HOW TO PERFORM STOCK VALUATION AND CALCULATE FAIR VALUE USING 7 PROVEN VALUATION METHODS
If you’re interested in calculating the intrinsic value of a stock to help inform your buy or sell decision, it’s hard not to feel overwhelmed by all the data, news, models, and formulas you think you need to use.
From Discounted Cash Flow Analysis to Benjamin Graham’s Formula, we’ll help you determine the fair value of a stock.
You could purchase the best stock in the world, but if you buy it at a lofty premium, it is a bad investment. And vice-versa.
As Warren Buffett said, “Price is what you pay. Value is what you get.”
To help you figure out the value of a stock, you’ll find an overview of 7 ways to calculate intrinsic value below.
You don’t need to know or use them all. In fact, I usually just use the Discounted Cash Flow method, but it can be helpful to triangulate value using a few different approaches.
Different industries also require different valuation methods. Banks can’t be valued the same way as consumer packaged goods. We’ll help you figure out what to use when.
7 Ways to Value Stocks
Type: Multiples of value.
When to Use: Works for all types of companies and may be the most-used valuation method. Other methods may provide more accurate estimates, however.
Description: You can estimate the value of a company by taking one of any number of valuation metrics and comparing it to the current price of the company.
The most commonly used valuation metrics are Earnings/Net Income, Earnings Before Interest and Taxes (EBIT, also known as operating income), Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA), etc.
Valuing a company based on its Net Income is the same as looking at its Price to Earnings ratio, or P/E.
Better ratios to use are Enterprise Value to EBIT or EBITDA, where
Enterprise Value = Market Cap + Market value of Debt – Cash & Equivalents
Let’s say you’re using P/E. You have a couple ways to assess the valuation:
Review the company’s historic P/E ratio and use that to estimate the upside, downside, and base case for where that ratio will go. Let’s say the company has traded anywhere from 10-20x earnings in the last decade, but the median value has been around 15.
Next, project what you think the company’s earnings will be next year. You can also use consensus analyst estimates (though we encourage you to judge for yourself). It’s even better if you can come up with a range.
Then you can take your low-end P/E ratio of 10, multiply that by your low-end earnings estimate for next year, and you’ll get your low end valuation. Repeat that for your expected P/E ratio and expected earnings, and your upside case.
Taken together, that’s your valuation range. Compare that with the current price and decide if the stock is an attractive value.
You can improve your estimate by looking at the P/E ratios of comparable companies. If you look across the top few most similar companies, you may be better able to estimate a target P/E multiple or range of multiples.
It’s always worth asking yourself why one company might trade at a higher or lower multiple, however. Better margins or a stronger market position could lead to different multiples, so you have to think about how your target company stacks up.
We generally prefer not to use P/E, and recommend using EBIT or adjusting your P/E valuation according to the fourth valuation method (below).
2 | Discounted Cash Flow (DCF) Stock Valuation
Type: Cash flow valuation.
When to Use: Consistent free cash flow, bigger companies, predictable companies.
Description: Discounted Cash Flow analysis is the most important valuation method to know. Imagine if you were the full owner of a company and you got to keep all future cash flows. A DCF will help you figure out how much that should be worth to you today.
For example, if I promised you $1 per year for the 10 years, how much would you pay for that privilege?
Well, we know it’s not worth $10, because inflation over 10 years will make the value of that $1 in 10 years worth less. There’s also the risk that I get hit by a bus and fail to pay you.
A discounted cash flow analysis will help you answer the simple question of how much you should pay for the $1 per year for 10 years, or the more complex question of how much you should pay for a company’s future cash flows. Once you can answer that, you can see if the company’s current price is more or less than that to determine if it’s over- or under-valued.
The difficulty with a DCF is that you have to project those cash flows, their growth, then estimate a discount rate. With unrealistic assumptions, you can make the model say what you want it to say. With realistic assumptions, it is a valuable tool.
Here’s an overview of a DCF and its components:
Here’s a two articles on how to perform a DCF:
We also have a great FREE 5-year DCF spreadsheet you can use on your own.
We have tons of examples on our blog that walk through sample analyses of stocks using DCF analyses. Check out this one on Harley Davidson.
3 | Benjamin Graham Valuation Formula
Type: Earnings stock valuation method
When to Use: Cyclical companies, volatile cash flows, and young companies where there is not much history.
Description: Graham has always been a balance sheet analysis investor who wanted to buy a basket of companies at a cheap price. However, he offered a formula in his book The Intelligent Investor that uses earnings to value a company.
The formula he introduced is
where V is the intrinsic value, EPS is the trailing 12 month EPS, 8.5 is the PE ratio of a stock with 0% growth and g being the growth rate for the next 7-10 years.
However, this formula was later revised as Graham included a required rate of return:
The formula is essentially the same except the number 4.4 is what Graham determined to be his minimum required rate of return. At the time of around 1962 when Graham was publicizing his works, the risk free interest rate was 4.4% but to adjust to the present, we divide this number by today’s AAA corporate bond rate, represented by Y in the formula above.
But after using this formula, we found that the valuation numbers were far too optimistic. Back in Graham’s days, all companies were industrial and so growth was limited. 20% to 30% growth was unrealistic whereas you see many companies able to achieve this standard in today’s era.
We further modified Ben Graham’s formula to:
4 | PE Model for Stock Valuation
Type: PE multiplier stock valuation method
When to Use: Robust method that can be used for any company.
Description: An absolute, instead of relative, PE valuation model that Vitaliy Katsenelson created and explains in his book Active Value Investing.
There are subjective inputs required in this model with the intrinsic value of the stock based on the following five conditions.
For each of the 5 points above, the idea is to assign it a value and then to calculate the fair value PE with the following formula.
Fair Value PE = Basic PE x [1 + (1 – Business Risk)] x [1 + (1 – Financial Risk)] x [1 + (1 – Earnings Visibility)]
Full description and examples are provided in the link below.
Read the full article: PE Model Stock Valuation Technique
5 | Net-Net Working Capital and Net Current Asset Value
Type: Balance sheet and tangible asset valuation
When to Use: Net-net stocks, when trying to determine where a company’s stock price is priced relative to its net assets. Can’t be used for service or low asset companies such as software.
Description: When Graham was around, the only types of companies that existed were industrial businesses. Mainly factories, manufacturers and retailers. There were no consulting, software, or high tech companies like you see today. This made analyzing the balance sheet very easy and worthwhile because mostly all companies fit into this mold.
Because there were no computers, stock market radio, TV shows, news etc., information was slower to circulate and more inefficiencies existed that Graham could take advantage of. This allowed Graham to buy companies at or below liquidation value.
For you and me, knowing the liquidation value of a company is advantageous because it gives us a reference point for a floor value of the stock.
Companies where the stock price is below this floor value are called net-nets. There are two ways to calculate this.
Net Current Asset Value
NCAV = Current Assets – Total Liabilities
Net-Net Working Capital
A stricter version of the NCAV because it discounts certain items from the balance sheet.
NNWC = Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities
Provided the company has a decent business model and is not burning cash, a net-net stock could work out to be a fantastic investment.
Read the original article: Graham Net Net Asset Valuation
6 | Asset Reproduction Value
Type: Balance sheet valuation
When to Use: To figure out how much a competitor would have to spend in order to replicate the company’s business. Sort of like a moat test.
Description: The phrase “asset reproduction value” just means figuring out how much it would cost a competitor to replicate the assets of the business of interest.
This method is really part 1 of the Earnings Power Value (EPV) explained next.
To calculate the reproduction value of the assets, you need to go through each line in the balance sheet and see whether anything needs adjustment. This method involves quite a bit of work, because you need understand the industry in order to adjust the balance sheet appropriately.
Unlike Graham, who just slapped a discount percentage of 50% to inventory and ignored things such as goodwill, the asset reproduction value requires you to include goodwill because it is something that a new competitor will not have and will therefore be required to spend money on in order to acquire such things as brand recognition, partnership agreements, and patents.
To really get a better understanding, go through the detailed tutorial I wrote via the link below.
Read the original article: How to Perform an Asset Reproduction Value Analysis
7 | Earnings Power Value (EPV)
Type: Earnings stock valuation method
When to Use: To find good companies. Also can be used for cyclical companies, volatile cash flows, and young companies where there is not much history.
Description: It is best to use EPV in conjunction with the Asset Reproduction Value above. Although the formula for EPV is quite simple, arriving at the adjusted earnings number is a little more difficult.
You saw how the balance sheet had to be adjusted to make Asset Reproduction Value work. For EPV, you need to do it for the income statement which will give you a no growth value of the company.
Go through the article below to get the detailed step by step instructions of how this works, but see here for a quick idea of how how Asset Reproduction Value and EPV come together.
With just the asset reproduction value alone, you see that it is the minimum required level for free entry into an industry.
The middle bar shows that having a competitive advantage will create an EPV that is higher than the asset reproduction value with zero growth assumption.
If you include growth, you get the total value, but since growth is so difficult to predict, sticking with the EPV alone is good enough.
However, there are different cases which could break the model above:
In case A, you have a company where the asset value is much higher than the EPV. In this case, the company has no moat, no strategic advantage, bad management and is in a bad industry.
In case B, asset reproduction value is equal to EPV. Such a company has no moat and is in a competitive industry where companies usually earn only their cost of capital.
Case C is the type of company to look for, where asset value is less than EPV which means that the business has a moat, strong advantages, brand recognition and good management. Think KO, MSFT or AAPL.
Read the original articles: