Stock Analysis - Valuation Process
Welcome to the second part of the introduction to my Stock Analysis process!
If you’ve seen the first part about how I fundamentally evaluate a stock first or read my Starbucks (SBUX) Stock Analysis here then you might have already gotten a peak at how I am generally doing my valuation before investing in any stock.
If you didn’t see it yet, it looks (kinda) like this:
1) Calculating company value via standard DCF method
2) Calculating company value via Dividend discount model (if possible)
3) Calculating company value via 2-3 different multiple approaches
4) Using the average result to compare equity value against the current market cap
Using the latest reports of the company itself as well as current micro/macro environment as indicators and trying to stay as objective as possible, please bear in mind that most of this cannot be done without input from my side. You might therefore come to a completely different result, when you do your evaluation (which is fine).
If you feel, I am being overly optimistic or pessimistic, you are free to give a thoughtful comment of course!
While I will not go into too much detail about the technicalities or mathematics, I want to comment shortly on each of the calculation types and how I apply them.
1) Discounted Cash Flow method
If you want to learn about just one valuation method, this might be it.
While it has its’ flaws and is much more prone to delivering a completely unusable result if you get a few (or maybe just one) of the inputs wrong. Nevertheless, it also provides much more options for you to adjust the calculation based on what you’ve learned during your Fundamental Analysis.
Main input factors influencing the outcome here are:
The Cash Flows forecasted for the following years
The discount rate and (by extension)
The interest rates
Starting with the latest yearly and quarterly reports as an indication, I usually dedicate most of the time to the forecasting of the actual cash flows. Many factors investigated during the fundamental part of my analysis once again come into play here once again.
Did the companies cash flow grow significantly in the past years? Are they ahead of the competition with significant pricing power? Or is there a high chance of increasing network effects which could lead to further growth in the future?
Long story short, I am usually forecasting 3-5 scenarios with different assumptions in order to find the (subjectively) most realistic outcome for the Cash Flow development over the next 5 years. The final result just contain this most likely (average) result:
One of the biggest critique points for the DCF method is that especially for extremely young companies which can have years of explosive growth but also years of stagnation, it is very difficult (or almost impossible) to forecast any cash flow development. Yet (besides a thorough qualitative analysis), it provides an approach that is almost always workable in some way, while other valuation methods can not be applied due to missing income (or even missing sales) etc.
Global interest rates being historically low and loans being available to companies basically “for free” have an effect on the other side of the equation. With decreasing cost of capital and an increasing amount of debt for many companies, the applied discount rates are also much lower than just a few years (or maybe a decade) ago.
While overall cost of capital might have regularly been on or above the 10% mark, this figure is now rarely reached.
For my calculation I am forecasting a yearly discount rate based on the CAPM model. Whenever I clearly see a big change in market interest rates or company equity structure coming up, I try to update the rate accordingly, which would look something like:
2) Dividend Discount Model
I will just quickly touch this model, as there are many cases in which it is not applicable. Therefore it also has a slightly lower significance in my valuation process. However, when application is possible it provides good supplemental value in determining the final company value (in combination with other valuation methods).
The basic idea of the model is that for you, the investor, the worth of a companies’ stock would be based on the sum of all its’ future dividend payouts. It therefore calculates a company value approximation based on the present value of those expected dividends. You can see right away that this would be a problem for companies not (yet) paying any dividends.
Further, as it is not possible to calculate a value if the expected dividend growth rate is higher than the companies’ cost of equity, the model is mostly applicable for dividend paying stocks that are established for a longer time, with a steady dividend, that is increased in small but steady increments.
3) Calculating company value via 2-3 different multiple approaches
Finally, to round of the overall valuation I am taking a look at comparative multiple valuation approaches. The process usually includes searching for comparable assets (companies) that operate in a similar (or ideally the same) market, defining key statistics which will be used for comparison and then applying the identified multiple to the company that is being valued.
In most cases I will always try to find at least two comparative multiples that can be applied, choosing from:
• P/E ratio
• P/S ratio
• P/CF ratio
• P/B ratio
• EV/EBIT ratio
• P/FFO or P/AFFO ratio (for REITs)
• And others as they may become applicable
Depending on the company I will choose relevant peers based on a close industry competitors shown on diverse financial websites or based on my own knowledge / understanding of the relevant industry, with the target of finding the group of closest peers.
The reason why I will always try to have at least two different multiple valuations available for any given company is the vast difference in results that could possibly arise from two separate multiples.
While just using one indicator might lead to an unexpectedly high or low valuation, averaging it with other comparative indicators instead can serve as a good reference point for the overall company value calculation.
4) Determining the final Equity value
This step is fairly simple in that I usually just go ahead and prepare the results I got from the previous (in the best case) 3 valuation approaches. If there are any significant outliers I go back to that specific valuation and check if it can logically be explained and/or needs to be corrected. This process could include adjusting cash flow assumptions inside the DCF model, exchanging one multiple for another or adjusting the expected dividend growth rate inside the Dividend Discount Model.
Finally I am presented with a range of results from which, in order to have a unified figure to present, I will take the average and select it as the (for me) most likely outcome.
From here, possible updside or downside can be evaluate right away through comparison with the current market cap / share price.
At this point in time I have usually either already made my decision to invest or not, or am very close to it. If I am still concerned about one or the other factor, it helps me to list up possible chances or risks that might affect the company in the future and estimate what that would change in my valuation.
I am usually not going much deeper into any of my stock analyses, unless I am super interested in a topic or a stock itself. So if what I see from all of the above does not appeal to me (e.g. a bad scoring result during my fundamental analysis, only little upside from the valuation or suddenly I come up with a lot of risks..), I will move on to look for another opportunity.
After having introduced my approach, let me know what you think!
Am I doing something wrong (or right)?
How would you / do you go about analyzing a stock?
With the introduction now concluded I will in the next weeks move on towards analyzing some more companies in order to slowly fill up this website.
Please expect regular (slight) layout changes during that time, as I am trying to figure out, how to best present this stuff ;)
In the meantime we (me) would be happy to see you on our Facebook page!