Knowing how to evaluate a stock is a crucial step in developing your investment skills so you know whether you are getting a deal or not!
How to Evaluate a Stock Example
Imagine you’re wealthy and would like to invest some of your money into local businesses. Two business owners, both in the dry cleaning business, approach you for investment.
The first, Bob, has been in business for 20 years. He is well-liked in town, his customers are loyal, and his company has survived two recessions.
The second, Tony, just opened his business two years ago and doesn’t have the best reputation. There have been a few stories of his business losing people’s clothing, and he has a higher rate of customer turnover than Bob.
Both businesses produced $120,000 in sales last year, with costs of $20,000, leaving a net profit of $100,000 for each dry cleaner.
Think about how you would value a business like this, then think about the difference in value you would attribute to Bob’s company as opposed to Tony’s.
Would that calculation change if you found out that Tony is planning on opening five new stores next year (Bob is not growing), but will fund that project with a bank loan?
How do you account for the additional growth potential of Tony’s business, while also realizing that the level of risk is much higher?
The Art of Valuation
This is the field of valuation. It’s what value investors base their investing philosophy on: that they’re buying assets at valuations lower than they should be. Valuation is more art than science.
Two billionaire investors can have completely diverging opinions on a stock. Bill Ackman and Carl Icahn’s tussle over Herbalife stock is a great example.
In this article, we’ll go through some a few different ways people value stocks, going from the most simple to slightly complicated.
Comparable: Relative Value
The simplest way to get a rough valuation for a stock is through comparing the stock to its peers, both industry and positioning-wise.
For example, to get a raw value for Ford Motors, you might look at how the market is pricing other automobile companies with the focus on primarily American companies: General Motors and Fiat-Chrysler.
A simple method would be to take the P/E ratio of all of the stocks in a group and average them. Currently, the P/E ratio of both Chrysler and General Motors is sitting at around 6.
Using the comparable method, you have a starting point for your analysis.
If you decide that Ford is a lower quality company than Chrysler and GM, then you know it should be trading at a P/E of less than 6, and vice versa.
While the comps method is a rough way to understand how the market values different industries, there are few true apples-to-apples comparisons in the stock market.
Large companies are so complex, with several products, operational differences, talent, patents, costs, etc.
Balance Sheet: Absolute Deep Value
Benjamin Graham was the first to write about buying stocks based on their liquidation value, not on their business prospects. It’s simple conceptually, identify businesses that are trading for less than their net current assets, and buy them.
This is known as net-net investing and has mostly died out due to so few net-nets being available in the market. However, teaching this strategy to a novice usually gives them a lightbulb moment when it comes to valuing assets.
Basically, Graham would look for companies that have a market capitalization less than that of their net current assets. Current assets are assets that can be turned into cash within a year.
These are things like marketable securities, cash and equivalents, accounts receivable, and inventory. To arrive at net current assets, you simply subtract the company’s current liabilities from their current assets.
If that number is more than a company’s market cap, you’re basically buying assets for a discount, plus the business on top of it.
This method of valuation is dumb simple. All of the numbers are plain and clear in front of you. No complicated calculations or forecasts are required. The problem is, there are so few of them in today’s market.
If you can find them, they’re usually foreign companies from companies with fewer securities regulations, opening you up to possible accounting fraud.
Even if you can find a domestic net-net, their operations are usually steadily declining, making it likely that they’ll eat through those assets over time too.
This is why Graham suggested holding a large basket of net-nets, to benefit from the average performance, as several will be big losers.
If you can perform the net-net calculation, congratulations! You just created your first valuation model. Try it out on a bunch of stocks.
Getting More Complex: Building Models
Most of the time, the sell-side guys are creating more models, while buy-side guys are more focused on understanding the catalysts that will prompt the market to revalue it.
Of course, buy-side analysts still build models; their analysis is typically focused on the models.
Of the several models available to you to value a company, none are more prominent than the discounted cash flow analysis.
In a nutshell, it’s a financial model that attempts to forecast the future cash-flow of a company, and apply a discount to that future cash-flow based on several factors like industry and risk.
I’ll gladly pay you Tuesday for a hamburger today.
The idea behind a DCF is that cash today is more valuable than cash tomorrow. The model tries to determine how much tomorrow’s cash-flow is worth today.
The Corporate Finance Insitute made a helpful graph to illustrate how the model works simply:
While building a DCF yourself might seem daunting; understanding it is quite easy. The model is a matter of three simple factors:
- Cash flow forecast
- Terminal value
- Discount rate
The forecast requires you to make some assumptions about the company’s future performance, usually on a 5-year basis. While you can’t expect to be super accurate in this, it should shape your general view of the company.
The discount rate is the level of discounting done to future cash flows. If you come to a discount rate of 10%, you’d discount the first year’s cash flow, the second year’s cash flow 10% to the second power, and so on. The discount rate is determined through many factors:
- The risk of the company not realizing their cash-flow forecasts
- The risk-free interest rate
- The company’s cost of capital
The terminal value is basically how much the company would be sold for if it realized your forecast numbers. An analyst typically arrives at a terminal value through the use of a multiple, like enterprise-value-to-free-cash-flow.
The multiple, like the discount rate, is based on a number of factors. A company like Google would probably be given a higher multiple than Yahoo.
The problem with models like the DCF is that they require forecasting future performance. Most forecasts longer than a year have the accuracy of a coinflip, so the value of several assumptions about the future is questionable.
However, I think the DCF is an excellent model to run in your head when thinking about the returns of a potential investment.
Questions like, how long will it take for me to get my principal back, and how risky are the returns of this investment, are baked into the math of a DCF, making it worth your time if you’re trying to understand valuation.
How to Evaluate a Stock – Creating a Thesis
Guys on the buy-side, that’s hedge funds, mutual funds, and the like, usually invest based on a thesis. Rather than crunching numbers, the buy-side often comes up with ideas, looking for unnoticed market anomalies, asymmetric risk/reward profiles.
They’re not typically crunching numbers all day.
A basic thesis might be that electric vehicles won’t replace the internal combustion engine, and therefore you’re bearish on companies heavily exposed to the EV business, like Tesla and Ford.
At this stage, this is just an idea. Bringing this idea to the level of investability will take tons of research outside of reading SEC filings and creating financial models.
Most great stock picks are the meeting of a big picture thesis, as well as the math and due diligence, to remain confident in the idea if it experienced turbulence.
Valuation is a tough skill to practice. Because stock values typically change slowly, it’s challenging to get quick feedback on your work. And even so, the change in values could be due to so many factors.
This is why valuation is more art than science. Some billionaire investors got through with little math knowledge, while others would credit their ability to value an asset to their success.