How to value a Stock

A stock represents a share of ownership of a company, and that share of ownership has a transacted value that people buy or sell in the stock exchanges; however, the buy/sell price may not always represent the actual value of the stock. Valuating a stock is essential when you are about to buy/sell a stock because it gives you hard evidence on how the company is performing relative to others in its industry, and it highlights how the market values the stock compared to its actual value.

What are some of the different ways you can value a company?

·       Relative Valuation Models: P/E, EV/EBITDA

·       Absolute Valuation Models: FCF and DCF

Relative Valuation Models

Relative valuation models consist of using a company’s data to compare it to other companies within the same industry. By comparing the data in various companies of the same industry, you can assess whether a company’s stock is undervalued, overvalued, or fairly valued relative to its competitors.

These relative valuation models use financial ratios such as price to earnings (P/E), enterprise value to its earnings before interest, taxes, depreciation, and amortization (EV/EBITDA), and many more. The two main valuation methods we are going to be looking at are the P/E Ratio and the EV/EBITDA.

Price to Earnings Ratio

The price-to-earnings ratio compares a company’s stock price to the earnings per share: price/earnings per share. This valuation method demonstrates how much the investor is willing to pay for every dollar they earn. To put it into simpler terms, using an example: a company earns 5$ per share, and each share is valued at 50$, the P/E ratio is 10; if an investor chooses to invest in this stock, it implies that they are willing to pay 10$ for every 1$ earned. A P/E ratio can vary significantly; however, just for a reference, the Vanguard S&P 500 P/E ratio is around 28. If a company’s P/E ratio is negative, it means that the earnings per share is a negative number, the company is losing money, and it is a very high-risk investment (this could be because it is an early startup, or the company has made bad financial and executive decisions).

               You may use this valuation method to compare the stock to other companies and determine its true value. For example, you are looking into investing in Devon Energy’s (DVN) stock and have observed that their P/E ratio is around 8. You research other companies within the same industry such as Exxon Mobil and Chevron, and you take note of their P/E ratio: 16 and 20.5, respectively. By observing the other companies’ P/E ratio you can deduce that Devon Energy’s stock is undervalued relative to their competition. This can be perceived as a good thing; however, you must also look at news and financial reports on the company to get a good understanding about whether it is a good investment choice. Additionally, investors may investigate companies with a higher P/E ratio because it could indicate opportunity for future growth. A higher P/E ratio indicates that the price of the stock is well above it’s earnings, which can be caused by a company announcement that leads investors to have high expectations for the company’s future. However, higher P/E ratios can also mean that the company is overvalued, which in this case, you should do some research as to why it could be overvalued and what issues the company may have that could cause the stock to go down.

Context is important with looking into the P/E ratio, so based on the data that you collect on your stock, you can choose to invest because it is undervalued, or because it has high growth opportunities.

Summary

·       What does it do: The P/E ratio shows you how much investors are willing to pay for every dollar that they make in profit from the stock. Another way of thinking about this is how many years of profits it will take to make back your investment through profits.

·       Example: Devon energy’s P/E ratio is at 8 and their competition stands at 16 and 20.5 -> the stock is undervalued compared to others in its industry

·       What do low/high P/E ratios mean:

o   Low: Stock is undervalued

o   High: Stock has large growth opportunity OR Stock is overvalued

·       Note: Negative P/E ratios mean that the stock/company is losing money (which can be caused by various factors)

·       Limitations: The P/E ratio does not consider important factors such as debt levels and cash flows. Therefore, this method should be used in conjunction with other valuation methods to have a full understanding of a company’s financial position.

Enterprise Value to its Earnings Before Interest, Taxes, Depreciation, and Amortization

Enterprise value is the total value of a business or organization, which is found by adding the market capitalization (stock price X number of outstanding shares) with the total debt and then subtracting it from the cash and cash equivalents (liquid assets):

EV = Market capitalization + Total debt – Liquid assets

A company’s enterprise value can be useful to do a 1 to 1 comparison with other companies’ enterprise value and deduce if the company is undervalued, overvalued, or performing well.

The EBITDA is a financial metric that is used to calculate a company’s earnings before it is diluted (reduced) by non-operational expenses: interest, taxes, depreciation and amortization.

Vocabulary:

·       Interest:

o   The payment from a debtor (a company) to a lender (a bank) that consists of the money lent plus additional money for lending the money

o   The higher the risk of the investment, the higher the interest rate

·       Taxes:

o   A mandatory payment that a company must pay to a government body relative to the profits (or other things) that they make

o   Tax rates can fluctuate based on the quantity of the profits

o   E.g. If a company makes $100 in profit and the tax rate is 15%, the company will end up earning $85

·       Depreciation:

o   The reduction of value of a company’s tangible asset over the course of time

o   E.g. A company buys a sewing machine for $100. The sewing machine has 10 years of useful life, meaning that the machine will depreciate $10 in value every year until the 10 years are over.

·       Amortization:

o   Gradually expensing the cost of non-tangible assets over the course of their useful life

o   E.g. A company purchases a 5-year software license for $5,000. Instead of using that $5,000 all out once, they spread it out throughout the 5 years of useful life to use it more efficiently.

By dividing the enterprise value by the EBITDA, we can observe and compare the company’s value compared to its earnings and conclude if it is overvalued or undervalued.

Summary

·       What is EV: EV Stands for Enterprise Value which is the total value attributed to a business

·       What is EBITDA: EBITDA is Earnings before interest, taxes, depreciation, and amortization; it is a financial metric that is used to value a company’s earnings before they are diluted

·       What does it do: The EV/EBITDA ratio allows you to compare different companies’ earnings without accounting for their debt or other diluting factors

·       Limitations: The EV/EBITDA does not account for a company’s growth variations or competitive environment, which, like the P/E ratio, is why it is useful to use this among other valuation metrics.

Absolute Valuation Models

An absolute valuation model is a method to calculate the intrinsic value (true value) of a stock by forecasting future cash flows. The most important models that we will cover today are the Free Cash Flow and the Discounted Cash Flow.

Free Cash Flow

               The Free Cash Flow represents the money that a company has generated after subtracting its operating expenses and CapEx (capital expenditure). Calculating the Free Cash Flow can be useful for evaluating a stock because it allows you to assess a company’s financial performance while also revealing the cash that is available for public investors: you. The basic way of calculating the free cash flow would be the following:

Free Cash Flow = Operating Cash Flow – CapEx

Even though this information seems complicated and hard to obtain, all of this data is shared publicly on either websites such as Investopedia, or the company’s financial reports: 10k

Summary

·       What does it do: The FCF shows how much a company has after paying expenses and investing in its business

·       High FCF: Company is doing well and has money to expand and give back to shareholders

·       Low FCF: Company is struggling financially and is a riskier investment choice

·       Note: Information on a company’s FCF can be found in company’s 10k or some financial websites

Discounted Cash Flow

               The Discounted Cash Flow is a valuation method that illustrates a company’s stock’s intrinsic value. Although the DCF may appear similar to the FCF, the DCF is a forward-looking valuation method that forecasts the company’s future FCFs and discounts them back to the present. By calculating the Discounted Cash Flow, you can observe and predict whether the company’s stock is likely to increase or decrease in value, and make an educated decision on whether you should buy or sell the stock.

Below is a formula that shows how to calculate the DCF:

It is much too complicated to get into the details of how to calculate the DCF; however, most of the information on how to calculate the DCF can be found on sites such as Investopedia or other financial websites.

When to use these valuation methods

The relative valuation methods, such as the P/E and EV/EBITDA ratios, should be used to compare with other companies within the same industry. Ultimately, the decision on whether to buy or sell is yours, meaning that it is up to you to decide if you want to buy/sell because it is overvalued/undervalued, because the company is likely to go up/down in value, or because you believe it is a good company to invest your money in during a long period of time.

The absolute valuation methods allow you to judge whether the company that you plan to invest in is profitable and has good operating performance. The DCF allows you to look more forward and observe whether a stock is a good investment by forecasting a company’s future cash flows.

Of course, using these various valuation methods is useful for various reasons, but when planning to make an investment in a company, it is always useful to look at news reports to see any recent operations the company plans to do, or if there are any financial or social issues with the company’s current performance.

Matías Neves, Ockham Finance Contributor