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How to Value Stocks - Part 1

How to Value Stocks - Part 1

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Published by vurublog
Learn how to calculate the intrinsic value of stocks in four steps. It's easier than you think!
Learn how to calculate the intrinsic value of stocks in four steps. It's easier than you think!

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Published by: vurublog on May 04, 2011
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05/12/2014

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How to ValueStocks: Part 1
Discounted Cash Flow
By:Visit us at:http://www.vuru.coFollow us:@VuruDotCo
 
Introduction
The key to buying low and selling high is identifying the intrinsic value of apotential investment. “It’s the only logical approach to evaluating the relativeattractiveness of investments and businesses.”“Intrinsic value can be defined as simply: It is the discounted value of the cashthat can be taken out of a business during its remaining life.” (Warren Buffett)Note that Buffett states the “value of the cash”, not “earnings” or “net income”.That’s because a company’s reported income often doesn’t paint the wholepicture. It doesn’t include the company’s capital expenditures, like buying newequipment or investing in new facilities.A company could be posting positive net income for the past 10 years, butbecause of its capital expenditures, it could actually be losing money. This losswill only be reflected in the company’s free cash flow.In this series, we’re going to highlight a couple different approaches to calculatingthe present value of a company’s future free cash flow. For this installment, we’llfocus on how to do a discounted cash flow valuation. It’s the present value of thefuture free cash flow of the business plus its equity.It’s simpler to do than you’re probably expecting. It just requires some basic mathand there are tools that can help you, but we’ll get to those later.
Discounted Cash Flow
To do this approach, you need 10 years of financial statements. Locating 10years of financial statements for free is somewhat difficult. But, there are acouple sources:Vuru- At the bottom of each stock analysis, you can export up to 10 years of Cash Flows, Income Statements and Balance Sheets. We also calculate FCF for you.ADVFN.com- Not very user-friendly, but if the company’s existed for 10 years,they’ll have the financial data. They also calculate Free Cash Flow (FCF) for you.Once you have 10 years of Free Cash Flow numbers, we can start.To calculate a stock’s intrinsic value using a DCF, there are four main questions:
1. How much has Free Cash Flow Grown During the Last 10 Years?
 
 Vu r u|Share on Twitter  To figure this out, we have to calculate the compound average growth rate(CAGR) for several time periods over the past 10 years. It’s a pretty simplecalculation.Let’s say the most recent data we have is 2010. We’ll call that Year 10. 2001 willbe Year 1. Here are the time periods we need to calculate their CAGR:Year 1 to Year 8Yr 2 to Yr 9Yr 3 to Yr 10Yr 1 to Yr 6Yr 3 to Yr 8Yr 4 to Yr 9Yr 5 to Yr 10To calculate the CAGR for each time period, the formula is:(Yr 8 / Yr 1)
(1/ # of years between Yr 8 and Yr 1)
- 1For example, if Yr 8’s Free Cash Flow was $1,000 and Yr 1’s FCF was $500, thecalculation would look like this:(1000/500)
(1/7)
- 1
 
= 0.104That gives us a CAGR of 10.4% from Year 1 to Year 8.Calculate the CAGR for each of the time periods above. If either the first or lastyear of the time period is negative, make the CAGR 0% for that time period.Take the average of the two median CAGRs. We’ll use this number as a base toproject the company’s future free cash flow.
2. How will the Company Perform in the Future?
This is a difficult question to answer. That’s why it’s vital to be conservative inyour estimate of future growth, since growth generally fades over time. “A recentarticle in the
Financial Analysts Journal 
confirmed...that the fastest-growingcompanies tend to overheat and flame out.” (pg. 305 of 
The Intelligent Investor 
by Benjamin Graham)We recommend capping the growth rate you calculated above for that veryreason.At Vuru, the growth rate we use is capped at 11.25% and we slow it down as theyears pass, as it’s likely that growth will slow over the years, as stated above.

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