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PART-TIME MASTER’S DEGREE IN MANAGEMENT
MMM/ MFM/ MHRDM/ MIM – THIRD YEAR SEMESTER FIRST [2010-2013]
CERTIFICATE FROM GUIDE
This is to certify that the project entitled “Valuation of Stocks.” has been successfully completed by MR.Tarun Ruparelia under my guidance during the Third year i.e. 2009-2010 in partial fulfillment of his/her course, Master Degree in Finance under the University of Mumbai through the MET’s Institute of Management, General Arun Kumar Vaidya Chowk, Bandra Reclamation, Bandra (W.), Mumbai – 400 050.
Name of Project Guide:
Prof Nitin Kulkarni.
Address of Guide: MET Complex, Bandra Reclamation, Bandra (W), Mumbai 400-050 Tel. No.: 26440446 Date:
Signature of Project Guide:
Valuation of Stocks 201 2
UNIVERSITY PROJECT “Valuation of Stocks.”
Project Guide PROF. NITIN KULKARNI
Project prepared by Tarun Ruparelia (Master in Financial Management) MFM- III Year, Semister –I Roll No- 99
MET’S Institute of Management Bandra (W) - Mumbai Academic Year: 2009-2010
Valuation of Stocks 201 2
Table of Contents
MET’S INSTITUTE OF MANAGEMENT...................................................................................1 CERTIFICATE FROM GUIDE.................................................................................................1
TABLE OF CONTENTS..........................................................................................3 INTRODUCTION TO VALUATION......................................................................4 THE ROLE OF VALUATION ................................................................................7 READING A BALANCE SHEET:.........................................................................12
CURRENT ASSETS....................................................................................................................13 CURRENT LIABILITIES................................................................................................................15 DEBT & EQUITY.....................................................................................................................16 CURRENT & QUICK RATIO..........................................................................................................17 WORKING CAPITAL...................................................................................................................19 PRICE/BOOK, DSO & TURNS.....................................................................................................21
METHODS OF VALUATION...............................................................................23
EARNINGS-BASED VALUATIONS.....................................................................................................23 Is the P/E the Holy Grail?................................................................................................24 REVENUES-BASED VALUATIONS....................................................................................................27 CASH FLOW-BASED VALUATIONS..................................................................................................29 EQUITY-BASED VALUATIONS........................................................................................................31 YIELD-BASED VALUATIONS..........................................................................................................35 MEMBER-BASED VALUATIONS......................................................................................................35 DISCOUNTED CASH FLOW ANALYSIS...............................................................................................36
ANALYSING EQUITY VALUE USING DCF ANALYSIS.................................39 VALUE DRIVERS.................................................................................................41 CONCLUSION ......................................................................................................45 BIBLIOGRAPHY...................................................................................................47
Valuation of Stocks 201 2
Introduction to Valuation
Valuation is the first step toward intelligent investing. When an investor attempts to determine the worth of her shares based on the fundamentals, she can make informed decisions about what stocks to buy or sell. Without fundamental value, one is set adrift in a sea of random short-term price movements and gut feelings. For years, the financial establishment has promoted the specious notion that valuation should be reserved for experts. Supposedly, only sell-side brokerage analysts have the requisite experience and intestinal fortitude to go out into the churning, swirling market and predict future prices. Valuation, however, is no abstruse science that can only be practiced by MBAs and CFAs. Requiring only basic math skills and diligence, any person can determine values with the best of them. Before you can value a share of stock, you have to have some notion of what a share of stock is. A share of stock is not some magical creation that ebbs and flows like the tide; rather, it is the concrete representation of ownership in a publicly traded company. If XYZ Corp. has one million shares of stock outstanding and you hold a single, solitary share that means you own a millionth of the company. Why would someone want to pay you for your millionth? There are quite a few reasons, actually. There is always going to be someone else who wants that millionth of the ownership because they want a millionth of the votes at a shareholder meeting. Although small by itself, if you amass that millionth and about five hundred thousand of its friends, you suddenly have a controlling interest in the company and can make it do all sorts of things, like pay fat dividends or merge with your company. Companies buy shares in other companies for all sorts of reason. Whether it is an outright takeover, in which a company buys all the shares, or a joint venture, in which the company typically buys enough of another company to earn a seat on the board of directors, the stock is
simply because dividends to shareholders get taxed twice.in choosing investments for a portfolio. This effectively drives up the stock price by providing a buyer as well as improving earnings per share (EPS) comparisons by decreasing the number of shares outstanding. The premise of valuation is that we can make reasonable estimates of value for most assets. Some assets are easier to value than others. Finally. to make intelligent business decisions with clear and concise information about what another company's shares might cost them. Even if the company's stock does not currently have a dividend yield. shareholder's equity -. The price of a stock translates into the price of the company.you name it. Mature. there always remains the possibility that at some point in the future there could be some sort of dividend. and the uncertainty associated with value estimates is different for different assets. It is this information that allows other companies. in deciding on the appropriate price to pay or receive in a takeover and in making investment. Knowing what an asset is worth and what determines that value is a pre-requisite for intelligent decision making -. equity. cash flow. cash-flow positive companies tend to be much more liberal in this day and age with share repurchases as opposed to dividends. For the individual investor. public or private. I will sum this all up in a conclusion that positions these valuations in the broader context of fundamental analysis and gives us a sense of how to apply these in our own investment efforts. real as well as financial. but the core principles remain the same. and that the same fundamental principles determine the values of all types of assets. earnings. a company can simply repurchase its own shares using its excess cash. rather than paying out dividends to shareholders. cash flow. The share of stock is a stand-in for a share in the company's revenues. The main categories of valuation I will elucidate are valuations based on earnings. This introduction lays out some 5|Page . however. The share of ownership entitles you to a share of all dividends in perpetuity. revenues. financing and dividend choices when running a business. the whole enchilada. five days a week. on sale for seven and a half hours a day. dividends and subscribers. the details of valuation vary from asset to asset. Finally.Valuation of Stocks 201 2 always on sale. this normally means just worrying about what portion of all of those numbers you can get in dividends.
uncertainty about and expected growth in these cashflows. That is the equivalent of playing a very expensive game of musical chairs. we buy financial assets for the cashflows we expect to receive from them. But there is one point on which there can be no disagreement. when the time comes. is that you might end up being the looser of all. Asset prices cannot be justified by merely using the argument that there will be other investors around who will pay a higher price in the future. or something else entirely? Or do you simply apply multiple valuations in order to discern what the fair price for a share of stock might be? 6|Page . but it is forgotten and rediscovered at some time in every generation and in every market. It also examines the three basic approaches that can be used to value an asset. There are many aspects of valuation where we can agree to disagree. There are those who are disingenuous enough to argue that value is in the eyes of the beholder. The problem with investing with the expectation that there will be another person around to sell an asset to. where every investor has to answer the question. "Where will I be when the music stops? before playing. A philosophical basis for valuation A postulate of sound investing is that an investor does not pay more for an asset than it is worth. revenues. So just how do you value the shares of a company? Based on earnings.Valuation of Stocks 201 2 general insights about the valuation process and outlines the role that valuation plays in portfolio management. cash-flow. which implies that the price we pay for any asset should reflect the cashflows it is expected to generate. Perceptions may be all that matter when the asset is a painting or a sculpture. This statement may seem logical and obvious. including estimates of true value and how long it will take for prices to adjust to that true value. acquisition analysis and in corporate finance. perceptions of value have to be backed up by reality. . . That is patently absurd. and that any price can be justified if there are other investors willing to pay that price. but we do not and should not buy most assets for aesthetic or emotional reasons. Valuation models attempt to relate value to the level of. Consequently.
different investment philosophies and the roles played by valuation in each one. The role it plays. Portfolio Management The role that valuation plays in portfolio management is determined in large part by the investment philosophy of the investor. Valuation plays a minimal role in portfolio management for a passive investor. Fundamental Analysts: The underlying theme in fundamental analysis is that the true value of the firm can be related to its financial characteristics -. (c) Deviations from the relationship are corrected in a reasonable time period. valuation plays a central role in portfolio management for fundamental analysts. whereas it plays a larger role for an active investor. Even among active investors. 7|Page . Any deviation from this true value is a sign that a stock is under or overvalued. however. is different in different arenas. in broad terms. in acquisition analysis and in corporate finance. Market timers use valuation much less than investors who pick stocks. and a peripheral role for technical analysts.its growth prospects. (b) The relationship is stable over time. The following section lays out the relevance of valuation in portfolio management. The following sub-section describes. the nature and the role of valuation is different for different types of active investment. 1. It is a long-term investment strategy. and the focus is on market valuation rather than on firm-specific valuation.Valuation of Stocks 201 2 The Role of Valuation Valuation is useful in a wide range of tasks. and the assumptions underlying it are that: (a) The relationship between value and the underlying financial factors can be measured. risk profile and cashflows. 1. Among security selectors.
these portfolios will do better than the market. the former are fixable but the latter are not. 3. Reverting back to our break down of assets in figure 1. some analysts use discounted cashflow models to value firms. The key difference between the two is in where the valuation focus lies. They then have to consider the effects of changing management on value. While valuation is the central focus in fundamental analysis. trading volume and short sales -. Since investors using this approach hold a large number of 'undervalued' stocks in their portfolios.1. As a consequence.Valuation of Stocks 201 2 Fundamental analysts include both value and growth investors. they have to separate how much of a firms poor stock price performance has to do with bad management and how much of it is a function of external factors.price movements. The information available from trading measures -. Growth investors. The assumptions here are that prices move in predictable patterns. they wield influence on the management of these firms and can change financial and investment policy.gives an indication of investor psychology and future price movements. How can valuation skills help in this pursuit? To begin with. Their focus is not so much on what the company is worth today but what its value would be if it were managed well. are far more focused on valuing growth assets and buying those assets at a discount. Activist Investors: Activist investors take positions in firms that have a reputation for poor management and then use their equity holdings to push for change in the way the company is run. that 8|Page . In other words. on the other hand. while others use multiples and comparable firms. value investors are primarily interested in assets in place and acquiring them at less than their true value. Activist investors generally concentrate on a few businesses they understand well. these investors have to ensure that there is additional value that can be generated by changing management. Chartists: Chartists believe that prices are driven as much by investor psychology as by any underlying financial variables. 2. on average. they have to not only know the businesses that the firm operates in but also have an understanding of the interplay between corporate finance decisions and value. Often. Michael Price and Kirk Kerkorian have prided themselves on their capacity to not only pinpoint badly managed firms but to also create enough pressure to get management to change its ways. and attempt to acquire undervalued firms. their hope is that. financing and dividend policies. this will require an understanding of how value will change as a firm changes its investment. Investors like Carl Icahn.
5. increases relative to the number that are undervalued. For an information trader. Information traders attempt to trade in advance of new information or shortly after it is revealed to financial markets. using the valuation model.Valuation of Stocks 201 2 there are not enough marginal investors taking advantage of these patterns to eliminate them. The underlying assumption is that these traders can anticipate information announcements and gauge the market reaction to them better than the average investor in the market. 6. Information Traders: Prices move on information about the firm. rather than on value. as the number of stocks that are overvalued. Thus an information trader may buy an 'overvalued' firm if he believes that the next information announcement is going to cause the price to go up. valuation can be used to determine support and resistance lines on price charts. there are ways in which an enterprising chartist can incorporate it into analysis. For instance. and that any attempt to exploit 9|Page . and that the average investor in the market is driven more by emotion than by rational analysis. While valuation of individual stocks may not be of much direct use to a market timer. with some legitimacy. the focus is on the relationship between information and changes in value. and how its stock price reacts to new information. While valuation does not play much of a role in charting. For example. 4. They argue that it is easier to predict market movements than to select stocks and that these predictions can be based upon factors that are observable. If there is a relationship between how undervalued or overvalued a company is. because it contains better than expected news. per se. (b) Valuation models can be used to value a large number of stocks. Efficient Marketers: Efficient marketers believe that the market price at any point in time represents the best estimate of the true value of the firm. and the results from the cross-section can be used to determine whether the market is over or under valued. there may be reason to believe that the market is overvalued. then valuation could play a role in investing for an information trader. Market Timers: Market timers note. that the payoff to calling turns in markets is much greater than the returns from stock picking. market timing strategies can use valuation in one of at least two ways: (a) The overall market itself can be valued and compared to the current level.
The bidding firm or individual has to decide on a fair value for the target firm before making a bid. the increase in value that many managers foresee as occurring after mergers because the combined firm is able to accomplish things that the individual firms could not. valuation is a useful exercise to determine why a stock sells for the price that it does. the value of control. First. the objective becomes determining what assumptions about growth and risk are implied in this market price. Since the underlying assumption is that the market price is the best estimate of the true value of the company. Target firms may be over-optimistic in estimating value.Valuation of Stocks 201 2 perceived market efficiencies will cost more than it will make in excess profits. that marginal investors promptly exploit any inefficiencies and that any inefficiencies in the market are caused by friction. 8. for strategic reasons. will have to be taken into account in deciding on a fair price. Similarly. Second. valuation plays a key role when they approach venture capital and private equity investors for more capital. For small private businesses thinking about expanding. if the bidding firm has decided. There are special factors to consider in takeover valuation. rather than on finding under or overvalued firms. there is a significant problem with bias in takeover valuations. As we noted earlier. This is of particular concern in hostile takeovers. to do an acquisition. there may be strong pressure on the analyst to come up with an estimate of value that backs up the acquisition. especially when the takeover is hostile. and the target firm has to determine a reasonable value for itself before deciding to accept or reject the offer. Valuation in Acquisition Analysis: Valuation should play a central part of acquisition analysis. which measures the effects on value of changing management and restructuring the target firm. They assume that markets aggregate information quickly and accurately. and they are trying to convince their stockholders that the offer price is too low. For efficient marketers. and cannot exploited. 7. there is synergy. Valuation in Corporate Finance: There is a role for valuation at every stage of a firms life cycle. such as transactions costs. The effects of synergy on the combined value of the two firms (target plus bidding firm) have to be considered before a decision is made on the bid. The share of a firm that a venture capitalist will demand in exchange for a capital infusion will depend upon the 10 | P a g e .
are done for legal or tax reasons. 9. Valuation for Legal and Tax Purposes: Mundane though it may seem. for instance) that they contend facilitate value enhancement. whenever a new partner is taken on or an old one retires. especially of private companies. 11 | P a g e . valuations determine the prices at which they are offered to the market in the public offering. and businesses that are jointly owned have to be valued when the owners decide to break up. most valuations. how much to borrow and how much to return to the owners will be all decisions that are affected by valuation. Businesses have to be valued for estate tax purposes when the owner dies. the objective often becomes providing a valuation that the court will accept rather than the right valuation. and for divorce proceedings when couples break up. In fact. the relationship between financial decisions. As the companies get larger and decide to go public. and doing it right requires an understanding of the levers of value. As a final note. value enhancement has become the mantra of management consultants and CEOs who want to keep stockholders happy. many consulting firms have come up with their own measures of value (EVA and CFROI. decisions on where to invest. Once established. If the objective in corporate finance is to maximize firm value . While the principles of valuation may not be different when valuing a business for legal proceedings. A partnership has to be valued. corporate strategy and firm value has to be delineated.Valuation of Stocks 201 2 value she estimates for the firm.
giving the money to shareholders. But what the heck does that really mean? Publicly traded companies are designed to make money. The first is to look at terminal value. The second is to look at where tangible shareholder value comes from -. However. A company's value is determined by how much in the way of liquid assets it can amass. A company's real earnings are the earnings that make it from the Consolidated Statement of Earnings to the Balance Sheet as a liquid asset. Shareholder value ultimately derives from liquid assets.dividends and stock buybacks. you don't dare ask for clarification for fear of looking like a fool. this is not the only way to determine if there is real value in a company's stock. cryptically saying. The conventional way of scoring this pursuit is by looking at the company's ability to grow various flavors of earnings -. You will be talking to another investor about the latest addition to your portfolio and the conversation will turn to how each of you picks stocks. net income and earnings per share are all common measures.Valuation of Stocks 201 2 Reading a Balance Sheet: "Cash Is King?" Sure. If a company has excess liquid assets that it does not need." Although somewhat perplexed.returns on invested capital generated by the company's operations. the assets that can easily be converted into cash. There are two ways to think about this.operating earnings. which assumes for the sake of calculating potential return that at some future point a company will close down its operations and turn everything into cash. it can deploy those assets in two ways to benefit shareholders -. "Cash is king. The other investor will smile at you and wink. 12 | P a g e . you have heard the cliche. pretax earnings.
The 10-K is a toned-down version of the annual report with more text and fewer pretty pictures that comes out once a year. The advantage of the annual balance sheet over the quarterlies is that the annual balance sheet has been double-checked by accountants before it was filed with the SEC. An operating cycle is the time that it takes to sell a product and collect cash from the sale. It is the balance sheet that can tell you if a company has enough money to continue to fund its own growth or whether it is going to have to take on debt. Most investors who look at annual reports. the Statement of Cash Flows. you are ready to begin your journey through the balance sheet. 10-Ks and 10-Qs spend far too much time worrying about earnings and far too little time worrying about the balance sheet and its cousin. Armed with this information. Current Assets The first major component of the balance sheet is Current Assets. containing the company's annual balance sheet. Does a company have too much inventory? Is a company collecting money from its customers in a reasonable amount of time? It is the balance sheet -. then the company is going to have to dig around to find some other form of short-term funding. day-to-day operations. The 10-Q is a quarterly filing that a company makes with the SEC three times a year (with the fourth filing being the 10-K in the fourth quarter) that also tracks the balance sheet through the course of the year. issue debt.Valuation of Stocks 201 2 Knowing what is on the balance sheet is crucial to understanding whether or not the company you are investing in is capable of generating real value for shareholders. Current assets are important because it is from current assets that a company funds its ongoing. If there is a shortfall in current assets. It can last anywhere from 60 to 180 days.the listing of all of the assets and liabilities of a company -. Where do you find all this information about the balance sheet? Would you believe that you can get it for free? The documents that the Securities and Exchange Commission (SEC) makes available to you online at the Edgar website give you all sorts of balance sheet information in the 10-Ks and 10-Qs. which normally results in interest payments or dilution of shareholder value through the issuance of 13 | P a g e . or issue more stock in order to keep on keeping on.that can tell you all of this. which are assets that a company has at its disposal that can be easily converted into cash within one operating cycle.
Cash and equivalents are completely liquid assets. This money cannot be immediately liquefied without some effort.Cash & Equivalents. and thus should get special respect from shareholders. normally abbreviated as A/R. However. there are instances where a company will be forced to take a write-off for bad accounts receivable if it has given credit to someone who cannot or will not pay. Companies routinely buy goods and services from other companies using credit. The allowance for bad debt is the money set aside to cover the potential for bad customers. This is why you will see something called allowance for bad debt in parentheses beside the accounts receivable number. is the money that is currently owed to a company by its customers. These normally come into play when a company has so much cash on hand that it can afford to tie some of it up in bonds with durations of less than one year. This is the money that a company could immediately mail to you in the form of a fat dividend if it had nothing better to do with it. it does not include vintage comic books. All right. Accounts Receivable. you know that a lot of the sales for that particular quarter 14 | P a g e . Short-Term Investments are a step above cash and equivalents. like bearer bonds.Valuation of Stocks 201 2 more shares of stock. Cash & Equivalents are assets that are money in the bank. Although typically A/R is almost always turned into cash within a short amount of time. based on the kind of receivables problems the company may or may not have had in the past. sometimes a company will be forced to take a write-down for accounts receivable or convert a portion of it into a loan if a big customer gets in real trouble. and thus enhance the value of the shares that you own.if receivables are up more than revenues. money market funds. It is cash and investments that give shares immediate value and could be distributed to shareholders with minimal effort. even given this allowance. Shortand Long-Term Investments. literally cold. hard cash or something equivalent. Looking at the growth in accounts receivable relative to the growth in revenues is important -. There are five main kinds of current assets -. but it does earn a higher return than cash by itself. The reason why the customers owe money is that the product has been delivered but has not been paid for yet. This is the money that the company could use to buy back stock. Inventories and Prepaid Expenses. or vintage comic books. Accounts Receivable.
however. This can be a lump sum given to an advertising agency or a credit for some bad merchandise issued by a supplier. Prepaid Expenses are expenditures that the company has already paid to its suppliers. Companies that have inventories growing faster than revenues or that are unable to move their inventories fast enough are sometimes disasters waiting to happen. Not all companies have inventories. For those that do.Valuation of Stocks 201 2 have not been paid for yet. because of various accounting systems like FIFO (first in. Any money that a company pulls out of its line of credit or gains the use of because it pushes out its accounts payable is an asset that can be used to grow the business. Inventories are the components and finished products that a company has currently stockpiled to sell to customers. first out) as well as real liquidation compared to accounting value. We will look at accounts receivable turnover and days sales outstanding later in this series as another way to measure accounts receivable. Although this is not liquid in the sense that the company does not have it in the bank. We will look at inventory turnover later as another way to measure inventory. services or information industries. It means that these bills will not have to be paid in the future. Finally. These are all bills that are due in less than a year. Second. inventories tie up capital. consulting. particularly if they are involved in advertising. liabilities are also a source of assets. first out) and LIFO (last in. There are five main categories of 15 | P a g e . As well as simply being a bill that needs to be paid. Inventories should be viewed somewhat skeptically by investors as an asset. These are short-term debts that normally require that the company convert some of its current assets into cash in order to pay them off. the value of inventories is often overstated on the balance sheet. First. having bills already paid is a definite plus. Money that it is sitting in inventories cannot be used to sell it. Current Liabilities Current Liabilities are what a company currently owes to its suppliers and creditors. and more of the revenues for that particular quarter will flow to the bottom line and become liquid assets. inventories are extremely important.
Basically. A specific type of accrued expense is Income Tax Payable. LongTerm Notes Payable. Although subject to withholding. these are the basic costs of doing business that a company. Accrued Expenses are bills that the company has racked up that it has not yet paid. Income Tax Payable. One company's accounts payable is another company's accounts receivable. its partners and its employees. there are some taxes that simply are not accrued by the government over the course of the quarter or the year and instead are paid in lump sums whenever the bill is due. Short-Term Notes Payable and Portion of Long-Term Debt Payable. which is why both terms are similarly structured. Accrued Expenses. which often produces a short-term increase in earnings and current assets.Total Assets. Stockholder's/Shareholder's Equity. state and local tax schedules. there are five main categories -. A company has the power to push out some of its accounts payable.Valuation of Stocks 201 2 current liabilities: Accounts Payable. These are normally marketing and distribution expenses that are billed on a set schedule and have not yet come due. Specifically. Debt & Equity The remainder of the balance sheet is taken up by a hodge-podge of items that are not current. The company also might have a portion of its Long-Term Debt come due with the year.one of those little accounting quirks. 16 | P a g e . has not paid off yet. which is why this gets counted as a current liability even though it is called long-term debt -. meaning that they are either asset that cannot be easily turned into cash or liabilities that will not come due for more than a year. This is the income tax a company accrues over the year that it does not have to pay yet according to various federal. for whatever reason. Short-Term Notes Payable is the amount that a company has drawn off from its line of credit from a bank or other financial institution that needs to be repaid within the next 12 months. Accounts Payable is the money that the company currently owes to its suppliers. Capital Stock and Retained Earnings.
you have managed to read through my abbreviated definitions of various items on the balance sheet -. Stockholder's or Shareholder's Equity. is composed of Capital Stock and Retained Earnings.congratulations. Most companies will tell you in a footnote to this item when this debt is due and what interest rate the company is paying. property and equipment and encompasses any land.the amount of equity that shareholders currently have in the company. but that are kept on a company's books for accounting purposes. meaning that the stated value of the total assets and the actual value or price paid might be very different. it is any additional cash that a company gets from issuing stock in excess of par value under certain financial conventions. buildings. vehicles and equipment that a company has bought in order to operate its business. you get shareholder's equity -. and records this on the company's books. Retained earnings is another accounting convention that basically takes the money that a company has earned. this is more than a little bit confusing and does not always add all that much value to the analysis. less any earnings that are paid out to shareholders in the form of dividends and stock buybacks. These are normally loans from banks or other financial institutions that are secured by various assets on the balance sheet. Capital stock is the par value of the stock issued that is recorded purely for accounting purposes and has no real relevance to the actual value of the company's stock. Frankly. Essentially. Now we get to have some fun with numbers and start playing 17 | P a g e . If you add together capital stock and retained earnings. Current & Quick Ratio So. such as inventories. The last main component. Retained earnings simply measures the amount of capital a company has generated and is best used to determine what sorts of returns on capital a company has produced.Valuation of Stocks 201 2 Total Assets are assets that are not liquid. Capital in Excess of Stock is another weird accounting convention that is pretty difficult to explain. Much of this is actually subject to an accounting convention called depreciation for tax purposes. Long-Term Notes Payable or Long-Term Liabilities are loans that are not due for more than a year. The main component is plants.
If the company is not growing sales very quickly. a current ratio of 1. it pays to check the Quick Ratio. Certain industries have their own norms as far as which current ratios make sense and which do not. It is even worse when a company going out of business is forced to liquidate its inventory. This is particularly true in retail. For instance. if a company has a lot of its liquid assets tied up in inventory. By taking inventories out of the equation. The quick ratio is simply current assets minus inventories divided by current liabilities. If you recall the discussion on inventories.5 or greater is normally sufficient to meet near-term operating needs. it is very dependent on the sale of that inventory to finance operations. For instance. We do this to derive some rather compelling information about how well the company manages its assets and whether or not the company represents a bargain based on the assets it has at its disposal. you can check and see if a company has sufficient liquid assets to meet short-term operating needs.Valuation of Stocks 201 2 around with these various pieces of information. this is simply the current assets divided by the current liabilities. you get: Current Ratio = = 2. this can turn into an albatross that forces the company to issue stock or take on debt. You should always check a company's current ratio (as well as any other ratio) against its main competitors in a given industry.5 million 18 | P a g e . sometimes for pennies on the dollar.0 As a general rule.not the worst thing in the world. in the auto industry a high current ratio makes a lot of sense if a company does not want to go bankrupt during the next recession. A current ratio that is too high can suggest that a company is hoarding assets instead of using them to grow the business -. Also. The first tool you can use is called the Current Ratio. Say you look at the balance sheet of Joe's Bar and Grill and find out that they have $2. I mentioned that sometimes inventories are not necessarily worth what they are on the books for. Because of all of this. where you routinely see close-out sales with 60% to 80% markdowns. if JOE'S BAR AND GRILL has $10 million in current assets and $5 million in current liabilities. but potentially something that could impact long-term returns. A measure of how much liquidity a company has.
0 to ensure that there is enough cash on hand to pay the bills and keep on going. Working capital is basically an expression of how much in liquid assets the company currently has to build its business. so I know of no general guideline to use when you want to check it. About 99% of the reason that the company probably came public in the first place had to do with getting working capital for whatever reasons -. however. 19 | P a g e . Finally. If a company has negative working capital. with plenty of cash on hand to pay for everything it might need to buy.building the business. fund its growth. a company with positive working capital will always outperform a company with negative working capital. Most people look for a quick ratio in excess of 1. The quick ratio can also vary by industry. If a company has ample positive working capital. All other things being equal. some investors will use something called the Cash Ratio. Working capital is the absolute lifeblood of a company. and produce shareholder value. it always pays to compare this ratio to that of peers in the same industry in order to understand what it means in context. You now can figure out the company's quick ratio: Quick Ratio = = = 1. As with the current ratio.5 Looks like Joe's makes the grade again. Working capital is simply current assets minus current liabilities and can be positive or negative. which is the amount of cash that a company has divided by its current liabilities. so the company lacks the ability to spend with the same aggressive nature as a working capital positive peer. Working Capital The best way to look at current assets and current liabilities is by combining them into something called Working Capital. It is just another method to compare various companies in the same industry with each other in order to figure out which one is better funded.Valuation of Stocks 201 2 of their current assets in hamburger buns that are sitting in inventory. I cannot emphasize enough how important working capital is. This is not a common ratio. then it is in good shape. then its current liabilities are actually greater than their current assets.
Working Capital = = = 50% What all of that math tells you is that 50% of the market's valuation of Joe's Bar and Grill is backed up by working capital. hard cash. The reason you add long-term debt and preferred shares (which are a special form of debt) to the market capitalization is because if you were to buy the company. you would get 50 cents on the dollar just from working capital alone. Even though working capital is nifty.Valuation of Stocks 201 2 funding acquisitions or developing new products. not only would you have to pay the current market price but you would also have to incur the responsibility for the debt as well. you have a 20 | P a g e . if we use Joe's Bar and Grill again. you can figure out the working capital to market capitalization ratio. one million shares outstanding and each share is $10 a pop. If a company runs out of working capital and still has bills to pay and products to develop. things are pretty good. This is a tremendous amount of money to have at your disposal and really very nice for Joe's. Simply take the cash and equivalents and divide it by the market capitalization to see what the percentage is. If you know that Joe's Bar and Grill has no debt. if you see working capital to market capitalizations of 50% or higher. Basically. Market capitalization is the value of all the shares of stock currently outstanding plus any long-term debt or preferred shares that the company has issued. A valuation that I am coming to like more and more is comparing working capital to the company's current Market Capitalization. You can compare working capital to market capitalization by dividing working capital by that market capitalization. For instance. Anything good that comes from a company springs out of working capital. it has big problems. we know that it has $10 million in current assets and $5 million in current liabilities. just looking at the amount of cash a company has relative to its market capitalization is also pretty enlightening. If you take a company's working capital and measure it against a company's market capitalization. you can find some pretty cool stuff. if you were to liquidate Joe's tomorrow. If you are dealing with a company where 10% or more of the capitalization is backed up with cold. Theoretically.
meaning it would effectively be deducted from the cost after the transaction was closed. you might want to net out the inventories from working capital and check that percentage just to make sure that the number is not all that different. I saved these for last because they are the most complicated. Traditional book value is simply the shareholder's equity divided by the number of shares of stock outstanding. I do my price-to-book ratios using the aggregate market capitalization of the company divided by the current shareholder's equity. Price/Book. DSO & Turns The last three ratios that you can derive from the balance sheet are the Price-to-Book Ratio. Days Sales Outstanding (DSO). then: EV/SE = 21 | P a g e . I also use something called Enterprise Value.it just means that the company does not need a lot of land and factories to make a very high-margin product. and Inventory Turnover. You do this by simply subtracting inventories from working capital. however. they would get all the cash the company currently has. which is market capitalization minus cash and equivalents plus debt. The enterprise value (EV) to shareholder's equity (SE) looks like this. The fact that Microsoft (Nasdaq: MSFT) doesn't have very much in the way of book value doesn't mean the company is overvalued -. Since I think that it is more informative to look at the company as a whole. The one of these that I think is absolutely useless is the venerable Price-to-Book Ratio. Conceived in a time when America was made up mainly of industrial companies that had actual hard assets like factories to back up their stock.Valuation of Stocks 201 2 company that has ample funds to get itself going. Also. The reason you subtract cash and equivalents from market capitalization is because if someone were to actually buy the company. its utility has waned in the past few decades as more and more companies that are not very capital intensive have grown and become commercial giants. especially for retailers and clothing manufacturers.
As you might have expected. To turn this number into days sales outstanding. 22 | P a g e . Some value investors will shun any companies that trade above 2.0 times book value or more.Valuation of Stocks 201 2 This number will get you a simple multiple. To figure out DSO. much like the price/earnings ratio or the price/sales ratio. and therefore will have to use the revenues from the last fiscal year. If it is below 1. then it means that the company is selling below book value and theoretically below its liquidation value. By "turn. the lower this number is. However. you first have to figure out Accounts Receivables Turnover. you do the following: DSO = This tells you roughly how many days worth of sales are outstanding and not paid for at any given time. For this number. This is: A/R Turnover = Sometimes you will only be able to get the accounts receivable from the last fiscal year. the better. What this ratio tells you is how many times in a year a company turns its accounts receivable." I mean the number of times it completely clears all of the outstanding credit. By comparing DSOs for various companies in the same industry. It is a way of transforming the accounts receivable number into a handy metric that can be compared with other companies in the same industry to determine which player is managing its receivables collection better. higher is better.0. This is a crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business. Days Sales Outstanding is a measure of how many days worth of sales the current accounts receivable (A/R) represents. the fresher the information. you can get a picture of which companies are managing their credit better and getting money in faster on their sales. getting an edge on the competition. A company with a lower amount of days worth of sales outstanding is getting its cash back quicker and hopefully putting it immediately to use. the better it is for the company.
allowing you to make better investments. COGS is the second entry in the Consolidated Statement of Earnings right below the revenue line. a call to the company's investor relations department will usually get you the information you need. you need to find out the Cost of Goods Sold (COGS) for the past 12 months. Earnings. acquisitions. If you have problems finding these numbers. also called net income or net profit. tying up a lot of working capital that could be better used elsewhere. is the money that is left over after a company pays all of its bills.Valuation of Stocks 201 2 The same is true of Inventory Turnover. 23 | P a g e . To figure out how much a company is turning its inventory. the one with better inventory management is the one that is going to be able to grow faster. Methods of Valuation Earnings-Based Valuations Earnings Per Share and the P/E Ratio The most common way to value a company is to use its earnings. most people who look at earnings measure them according to earnings per share (EPS). To allow for apples-to-apples comparisons. Just add up the last four quarters worth of COGS and then find out the current inventory level. The less money you have tied up in inventory in order to fill your distribution channels. research and development. advertising. Inventory Turnover = If two companies are the same in every way but one is turning over its inventories more often. and so on. you will have an incredible view into how well the company can fund its own growth going forward. Inventory management actually is a bottleneck for growth if it is not efficient enough.marketing. You want a company to turn its inventories as often as possible during the year in order to free up that working capital to do other things. the more money you will have to do all the other things a company needs done -. If you can find out a company's DSO and inventory turns relative to its peers. expansions.
Is the P/E the Holy Grail? There is a large population of individual investors who stop their entire analysis of a company after they figure out the trailing P/E ratio. People believe that P/E only makes sense for growth companies relative to the earnings 24 | P a g e . suggesting that at a P/E of 15 the company is pretty fairly valued.the quarters that trail behind the most recent quarter reported. These are companies that have a very low price relative to their trailing earnings.. it would have a P/E of 15. To look at a company's earnings relative to its price. in our example above. Such investors look for "low P/E" stocks. this group of intelligent investors blindly plunge ahead armed with this one ratio. With no regard to any other form of valuation. Thus. In our example of XYZ Corp. was currently trading at $15 a share. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. purposefully ignoring the vagaries of equity analysis. if.00. grew its earnings per share at a 13% over the past year. the P/E is most often used in comparison with the current rate of growth in earnings per share. (The reason it is called a trailing EPS is because it looks at the last four quarters reported -. in a fairly valued situation the price/earnings ratio is about equal to the rate of EPS growth. it has a trailing EPS of $1. For instance. for instance. though. The assumption is that for a growth company. Popularized by Ben Graham (who used a number of other techniques as well as low P/E to isolate value). The earnings per share alone means absolutely nothing. if XYZ Corp. we find out that XYZ Corp. Also called a "multiple". has one million shares outstanding and has earned one million dollars in the past 12 months. XYZ Corp. the P/E has been oversimplified by those who only look at this number.Valuation of Stocks 201 2 You arrive at the earnings per share by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding. most investors employ the price/earnings (P/E) ratio.
The PEG simply takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. one had to search manually through pages of stock tables in order to ferret out companies that had extremely low P/Es. If a company has lost money in the past year or has suffered a decrease in earnings per share over the past twelve months. Since it is future growth that makes a company valuable to both an acquirer and a shareholder.Valuation of Stocks 201 2 growth.you still can and it happens all the time. all you have to do is punch a few buttons on an online database and you have a list as long as your arm. The PEG and YPEG : The most common applications of the P/E are the P/E and growth ratio (PEG) and the year-ahead P/E and growth ratio (YPEG). the P/E becomes less useful than other valuation methods we will talk about later in this series. more often than not it deserves to have a low P/E because of its questionable future prospects. low P/E stocks that have been mispriced have become more and more rare. This screening has added efficiency to the market. Today. you need to confirm the value in these companies by applying some other valuation techniques. In the end. Are Low P/E Stocks Really a Bargain? With the advent of computerized screening of stock databases. seeking either dividends or free cash flow. When Ben Graham formulated many of his principles for investing. to fund stock 25 | P a g e . As intelligent investors value companies based on future prospects and not past performance. When you see a low P/E stock these days. stocks with low P/Es often have dark clouds looming in the months ahead. P/E has to be viewed in the context of growth and cannot be simply isolated without taking on some significant potential for error.. Rather. This is not to say that you cannot still find some great low P/E stocks that for some reason the market has simple overlooked -.
Thus. these are simply taken as an indication of the fair multiple for a company's stock going forward. in the real world. A PEG of 1. the YPEG is equal to 0. While the PEG is most often used for growth companies. For example. the YPEG is best suited for valuing larger.5 -implying that it is selling for one half (50%) of its fair value. As always.5 and the stock looks cheap according to this metric. If the company in the above example only had a P/E of five but was expected to grow at 10% a year.Valuation of Stocks 201 2 buybacks. Only looking at the trailing P/E is kind of like driving while looking out the rearview mirror. This makes some degree of intuitive sense. As most earnings estimate services provide estimated 5-year growth rates. more-established ones. If a company is expected to grow at 10% a year over the next two years and has a P/E of 10. it would be reasonable to buy the stock with the expectation that it will return to its historic 10 times multiple if the missed quarter was only a short-term anomaly.0. has historically traded at about 10 times earnings and is currently down to 7 times earnings because it missed estimates one quarter. many simply look at estimated earnings and estimate what fair multiple someone might pay for the stock. Although the PEG and YPEG are helpful. it would have a PEG of 0.0 suggests that a company is fairly valued. one must view the PEG and YPEG in the context of other measures of value and not consider them as magic money machines. this is not always the case. worth double what it should be according to the assumption that the P/E should equal the EPS rate of growth.0. it will have a PEG of 1. Unfortunately. Thus. The YPEG uses the same assumptions as the PEG but looks at different numbers. 26 | P a g e . if the current P/E is 10 but analysts expect the company to grow at 20% over the next five years. it would have a PEG of 2. they both operate on the assumption that the P/E should equal the EPS rate of growth. If the company had a P/E of 20 and expected growth of 10% a year. if XYZ Corp.
The market capitalization is the current market value of a company. That said. If XYZ Corp. Although one can do enough research to make the risk of being wrong as marginal as possible. it will always still exist. so. For instance. have earnings depressed due to short-term circumstances (like product development or higher taxes). This historical relationship requires some sophisticated databases and spreadsheets to figure out and is not widely used by individual investors. A modification to the multiple approaches is to determine the relationship between the company's P/E and the average P/E of the S&P 500. many investors believe that XYZ Corp. if our example 27 | P a g e . most of the other investors and companies out there are using this same approach. in the worst-case scenario. Whether or not a company has made money in the last year. has historically traded at 150% of the S&P 500 and the S&P is currently at 10. although many professional money managers often use this approach.Valuation of Stocks 201 2 When you project fair multiples for a company based on forward earnings estimates. Should one of your assumptions turn out to be incorrect. assuming that nothing changes. Even companies that may be temporarily losing money. the stock will probably not go where you expect it to go. The price/sales ratio takes the current market capitalization of a company and divides it by the last 12 months trailing revenues. Revenue-based valuations are achieved using the price/sales ratio. Revenues-Based Valuations Valuation: The Price/Sales Ratio Every time a company sells a customer something. it is generating revenues. you start to make a heck of a lot of assumptions about what is going to happen in the future. This is the current price at which the market is valuing the company. or are relatively new in a high-growth industry are often valued off of their revenues and not their earnings. at least you won't be alone. often simply abbreviated PSR. making their own assumptions as well. there are always revenues. should eventually hit a fair P/E of 15. arrived at by multiplying the current share price times the shares outstanding. Revenues are the sales generated by a company for peddling goods or services.
the PSR can tell you whether or not the concern's 28 | P a g e . you would acquire its debt as well. who is most famous for using the PSR to value stocks. Unless the corporation is going out of business. The logic here is that if you were to acquire the company.0 in order to find value stocks that the market might currently be overlooking. many simply expropriate it for the stock market and use it to value a company as an ongoing concern. Say XYZ Corp." you have seen the PSR in use. As this is a perfectly legitimate way for a company to value an acquisition. has ten million shares outstanding.Valuation of Stocks 201 2 company XYZ Corp. Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. This avoids comparing PSRs between two companies where one has taken out enormous debt that it has used to boast sales and one that has lower sales but has not added any nasty debt either. Ken Fisher. the better. priced at $10 a share. This is the most common application of the PSR and is actually a pretty good indicator of value. had $200 million in sales over the last four quarters and currently has no long-term debt. Uses of the PSR As with the PEG and the YPEG. If you have ever heard of a deal being done based on a certain "multiple of sales. according to the work that James O'Shaughnessey has done with S&P's CompuStat database. The PSR is also a valuable tool to use when a company has not made money in the last year. then the market capitalization is $100 million. effectively paying that much more. the lower the PSR. The PSR would be: PSR = The PSR is a measurement that companies often consider when making an acquisition. looks for companies with PSRs below 1. Market Capitalization = (Shares Outstanding * Current Share Price) + Current Long-term Debt The next step in calculating the PSR is to add up the revenues from the last four quarters and divide this number into the market capitalization.
masking the company's real operating situation. it can warn an investor that there are potentially some one-time gains in the last four quarters that are pumping up earnings per share. as well as taxes. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. If XYZ Corp. for example. it will have a substantial upside as it increases that PSR to be more in line with its peers. Thus. new companies in hot industries are often priced based on multiples of revenues and not multiples of earnings. are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. not at all. This situation overstates CyberOptics' current earnings and understates its forward earnings. depreciation and amortization (EBITDA). There are some years during recessions.Valuation of Stocks 201 2 sales are being valued at a discount to its peers. CYBEROPTICS (Nasdaq: CYBE) enjoyed a 15% tax rate in 1996. but in 1997 that rate will more than double. Why look at earnings before interest. depreciation and amortization? Interest income and expense.50 when many companies in the same industry have PSRs of 2. if it can turn itself around and start making money again. Another common use of the PSR is to compare companies in the same line of business with each other. Cash Flow-Based Valuations Cash-Flow (EBITDA) & Non-Cash Charges Despite the fact that most individual investors are completely ignorant of cash flow.0 or higher. but has a PSR of 0. using the PSR in conjunction with the P/E in order to confirm value. you can assume that. If a company has a low P/E but a high PSR. lost money in the past year. a canny analyst would 29 | P a g e . taxes. when none of the auto companies make money. taxes. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. Does this mean they are all worthless and there is no way to compare them? Nope. You just need to use the PSR instead of the P/E to measure how much you are paying for a dollar of sales instead of a dollar of earnings. For instance. Cash flow is normally defined as earnings before interest. it is probably the most common measurement for valuing public and private companies used by investment bankers. Finally.
When looking at a company's operating cash flow. Rather. the price-to-cash flow multiple is normally in the 6.0 to 7. Cable TV companies like TIME-WARNER (NYSE: TWX) and TELECOMMUNICATIONS INC. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition. as the company is not actually spending any money on them. In a private or public market acquisition. (Nasdaq: TCOMA) have reported negative earnings for years due to the huge capital expense of building their cable networks. it makes sense to toss aside accounting conventions that might mask cash strength. according to generally accepted accounting principles (GAAP). As for depreciation and amortization. the acquisition is normally considered 30 | P a g e . is a rather complicated spreadsheet exercise that defies simple explanation. This is because huge depreciation and amortization charges have masked their ability to generate cash. thus it makes sense for investors to use it as well. When this multiple reaches the 8. Amortization normally comes in when a company acquires another company at a premium to its shareholder's equity -. depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. even though their cash flow has actually grown. The most common valuation application of EBITDA.0 range. these are called non-cash charges. EBIT is also adjusted for any one-time charges or benefits. When and How to Use Cash Flow Cash flow is most commonly used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. the discounted cash flow.0 to 9. The most straightforward way for an individual investor to use cash flow is to understand how cash flow multiples work.a number that it account for on its balance sheet as goodwill and is forced to amortize over a set period of time.0 range. Economic Value Added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just eat it up.Valuation of Stocks 201 2 use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth.
A LBO also looks to pay back all the cash used for the buyout within six years. The Balance Sheet: Cash & Working Capital Like to buy a dollar of assets for a dollar in market value? Ben Graham did. current assets. or intangible qualities like management or brand name.Valuation of Stocks 201 2 to be expensive. In a leveraged buyout (LBO). as the TV-dominated mass-consumer age has helped intangibles like brand names create powerful moats around a core business. investors who rely on buying companies with a substantial amount of equity to back up their value are a paranoid lot who are looking to be able to collect something in liquidation.0. and have total debt of only 4. but are absolutely vital to the company as an ongoing concern. contemporary investors have begun to push the boundaries of equity by emphasizing qualities that have no tangible or concrete value. it makes sense for investors to familiarize themselves with the logic behind them as this might enable an investor to spot a bargain before someone else.0 times the EBITDA. Equity-Based Valuations What is Equity? Equity is a fancy way of referring to what is actually there.0 or more times the interest payments. Traditionally. equity is everything that a company has if it were to suddenly stop selling products and stop making money tomorrow.0 times cash flow because so much of the acquisition is funded by debt. Investors interested in going to the next level with EBITDA and looking at discounted cash flow or EVA are encouraged to check out the bookstore or the library. However.5 to 5. have an EBITDA of 2. Some counsel selling companies when their cash flow multiple extends beyond 10. He developed one of the premier screens for ferreting out companies with more cash on hand than their current market 31 | P a g e . Whether it's tangible things like cash. working capital and shareholder's equity. Since companies making acquisitions use these methods. the buyer normally tries not to pay more than 5.
either. take a company's shareholder's equity and divide it by the current number of shares outstanding. hard assets like real estate. old T-shirts in inventory or replacement vacuum tubes for ENIAC systems. To calculate book value per share. This is an overall measure of how much liquidation value a company has if all of its assets were sold off -. so does working capital. you have the price-to-book ratio. The closer to book value you can buy something at. Book value is a relatively straightforward concept. the better it is. Another measure of value is a company's current working capital relative to its market capitalization.cash can fund product development and strategic acquisitions and can pay high-caliber executives. Dividing this number by the number of shares outstanding gives a quick measure that tells you how much of the current share price consists of just the cash that the company has on hand. If you then take the stock's current price and divide by the current book value. Buying a company with a lot of cash can yield a lot of benefits -. Shareholder's Equity & Book Value Shareholder's equity is an accounting convention that includes a company's liquid assets like cash. First. Shareholder equity helps you value a company when you use it to figure out book value. Book value is literally the value of a company that can be found on the accounting ledger. desks. Book value is actually somewhat skeptically viewed in this day and 32 | P a g e . as well as retained earnings. Just as cash funds all sorts of good things. Working capital is what is left after you subtract a company's current liabilities from its current assets. Even a company that might seem to have limited future prospects can offer tremendous promise if it has enough cash on hand. you have essentially bought a dollar of assets for a dollar of stock price -. Working capital represents the funds that a company has ready access to for use in conducting its everyday business.not a bad deal. Graham would look at a company's cash and equivalents and short-term investments.whether those assets are office buildings.Valuation of Stocks 201 2 value. If you buy a company for close to its working capital.
33 | P a g e . but quite possibly the one most important to a company's ability as an ongoing concern. as well as inflation or deflation of real estate depending on what tax consequences the company is trying to avoid. Another use of shareholder's equity is to determine return on equity. the company could simply go out and get a few loans and be built back up into a world power within a few months. Some use ROE as a screen to find companies that can generate large profits with little in the way of capital investment. with financial companies like banks. In fact. For instance. the book value is extremely relevant.Valuation of Stocks 201 2 age. if XYZ Corp. since most companies have latitude in valuing their inventory. This is why a pharmaceutical company like MERCK (NYSE: MRK) can grow at 10% or so every year but consistently trade at 20 times earnings or more. Intangibles Brand is the most intangible element to a company. or ROE. for instance. consumer loan concerns. then the ROE is 10%. takeovers are often priced based on book value.the syrup-making process does not regularly move ahead by technological leaps and bounds. It is measured as a percentage. in the banking industry. high ROE companies are so attractive to some investors that they will take the ROE and average it with the expected earnings growth in order to figure out a fair multiple. Return on equity is a measure of how much in earnings a company generates in four quarters compared to its shareholder's equity. What is it about McDonald's that would allow it to do this? It is McDonald's presence in our collective minds -.7 to 2. For instance. COCA-COLA (NYSE: KO). with banks or savings & loans being taken over at multiples of between 1. However. If every single MCDONALD'S (NYSE:MCD) restaurant were to suddenly disappear tomorrow. does not require constant spending to upgrade equipment -.0 times book value. The company has a well-known brand and this adds tremendous economic value despite the fact that it cannot be quantified. made a million dollars in the past year and has a shareholder's equity of ten million. brokerages and credit card companies.the fact that nine out of ten people forced to name a fast food restaurant would name McDonald's without hesitating.
for instance. is that it takes at least competent management to unlock the value. is because it already has incredible brand equity in applications and operating systems. a dominant market share. The real trick with brands. then many can become skeptical about the value of the brand. A brand is also transferable to other products -. particularly brands emerging in industries that have traditionally been without them. creating a new product that requires minimum advertising to build up. consistent estimate-beating performance or a debt-free balance sheet can trade at a slightly higher multiple than its growth rate would otherwise suggest. Intangibles can also sometimes mean that a company's shares can trade at a premium to its growth rate. If a brand is forced to suffer through incompetence. a company can sometimes be worth more divided up rather than all in one piece. The only problem with a company that has a lot of intangible assets is that one danger sign can make the premium completely disappear. like land purchased in the 1980s that has been kept on the books at cost despite dramatic appreciation of the land around it. leading them to doubt whether or not the brand value remains intact.the reason Microsoft can contemplate becoming a power in online banking. forgetting that brands normally survive even the most difficult of short-term traumas. The genius of INTEL (Nasdaq: INTC) and MICROSOFT (Nasdaq: MSFT) is that they have built their company names into brands that give them an incredible edge over their competition. This can happen because there is a hidden asset that most people are not aware of. such as AMERICAN EXPRESS (NYSE: AXP) in the early 1990s or Coca-Cola in the early 1980s. The Piecemeal Company Finally. though. or simply because a diversified company does not produce any synergies. SEARS 34 | P a g e . Although intangibles are difficult to quantify. Thus a company with fat profit margins.Valuation of Stocks 201 2 Some investors are preoccupied by brands. The major buying opportunities for brands ironically comes when people stop believing in them for a few moments. it does not mean that they do not have a tremendous power over a company's share price. It is as simple as Reese's Peanut Butter cups transferring their brand onto Reese's Pieces.
Keeping an eye out for a company that can be broken into parts worth more than the whole makes sense. Some. Many income-oriented investors start to pour into a company's stock when the yield hits a magical level. especially in this day and age when so many 1970s conglomerates are crumbling into their component parts. Subscriber-based valuations are most common in media and communication companies that 35 | P a g e . like Geraldine Weiss.00 in dividends per quarter and it is trading at $100. The simplest way to take advantage of stocks that are undervalued based on their yield is to use the Dow Dividend Approach. if a company pays $1. Four quarters of $1 is $4. it has a dividend yield of 4%. For instance. Member-Based Valuations Sometimes a company can be valued based on its subscribers or its customer accounts. above-average yielding stocks outperforms the market over time. Yield-Based Valuations A dividend yield is the percentage of a company's stock price that it pays out as dividends over the course of a year. The historical performance of the Dow Dividend Approach supports the general conclusion buttressed by Jim O'Shaugnessey's work that shows that a portfolio made up of large capitalization. Anyone interested in learning more about Weiss's yield-oriented valuation approach should check out Dividends Don't Lie. Weiss measures the average historical yield and counsels investing in a company's shares when the yield hits the edge of the undervalued band. actually invest in stocks based on what yield they should have. if a company has historically yielded 2.5% and is currently paying $4 in dividends. DEAN WITTER DISCOVER (NYSE: DWD) and ALLSTATE (NYSE: ALL) are all worth a heck of a lot more broken apart as separate companies than they ever were when they were all together. and this divided by $100 is 4%. the stock should trade in the $160 range.Valuation of Stocks 201 2 (NYSE: S). For example. Yield has a curious effect on a company.
in a subscriber-based valuation. companies are routinely acquired based on the value of their existing accounts. the company is worth 6 million times $20 times 30 or $3. Although member-based valuations seem rather confusing. working capital usage and taxes. but after capital expenditures. Studying the history of the last few major acquisitions can tell an inquisitive investor how the member model has worked in past mergers and can suggest how it might work in the future. cable TV and online companies.Change in non-cash working capital = Free Cash Flow to the Firm 36 | P a g e . on average. Discounted Cash Flow Analysis In the DCF methodology. This sort of valuation is also used for cable TV companies and cellular phone companies.like cellular. Symbolically. instead focusing on what additional revenue could be conceivably generated from these new accounts. These acquisitions often completely ignore the past earnings or revenues of the company. Another way a company can be valued on members is based on accounts. If AMERICA ONLINE (NYSE: AOL) has six million members and each sticks around. Continental Cablevision was bought out for $2000 a subscriber. there are two steps in the valuation process: Step 1: Forecast the Free Cash Flow to the Firm (FCFF) This is the cash flow excluding financing effects. Often. their exact mechanics are unique to each industry. Free Cash Flow to the Firm is calculated as: Earnings Before Interest and Taxes * (1-tax rate) + Non-cash charges (after Tax) . for 30 months.Valuation of Stocks 201 2 generate regular.(Capital Expenditures – Depreciation) . monthly income -. In the healthcare informatics industry. analysts will calculate the average revenues per subscriber over their lifetime and then figure the value for the entire company based on this approach.6 billion. For instance. spending an average of $20 a month.
the Weighted Average Cost of capital is calculated as: Weighted after-tax cost of debt + Weighted cost of equity = Weighted Average Cost of Capital WACC can be derived from the Capital Asset Pricing Model (CAPM). We’ll start first by calculating the cost of debt. considering both debt and equity.Valuation of Stocks 201 2 Forecasting free cash flow to the firm through some horizon date involves using financial modeling techniques. It is this last use that is important in equity valuation. Only those projects that generate returns in excess of the WACC should be undertaken. Measuring the WACC involves calculating the cost of a firm’s debt. A hurdle rate for all of the firm’s investments. What is WACC? The Weighted Average Cost of Capital (WACC) is: A measure of a company’s cost of funds. and combining the two. It is simply the after-tax cost of borrowing at current market rates.. Calculating the Cost of Debt: Calculating the cost of a firm’s debt is by far the easier of the two components of WACC to determine. 37 | P a g e . A discount rate that can be applied to a firm’s free cash flow to determine its present value. calculating the cost of the firm’s equity. Symbolically. Step 2: Calculate the Weighted Average Cost of Capital (WACC) This is used to discount the firm’s free cash flows back to the present date.
5% pretax. paid semi-annually. a risk measure relative to the market. 38 | P a g e . For WACC purposes. Today. the cost of debt is therefore 7. these bonds have five years to maturity and are trading in the market at a price of 102. This can be determined by using the Capital Asset Pricing Model (CAPM).CAPM One way of determining a firm’s cost of equity is to equate it to the rate of return required by investors. on a market value of $102. This market portfolio has a return of Rm and a beta of 1. it is the current market yield on the company’s outstanding debt. - For bonds. Compared with calculating the cost of debt. as we shall now see. it is the rate a bank would charge when lending to the company under current conditions. Example Five years ago. whose main features are: Investors demand a higher rate of return to compensate for higher levels of risk.a. The risk of a stock is measured as the stock’s beta ( ).Valuation of Stocks 201 2 For bank loans. calculating a firm’s cost of equity is more involved. - The market portfolio – a portfolio consisting of all the equities available in the market – is used as a benchmark..05 to yield 7.05m.50%. Company X used $100 million in ten-year notes at par with a coupon of 8% p. Calculating the Cost of Equity ..
Specifically. In general. Unfortunately. there is a trade-off between using data over: - A long period (five years or more) .the calculated beta will be more stable. but less reflective of current market conditions. and hence a firm’s cost of capital. and that of the market portfolio. but will be less stable over time.Valuation of Stocks 201 2 An individual stock will have a beta greater than 1 if it is more risky (volatile) that the market. once the firm’s beta is known – but how is a value for beta obtained? In practice. Standard and Poor’s. and a beta less than 1 if it is less risky. A short period (five years or less) – the calculated beta will reflect current market conditions more closely. The risk-return trade-off can then be shown on a chart plotting against risk. Barra and Ibbotson Associates. A commonly used method used by these firms to calculate beta is to perform a regression and analysis between the rates of return on a broad market index and the returns on a specific stock. the basic steps are as follows: Calculate the firm’s WACC 39 | P a g e . the trade-off is defined by the straight line drawn between the risk-return of the risk free security. there are numerous sources of published betas including the major brokerage houses and financial information providers such as Bloomberg. Analysing Equity Value Using DCF Analysis While there are many calculations involved in performing a DCF analysis. Determining a Stock’s Beta The CAPM provides a way of determining investor’s return. betas calculated for the same company will vary depending on the period during which the data was gathered. Beta is the slope of the resulting regression line.
Valuation of Stocks 201 2 Forecast the firm’s Free Cash Flow until the horizon period Calculate the firm’s value at the horizon period using the perpetual growth assumption Using the WACC. 40 | P a g e . and the market value per share. discount the above two amounts to obtain the firm’s Enterprise Value – the total market capitalization of the firm including both debt and equity Deduct the market value of a firm’s debt from the Enterprise Value to obtain the Market Value of Equity Some relationships Involving Enterprise Value… Enterprise Value = Market Value + Market Value of Debt Market Value of Equity = Enterprise Value – Market Value of Debt Market Value per Share = Market Value of Equity + Number of shares issued DCF Worked Example: The spreadsheet below shows a detailed calculation of the market value of equity.
Valuation of Stocks 201 2 Value Drivers In most businesses. there are a relatively small number of factors which determine the Discounted Cash Flow valuation for the company. They are: Sales Growth Rate (during growth period) Perpetuity Growth Rate (after horizon date) 41 | P a g e .
This is particularly true when the forecast period is fairly long. Sensitivity Analysis of Value Drivers 42 | P a g e . e.Valuation of Stocks 201 2 Operating Profit Margin Tax Rate on Operating Profit Incremental Capital Expenditures Incremental Working Capital Investment Cost of Capital Changes in any of the above parameters can result in substantial variations in the calculated value of a firm..g. 10 years.
we can obtain and Enterprise Value of $396. Initial sales of 100 grow at 15% p. Using the remaining base case assumptions. 43 | P a g e .a.Valuation of Stocks 201 2 The table below shows a simple company model.87.
and capital expenditures. during which the firm typically earns a return equal to its WACC. Sni i i y f . FCFF is available to repay debt and to make distributions to shareholders FCFF is protected over two periods: o A limited period of above-average growth.Valuation of Stocks 201 2 Sensitivity Analysis of Value Drivers – Chart The chart below shows how a one percentage point increase in each of the value drivers affects the Enterprise Value of the company (in percentage terms) analysed on the previous page. the key points of Discounted Cash Flow (DCF) analysis are: A company’s Free Cash Flow to the Firm (FCFF) consists of funds generated by the firm after allowing for taxes. o An infinite period of normal growth. changes in working capital. The sum of thee present values is the firm’s Enterprise Value (debt plus equity) - Relationships involving Enterprise Value: 44 | P a g e . - WACC is used to discount all free cash flows back to their present value. %o t hnen a e rvr e s v o1 Pi Cag i Vl D es t t 0 n u i 1 5 1 0 5 0 5 Cp x ae Sle a s Go t r wh P r eu y ep t it G wh r t o Poit rf Mr in ag W C WC AC u l V s p r t E i e g n a h c % - -0 1 -5 1 DCF Analysis – Summary To summarise. which is forecast year by year. depreciation.
The DCF methodology provides the best approach to valuation for the following reasons : 45 | P a g e .the level of its earnings. the sources of earnings growth.Valuation of Stocks 201 2 o Enterprise Value = Market Value of Equity + Market Value of Debt o Market Value of Equity = Enterprise Value – Market Value of Debt o - Market Value per Share = Market Value of Equity Number of shares issued Key Value Drivers are valuation parameters such as: sales growth rates. Once you decide to go with one or another of these approaches.discounted cashflow valuation. working capital requirements. Conclusion Valuation plays a key role in many areas of finance -. relative valuation and option pricing models. gross profit margins. the stability of its leverage and its dividend policy. you have further choices to make – whether to use equity or firm valuation in the context of discounted cashflow valuation. Valuation is not an objective exercise. in mergers and acquisitions and in portfolio management. and within each approach. All of these have a major influence on the determination of Enterprise Value and therefore share price. These choices will be driven largely by the characteristics of the firm/asset being valued . they must also choose among different models. but the cautionary note sounded in this introduction bears repeating. which multiple you should use to value firms or equity and what type of option is embedded in a firm. and WACC. and any preconceptions and biases that an analyst brings to the process will find their way into the value. The models presented will provide a range of tools that analysts in each of these areas will find of use. The analyst faced with the task of valuing a firm/asset or its equity has to choose among three different approaches -.in corporate finance. capital expenditures. its growth potential. Matching the valuation model to the asset or firm being valued is as important a part of valuation as understanding the models and having the right inputs.
Adjusting the size of the anticipated cash flow – the greater the uncertainty. Dealing with Uncertainty Uncertainty with respect to the probability of a cash flow occurring can be addressing either by: Adjusting the discount rate – the greater the uncertainty. which is why the probability of the cash flow occurring is one of the four variables that we must consider. It includes only cash “earnings”. the smaller the cash flow. It provides for an objective method for recognizing the cost of capital It recognizes the time value of money. the bigger the discount rate. the cash flows from equities are uncertain. net of the investment required to generate those earnings.Valuation of Stocks 201 2 It is not dependent upon accounting measures of earnings or assets. Principles of Valuation The present value of any future cash flow is influenced by four variables: Quantity What is the size of the cash flow? Probability What is the probability that the cash flow will actually occur? Timing When will the cash flow occur? Discount Rate What discount rate (interest rate) should be used to calculate the present value of the cash flow? Unlike a bond. 46 | P a g e .
com Investment Valuation : Second Addition by Aswath Damodaran ‘The Dark Side of Valuation’ by Aswath Damodaran 47 | P a g e .Valuation of Stocks 201 2 Bibliography http://acumennet.