In a continuation from What IS The Right Price and Time is Money post, if there weren’t any comparable companies to benchmark against, we would then not be able to employ relative valuation techniques to give an indication of fair value or the Right Price.
Absolute valuation (AV) would then come in useful; AV can of course also be used as an additional tool when comparables are available, after all, it might be that all companies in the same industry could be overvalued or undervalued at a given time. What AV does is to find a value for a stock by examining the fundamentals of a company. A word of warning, I am going to attempt to explain the AV methods, which are discounted cash flow methods below, but in an abbreviated fashion. While it isn’t rocket science, it is not trivial and for more details, you would do well to refer to a finance textbook to get a thorough run down of these very important concepts.
Theoretically, the fair value (FV) of an investment should be the sum of all its future cash flows that it gives to the investor. These cashflows could be dividends, and finally, the projected price upon sale. If the dividends distributed reflect the profitability of the firm, the Dividend Discount Model (DDM) can be used to value the firm. Essentially, the amount of dividends is projected into the future, with each discounted to the present time. A spreadsheet is your friend when your projections differ in its growth rate every year.
A useful version of the DDM is the Gordon constant growth model, which uses a constant rate of growth, representing the stable long-term growth rate of a mature company. It assumes a constant growth rate (clearly not applicable to all companies). This reduces the spreadsheet calculations to a rather simple form:
FV = D1 / (re-g) =D0*(1+g)/(re-g)
D is the dividend per share (the subscript indicates the year), re is the required return on equity for this company, and g is the constant long term growth rate.
The required return on equity is determined by the Capital Asset Pricing Model (CAPM), which is a terribly important concept for modern finance, albeit fraught with tenuous assumptions (it actually won Harry Markowitz, its author, the Nobel prize for economics). In short, it states that the required return on equity is the sum of the risk free rate (RFR) and the product of the stock’s beta and the market risk premium (the return from the market minus the RFR). Beta is the volatility of that stock relative to the market.
re= RFR + β（rm—RFR）
However, the DDM isn’t perfect. An investor needs to understand that a dividend is a distribution of the assets or funds of a company to its shareholders. That implies that it cannot use those funds to grow the company. Hence while a dividend is a sign of quality in the stability of its earnings, if a company can reinvest these funds at a higher rate than its shareholders, it might actually be contrary to the interests of its shareholders to receive a dividend.
Therefore, another good way of valuing a company is really the Free Cash Flow (FCF) that it can generate. For a company to keep afloat, it needs to generate enough cash to fund its continuing operations, which can be used to invest in plant, property and equipment (PPE, otherwise known as capital expenditure or capex), and to have working capital to buy inventories etc. There are quite a few equations to determine FCF, and the one I use is
FCFF = operating cash flow-change in capex.
(You may also notice that the after tax interest is added back if you refer to a finance textbook, the reason is because we are considering FCF to the Firm, or FCFF, which doesn’t exclude the financing costs. That book should give you a good explanation why). The FCFF is then projected and discounted back to the present in a similar fashion to the DDM. The discount factor here is the weighted average cost of capital (WACC). WACC is the weighted average of the cost of debt (or the effective interest rate of the company’s debt) and the cost of equity (or the required return to equity, for equity holders).
Value of the firm = FCFF*(1+g)/(WACC-g)
The fair value of a firm is the sum of its debt and equity. Hence the value of equity (which is the value shareholders are interested in) is the value of the firm less debt.
Value of the firm = value of its equity + value of its debt
ð Fair value of equity = value of firm – value of debt
So, if the fair value of equity is higher than the current share price, this indicates that the share is undervalued which suggests that there is an opportunity for profit. And if it is less than the current market price, then it is overvalued. You would have noticed that the assumptions above can be generous, the variables can be full of uncertainty, and yes, these theoretical methods should be tempered with a big dose of conservatism to give you a safety margin for your investment. Even if the calculations are correct, the market might take a very long time to reach its fair value, and the ride can be very bumpy. Similarly just because a stock appears overvalued does not make it is a short-sell candidate.
The reason why I had explained relative and absolute valuation at length (though even this length is vastly inadequate) is to lay the ground for future posts where I would post specific company analysis that I have done. Beyond the financial statements, the prospects for the company and the nature of its business must also be considered but these calculations give a firm basis and a discipline to analyse a firm. As we go along, I would attempt to also explain my assumptions, and considerations. At times, relative and absolute valuations can give conflicting directions, and judgement has to be exercised. A point to reiterate is that a good company might not make a great stock, while a lousy company at the right (i.e. cheap) price might make for a fantastic stock.
Finally, a word of advice is, do not rely on other people’s analysis to decide how to invest or what to invest in. On any given day, it is easy to find a whole slew of recommendations from sell-side analysts running from strong buy to strong sell (and we haven’t even considered their potential agendas, conflicts of interest and biases). Ideas and information certainly can be found in secondary research, and the news, but you would have to do your own analysis, to convince yourself if an investment is worthwhile or a dud. We all have differing levels of risk tolerances, and differing financial objectives.
Stock picking is not for everyone. Let me restate that: Active Investing is NOT for Everyone. Contrary to popular belief, successful investing takes a lot of effort, and entails a fair amount of risk. There is NO free lunch. And even after all that effort, one is subject to the vagaries of the market, which can prove to be a rather tempestuous creature.
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