out industry standard WACCs without making a big "Zampano".
You should always take into account country-specific and political risks. Therefore, always be aware that the interest rate is very individual. Basically, the higher the factor (e.g. due to interest rate increases or inflation) and thus the risk, the lower the valuation of a stock.
But you have already noticed that the DCF method has many variables and can therefore be used very individually. 10 analysts will probably come to 10 different results, due to different risk assessments and growth forecasts.
3) Free Cash Flows (FCF)
Of course you also need the free cash flows, which you finally discount (WACC) and multiply with the growth rates. For this purpose, I would refer to the annual report of the respective company. The easiest way to find it is on the company's homepage in the Investors Relations section. In the financial report you will see the so-called cash flow statement, which is divided into cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. The free cash flow is the operating cash flow minus the cash flow from investing activities and tells you how much money is left over to repay loans, pay dividends or buy back shares. You need this (FCF) for your discounting.
4) Toolbox
Now you have everything you need to perform a DCF calculation yourself:
-WACCs based on given magic links.
-Growth rates based on given links / business reports.
-Free cash flows via the respective annual reports (CFoper. - CFinvest. = FCF).
-Excel tool for calculation based on magic link 1 or in the www (https://www.omnicalculator.com/finance/dcf; https://tradebrains.in/dcf-calculator/)
Do not forget to divide the values by the "shares outstanding" (number of shares) in your calculation, so that you also get the value for a single share. If you google "shares outstanding" and the company name you will find enough information.
In addition, I would like to share two videos with you, in which the systematics of the free cash flow and the DCF calculation are explained very simply. You will get them from me in the comments.
𝗜𝗜𝗜. 𝗭𝘄𝗶𝘀𝗰𝗵𝗲𝗻𝗹ö𝘀𝘂𝗻𝗴/𝗞𝗼𝗺𝗽𝗿𝗼𝗺𝗶𝘀𝘀:
A compromise between the relative valuation methodology and a DCF valuation offers a simple present value calculation. Therefore, I think this methodology is good because it is less complicated and therefore less prone to error. Of course, one can argue that this also makes it less accurate. The method also takes into account a risk interest rate and growth forecasts.
Any cash flow, be it from stocks, real estate or bonds can easily be calculated with a Present Value (PV) calculation using the Perpetual Growth Model. You also get the fair value of a company, similar to the DCF calculation, but simpler and with fewer variables. But you have to decide for yourself what is better and more accurate for you. An example of regular cash flows for dividend aristocrats are of course the dividends. Here you can see the PV method well:
Calculation formula:
PV = Expected dividend next year / (Required Return - Expected growth Rate)
Required Return = Describes the uncertainty/risk interest rate that should be covered. Can be determined using CAPM. Can be derived from the WACC.
The basis for the Required Return varies:
For dividends: Cost of equity
For free cash flow (FCF): Cost of Capital (WACC) -->as for the DCF method
Reason: Dividends are not influenced by FC interest and especially the tax shield - dividends would flow directly into equity, in the form of profit, if they were not distributed. In the cash flow system, dividends would be in the area of "cash flow from financing activities" and thus outside the FCF. Therefore, the cost of capital approach would be wrong.
The distinction of the interest rate for the "Required Return" (whether Cost of Equity or Cost of Capital) is very important. You can read the data from the Magic Link 2. The interest rates change when you adjust the parameters for inflation and interest (e.g. 10 or 30 year government bonds) in Excel. You can find the file in the link under the heading "Cost of Capital by Industry Sector". There you will find all discount rates you need. Then select the appropriate country and the Excel file will open - magic! :)
Example Pepsi:
Inflation rate = 8%
10 year US t-bill = 3.12% [6]
Cost of Equity = 8.27% -->Magic Link 2 entered parameters on inflation (8%) and interest (3.12%) for Excel File in section "Cost of Capital by Industry Sector" - US entered
Dividend growth rate = 4% (perpetual growth rate)
Dividend 2021 = 4.25 USD
Due to different interpretation possibilities, I like to assume different scenarios:
PV of Pepsi (conservative): 4.25 x 1.04 / (0.085-0.04) = 98.22 USD
PV of Pepsi (optimistic): 4.25 x 1.04 / (0.075-0.04) = 126.29 USD
PV of Pepsi (realistic): 4.25 x 1.04 / (0.08-0.04) = 110.5 USD
P/E ratio Pepsi: 31.12
P/E Beverage (Soft): 29.93 (see magic Link 2)
PEG Beverage (Soft): 2.63 (see magic Link 2)
current share price: 170 USD
Result: Pepsi seems rather overvalued at the moment.
In contrast to the DCF approach, future cash flows are not discounted but only year 1, assuming a constant/infinite growth rate, including risk interest. This of course makes the DCF method much more variable and, properly applied, more accurate. Nevertheless, the PV methodology is a good indicator in your analysis. In addition, the PV method is the basis for the DCF method (if you take the FCF and not the dividends), because the DCF method also works with the perpetual growth rate. In Magic Link 1 you will also find the Dividend Discount Model (DDM), which takes future cash flows into account and thus builds on the simple PV method. Of course, you also have the DDM as an Excel template in the Magic Link. The calculation logic is similar to the DCFM.
𝗜𝗩. 𝗩𝗲𝗿𝗳𝗮𝗵𝗿𝗲𝗻 𝘇𝘂𝗿 𝗕𝗲𝘂𝗿𝘁𝗲𝗶𝗹𝘂𝗻𝗴 𝘃𝗼𝗻 𝗚𝗿𝗼𝘄𝘁𝗵 𝗨𝗻𝘁𝗲𝗿𝗻𝗲𝗵𝗺𝗲𝗻 (revenue/EBIT growth of at least 20% p.a.):
Valuing growth companies is always a bit more complicated as future growth is more uncertain and variable. If the company does not yet generate a profit, neither the P/E ratio nor the PEG ratio is applicable. Likewise, it may be that no positive FCF is generated yet. In order to expand your tools a bit, I would advise you to include the following ratio in your repertoire to be able to solidly assess whether a company also promises long-term and sustainable growth:
-Rule of 40
Rule of 40 = sales growth + free cash flow margin
or
Rule of 40 = Sales growth + EBITDA margin
The sum of revenue growth and free cash flow margin is referred to as the Rule of 40 score. If the sum is greater than or equal to 40 percent, the Rule of 40 is met. This ratio can be used to evaluate the efficiency of companies' growth. [4] For example, there are companies that have 20% revenue growth and 20% EBITDA margin or 40% revenue growth but 0% EBITDA margin. The aim is to "normalize" growth companies with this formula in order to filter out companies that take all aspects of growth into account. For example, it would make little sense to have 50% sales growth every year, although the EBITDA margin is negative due to high costs (e.g. manufacturing costs, administrative or personnel costs), so that the company never becomes profitable. [5]
Basic framework for growth companies:
-KUV (if no profit)
-PEG (if profit)
-DCF or PV (instead of a dividend, simply discount the FCF in the PV approach - watch out! Then with the WACC and not cost of equity!)
-Rule of 40
-continuous and stable sales growth as well as EPS growth
𝗩. 𝗙𝗮𝘇𝗶𝘁
In summary, hopefully I was able to introduce you to the following tools:
-Relative valuation (P/E, KUV, KCV, KBV, PEG).
-Intrinsic valuation using the discounted cash flow (DCF) method.
-Present Value Calculation (as a simple alternative to DCF)
-Dividend Discount Model (DDM), to be applied similarly to the DCF method
-Special features for growth companies
Finally, I would like to leave you with the following:
All Valuations are biased - The views of a stock/company are usually formed before you fundamentally value the company. Therefore, do not be too optimistic but rather choose pessimistic parameters. Nevertheless, a certain bias remains. As you could probably gather from my explanations, both methods offer advantages and disadvantages. It seems important to me that you do not stick to one method or just look at the P/E ratio. Combine quantitative and qualitative metrics in your due diligence, as presented in the previous post (https://app.getquin.com/activity/XcuRrJwmyP) with valuation methods from this post and you will get a feel for whether you have just found an undervalued company or just gold-plated junk. In the end, though, no one is safe from making a bad move, despite extensive analysis. It is more about reducing mistakes and increasing the probability of making the right decisions. Stock picking is no longer a game of chance but leads to targeted investments. The more precise your analysis, the less panic you will experience in turbulent times!
I hope you enjoyed it! Unfortunately I couldn't make it much shorter :)
Post created on request
Sources:
[2] https://www.investopedia.com/terms/c/capm.asp
[3] https://www.global-rates.com/de/zinssatze/libor/libor.aspx
[4] https://aktien.guide/blog/rule-of-40-einfach-erklaert
[5] https://softwareequity.com/blog-calculating-the-weighted-rule-of-40/
[6] https://ycharts.com/indicators/10_year_treasury_rate
other sources:
Book: The little book of valuation - How to Value a Company, Pick a Stock, and Profit - Aswath Damodaran
Graphic: https://articles.bplans.com/are-you-facing-the-valuation-trap/
Relevant links summarized:
Magic Link 1: www.wiley.com/go/littlebookofvaluation
-->PV Calculator
-->DCF Calculator
-->Dividend Discount Model Calculator
-->Differences "across life cycle" / "across sectors
Magic Link 2: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html
-->Risk Premiums (Betas) country-specific/sector-specific
-->Cost of Capital/Cost of Equity country-specific/sector-specific
-->Growth rates historical/per industry sector/country specific
-->Diverse multiples such as P/E/PEG ratios per industry sector/country-specific
WACCs: https://pwc-tools.de/kapitalkosten/
-->WACCs industry comparison
-->EBITDA/EBIT multiples industry comparison
