Now that the financial statements are covered, we’re ready to dip our toes into valuation. Financial literature is abundant with information on this topic, so let’s keep it as simple as possible.
Valuation Defined
John Burr Williams (November 27, 1900 – September 15, 1989) was an American economist, recognized as an important figure in the field of fundamental analysis, and for his analysis of stock prices as reflecting their “intrinsic value”. To summarize what Williams is famous for theorizing, it would be the following: “The value of an enterprise is the “present worth” of all its future distributions — whether interest or dividends“. To modernize this quote, what this means is that the value of any business is the total free cash flow it can produce for the remaining of its lifetime, discounted at an appropriate rate.
The Discount Rate & Time Value of Money
So what is is a discount rate? First, understand the concept of “The time value of money”. What this means is that a Euro today is worth more than a Euro next year, due to inflation. So the theory goes.
Since we are keeping it simple, there’s really no need to know the rate of inflation. The discount rate is essentially the “Cost of Capital”, ie: what rate of return would you be willing to give up (opportunity cost) for the investment cash flows that a company would produce. Therefore, the higher the discount rate you use, the more conservative the valuation.
What I recommend is doing your valuation with different discount rates. The higher the rate, the larger your margin of safety. I usually go with 7% or 10%. 7% being used in optimistic scenarios and 10% to be conservative. The reason I use 10% is because this number is the S&P 500 index long-term rate of return since inception in the 1970’s.
Discounted Cash Flow (DCF) and Terminal Value (TV)
The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money.
Terminal value (TV) is the value of a business beyond the forecast period when future cash flows can be estimated. TV assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.
Below is the formulas for both the DCF (on the left) and TV (on the right), followed by an example of an imaginary company (Good Business Inc.)
In this is example, we are assuming that Good Business Inc. will grow its Free Cash Flow by 5% each year, for five years. Since we are assuming that after five years, valuation will become difficult we will use a terminal value with a stable growth rate of 2% ’till infinity.
The Terminal value formula presented shows the acronym WACC. For simplicity’s sake, ignore it. instead of WACC, use a discount rate. As to which rate to use, I stick to 10% to make it simple.
Valuation in scenario 1 is more conservative than scenario 2. If we are looking to buy shares in Good Business Inc., we would prefer a share price of at least half of scenario 1, meaning a share price of around 6€ or below. If we choose to buy at a higher price, we need Scenario 2 to happen or better. This of course is up for individual interpretation. There is no definitive answer.
Hopefully this post gave insight on how to approach valuation. There are of course many aspects to consider, but the example above gives a simplified version on how I approach valuation.
Valuation is part science, part art. There are many ways to quantitative approaches. On your investing journey you will learn about different methods and come to your own conclusions. The main focus of my writings will be on the psychological aspect, since this is where most mistakes are made.
Cheers!
-IGTSKasimir
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