I went back and forth about whether I wanted to post this. But in the end I promised many people I would. So here it is :)
𝗜𝗻𝗵𝗮𝗹𝘁𝘀𝘃𝗲𝗿𝘇𝗲𝗶𝗰𝗵𝗻𝗶𝘀:
I. Relative valuation
II. Intrinsic valuation
III. interim solution/compromise:
IV. Procedure for the assessment of growth companies
V. Conclusion
In this article, I would like to introduce you to the tools and differences between the most common valuation methods. Building on my post on important key figures/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 have analyzed the balance sheet, income statement and cash flow statement? The key figures look great, but is the company currently available at a good price? I will try to explain all of this to you in a condensed form 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 that will already give you 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". Why am I telling you this? These links will provide you with explanations and Excel files that you can use to carry out your own analyses. You will not only receive Excel-based Present Value/DCF templates. You will also get various overviews of common industry multiples, common WACCs, explanations of the differences between the various stages (life cycles) of companies, sector/industry differences and how to take all this into account in the valuation. The following must therefore always be taken into account when valuing companies:
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. In addition, I would like to provide you with two links that you can use to create your own DCF analyses. These are simpler than those shown in magic Link 1, but without detailed information on common industry WACCs, risk betas and so on. You now have the choice of which calculator to use. However, I would not work entirely without the Magic Links.
DCF Calculator in the www (no guarantee about the 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 were not part of his lectures at New York University, you will probably never know about it (except you now ;)). The links provide extensive Excel tools that would have to be paid for on many sites. In some cases, you have also integrated YouTube explanatory videos by Damodaran directly into the respective Excel sheets. The book also provides all the tools you need 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 assesses an asset or company on the basis of prices for similar/equal companies/assets on the market. For example, if I want to buy Coca Cola shares, 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 using simple multiples such as [1]:
-CGV (rule of thumb <15 favorable): Tells us how many years it would take to earn back the purchase price via company profits. In a relative comparison with peers, we should prefer the share with the lowest P/E ratio. Calculation: Price/earnings per share
-KUV (rule of thumb < 1 favorable): The P/E ratio 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 set in relation to the value of the equity-financed portion of assets. Calculation: Price/equity per share
-KCV ((rule of thumb <15-18 favorable): Compared to the P/E ratio, the main effects from the differences between depreciation and actual investments as well as non-cash expenses are taken into account. As a rule, the operating cash flow is used. Advantage: Cash flows are more difficult to "manipulate" than earnings. I also refer to my post on big bath accounting: 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 the current price/earnings ratio and the expected earnings growth. I like to use the PEG because it builds a bridge to the intrinsic valuation (DCF) and thus incorporates a growth component. Calculation: P/E ratio/forecasted earnings growth
Under the "magic link 1 and 2" you will find current overviews (constantly updated) of average multiples per sector. This way you can already make good comparisons to expand your analysis. So you can already see. Save those damn links!
It should also be mentioned that the above rules of thumb for when a company appears cheap are not set in stone. They are by no means applicable to growth companies. But I'll come to that later under point IV.
I see two major disadvantages with the 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 here too, the ratio serves as a comparative value (relatively speaking). Particularly in the case of growth companies with high P/E ratios, it is difficult to assess whether the company is cheap or expensive in relative terms. The values fluctuate enormously here.
-Value trap: If the relative key figures are very low, this does not necessarily mean that the company is cheap. There may be reasons (high debt, miserable margins, political environment - e.g. China/Russia, poor management, etc.). None of this can be seen from the ratio.
The intrinsic valuation tries to eliminate all these disadvantages.
𝗜𝗜. 𝗜𝗻𝘁𝗿𝗶𝗻𝘀𝗶𝘀𝗰𝗵𝗲 𝗕𝗲𝘄𝗲𝗿𝘁𝘂𝗻𝗴:
The intrinsic value of an asset/company is the value we determine based on the current or future cash flows generated by that asset and taking into account the investment risk (defined the cost of capital or also known as WACC). For a real estate company such as Vonovia, for example, these cash flows would be defined by the net cold rents currently achieved or achievable in the future. The connection is clear: the higher the rental income from a property, the more we would be prepared 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 the share price/company value directly, which I have calculated using the parameters entered. 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.
The intrinsic valuation gives a "bigger picture": by taking into account the 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. Ultimately, I discount future cash flows with forecast growth rates and the cost of capital to the present day in order to determine the fair value of the company today. However, due to the many variables, 10 analysts will never have exactly the same risk assessment and therefore always arrive at different results. It is precisely because of their complexity that many mistakes can be made. Small adjustments can have a big impact. Therefore, there are situations in which the relative valuation gives a more realistic picture. I believe that you should find a middle ground and not ignore either method.
Advantage of the intrinsic valuation: The intrinsic valuation explains why share prices usually correct in a high interest rate environment (especially growth). High interest rates make financing more difficult for companies, making it harder for them to obtain cheap loans or even have higher interest charges if they already have variable interest rates. This puts direct pressure on the margin and the cash flow/profit and therefore also on the cost of capital or the interest rate at which I discount the cash flows. 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 address all these risk components and which can ultimately be taken into account in a risk interest rate (WACC):
-Value Investing - Buffett
https://app.getquin.com/activity/XcuRrJwmyP
-Government debt (incl. discussion of interest rates and inflation):
https://app.getquin.com/activity/eGyMOcHpaC
-Goodwill
https://app.getquin.com/activity/ymidZwhlTk
It is clear that a war, an embargo or production losses result in price corrections or that higher interest rates are bad for most companies (with the exception of banks). But which parameters are influenced and how analysts and investment banks assess this and translate it into figures can be understood on the basis of the DCF valuation and the parameters it contains (cost of capital, growth rates, cash flows). A DCF valuation ultimately tells me what share price reflects the fair price after micro- and macroeconomic adjustments (interest rates, inflation, production shortages, balance sheet structure, etc.). This means that I not only know that a share price will fall, but can also better estimate the extent of the fall and when it might be worth entering the market.
𝘞𝘪𝘤𝘩𝘵𝘪𝘨𝘦 𝘒𝘰𝘮𝘱𝘰𝘯𝘦𝘯𝘵𝘦𝘯 𝘻𝘶𝘳 𝘉𝘦𝘳𝘦𝘤𝘩𝘯𝘶𝘯𝘨 𝘥𝘦𝘳 𝘋𝘊𝘍 𝘔𝘦𝘵𝘩𝘰𝘥𝘪𝘬:
In order to be able to use 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 with the "magic links". However, I explicitly mention that I will explain everything to you in brief. The DCF calculation is not simple and can hardly be explained in a short article. That's why I want to give you a wide range of tools, combined with the "magic links". I will mainly focus on the entity method for DCF calculation. Basically, there are both the entity and the equity method, with different approaches and special features. However, the end result should always be the same.
1) Growth rates:
Growth rates are used in the relative valuation (PEG) but mainly in the intrinsic valuation. There are various 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, at the bottom of the overview, you will find the AQQS score, which shows 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 look through the published annual report and quarterly reports, as the company's internal forecasts are often mentioned there.
Combining all of this results in the growth rate that I use in the PEG or DCF method. I always show you an excerpt in my analyses (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 present them even more precisely. In the end, it can always be more precise or more complicated. Which way you choose is up to you.
-Perpetual growth rate: The DCF calculation still requires the perpetual growth rate, which is used to define "infinite growth". I would base this on the historical inflation rate or GDP rate. If the specified rate is higher than GDP, it is assumed that the company will "forever" outperform economic growth.
2) Cost of capital/discount rate:
Capital costs can be determined using the WACC method (Weighted Average Cost of Capital) and represent the discount rate used to discount the cash flows in the DCFM. The future cash flows (free cash flows) of a company are not simply added together 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. A distinction is made in the WACC interest rate between borrowing costs (generally consisting of interest + default risk) and equity costs. 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. A risk premium for default risks is also added. The weighting of the two components (equity vs. debt) then depends on the balance sheet structure. However, I don't want to go into too much detail here. The topic 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 tax-deductible. Therefore, debt capital is more favorable by the tax)
Finally, an interest rate (WACC) is required to discount future cash flows, which is derived from various components and risk factors. However, I would like to give you a shortcut here too. It is not necessary to laboriously calculate this interest rate yourself (just ce and cd).
The following page gives you an initial overview of common WACCs:
https://pwc-tools.de/kapitalkosten/
Of course, the magic Linke 2 also has great Excel files and industry/country comparisons that go into even more detail. You can view these under the heading "Costs of Capital by Industry Sector" in Link 2. There you can feed the WACC 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 themselves accordingly. The Excel file is great! All you have to do is add your parameters!
This means you can simply extract industry-standard WACCs without having to make a big fuss.
You should always take country-specific and political risks into account. Therefore, always be aware that the interest rate is very individual. Basically, the higher the factor (e.g. due to interest rate hikes or inflation) and therefore the higher the risk, the lower the valuation of a share.
However, you have already noticed that the DCF method has many variables and can therefore be used very individually. 10 analysts will probably arrive at 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 ultimately discount (WACC) and multiply by the growth rates. I would use the annual report of the respective company for this. The easiest way to find this is on the company's homepage in the Investors Relations section. In the financial report, you will see the cash flow statement, which is broken down into cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. The free cash flow results from the operating cash flow minus the cash flow from investing activities and shows 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 using given magic links.
-Growth rates based on given links / annual reports.
-Free cash flows via the respective annual reports (CFoper. - CFinvest. = FCF).
-Excel tool for calculation using magic link 1 or in the www (https://www.omnicalculator.com/finance/dcf; https://tradebrains.in/dcf-calculator/)
In your calculation, don't forget to divide the values by the "shares outstanding" (number of shares) so that you also get the value for a single share. If you google "shares outstanding" and the company name, you are guaranteed to find enough information.
I would also like to provide you with two videos that explain the free cash flow system and the DCF calculation in very simple terms. You will receive them from me in the comments.
𝗜𝗜𝗜. 𝗭𝘄𝗶𝘀𝗰𝗵𝗲𝗻𝗹ö𝘀𝘂𝗻𝗴/𝗞𝗼𝗺𝗽𝗿𝗼𝗺𝗶𝘀𝘀:
A simple present value calculation offers a compromise between the relative valuation methodology and a DCF valuation. I therefore like this methodology as 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 shares, real estate or bonds, can easily be calculated with a present value (PV) calculation using the perpetual growth model. This also gives you the fair value of a company, similar to the DCF calculation, only simpler and with fewer variables. However, you have to decide for yourself which is better and more accurate for you. An example of regular cash flows for dividend aristocrats are, of course, dividends. The PV method is well illustrated here:
Calculation formula:
PV = Expected dividend next year / (Required Return - Expected growth rate)
Required Return = Describes the uncertainty/risk interest that should be covered. Can be calculated using CAPM. Can be derived from the WACC.
The basis for the required return is different:
For dividends: Cost of equity
For free cash flow (FCF): cost of capital (WACC) --> as with the DCF method
Reason: Dividends are not influenced by FC interest and, above all, 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 included in "cash flow from financing activities" and therefore outside FCF. The cost of capital approach would therefore be wrong.
The distinction between the interest rate for the "required return" (whether cost of equity or cost of capital) is very important. You can read the data from Magic Link 2. The interest rates change if you adjust the parameters for inflation and interest rates (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". It contains all the 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 parameters entered for inflation (8%) and interest rate (3.12%) for Excel file in section "Cost of Capital by Industry Sector" - US entered
Dividend growth rate = 4% (perpetual growth rate)
Dividend 2021 = USD 4.25
Due to different possible interpretations, 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) = USD 126.29
PV of Pepsi (realistic): 4.25 x 1.04 / (0.08-0.04) = USD 110.5
P/E ratio Pepsi: 31.12
P/E ratio Beverage (Soft): 29.93 (see magic Link 2)
PEG Beverage (Soft): 2.63 (see magic Link 2)
current share price: 170 USD
Result: Pepsi appears to be 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. The DCF method is therefore naturally much more variable and more accurate when applied correctly. Nevertheless, the PV method is a good indicator in your analysis. In addition, the PV method forms the basis for the DCF method (if you use the FCF and not the dividends), as 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 (sales/EBIT growth of at least 20% p.a.):
The valuation of growth companies is always somewhat 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. It is also possible that no positive FCF has yet been generated. In order to expand your tools somewhat, I would advise you to include the following key figure in your repertoire in order to be able to make a solid assessment of 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 sales 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 fulfilled. This key figure can be used to assess the efficiency of a company's growth. [4] For example, there are companies that have 20% sales growth and a 20% EBITDA margin or 40% sales growth but a 0% EBITDA margin. The aim is to "normalize" growth companies somewhat 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 if the EBITDA margin is negative due to high costs (e.g. production costs, administrative or personnel costs), meaning 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 - attention! Then with the WACC and not cost of equity!)
-Rule of 40
-Continuous and stable sales growth and EPS growth
𝗩. 𝗙𝗮𝘇𝗶𝘁
To summarize, I hope I was able to give you an understanding of the following tools:
-Relative valuation (P/E ratio, P/B ratio, KCV, PEG)
-Intrinsic valuation using the discounted cash flow method (DCF)
-Present value calculation (as a simple alternative to the DCF)
-Dividend Discount Model (DDM), similar to the DCF method
-Peculiarities for growth companies
Finally, I would like to leave you with the following:
All valuations are biased - The views of a share/company have usually already been formed before the company is fundamentally valued. Therefore, do not be too optimistic, but rather choose pessimistic parameters. Nevertheless, a certain bias remains. As you have probably gathered from my explanations, both methods offer advantages and disadvantages. It just seems important to me that you don't stick to one method or stubbornly look at the P/E ratio. Combine quantitative and qualitative key figures in your due diligence, as shown in the previous post (https://app.getquin.com/activity/XcuRrJwmyP) with valuation methods from this post and you will get a feeling for whether you have just found an undervalued company or just gold-plated scrap metal. Ultimately, however, no one is safe from making a mistake, despite extensive analysis. It is more about reducing mistakes and increasing the probability of making the right decisions. Stock picking is therefore no longer a game of chance but leads to targeted investments. The more precise your analysis, the less panicky you will be 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
Further 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 sector comparison
-->EBITDA/EBIT multiples industry comparison
