When I first started learning about investing, I was overwhelmed by all the snippets of information that I found online. For the longest time it was I unsure about:
- “How is a stock valued?”
- “What different valuation methods?”
- “Is intrinsic, and fair value the same?”
- “DDM vs DCF vs FCFF vs FCFE vs relative evaluation vs intrinsic?”
- Time present value of money
Yup! I was just as confused about everything when I first started out! Hence, in this blog post, I hope I can bring clarity to your doubts.
Level 1: Basics How do we price stocks?
Every asset is priced is based on the “Buyer’s EXPECTED RETURNS!”. This a simple question that most people wouldn’t be able to answer. People EXPECTED RETURNS include:
- Capital Gains
buy Asset so they can sell at a higher price later
benefit from the interim earnings.
Important note: For stocks that don’t issue dividends, Investors would realize their expected return through capital gains. In theory, the retained earnings saved by not issuing dividends are assumed to be reinvested back into the company to boost growth.
When we buy stocks, we are buying ownership of a business. What does owning a business do for us? Ownership entitles us to a certain percentage of Net income earned.
Let’s take an example
Logically, we would pick Factory A because it yields us a higher return, 29.45%.
How much would you pay to buy Factory A today?
The price that we pay should net us a minimum of 5% ROI. Otherwise we should buy factory B
The above image illustrates the upper limit to what we can pay to buy factory A which would still yield us a superior return. Paying any amount more than $111.58 wouldn’t meet our minimum rate of return Requirement of greater than 5.0%
Level 2: Time value of money
Time value of money otherwise known as Time preference of money. People often misunderstood the reason for inflation.
Time value of money vs Inflation
Inflation and Time value of money are 2 different concepts. Here’s why
To summarize, Time value of money & Inflation implies that money in the present is worth more than the same sum of money to be received in the future. However, Time value of money describes the OPPORTUNITY COST, and Inflation refers to the erosion of purchasing power.
Formula for Time value of money
Time value of money is about simple interest & Compound interest. The two words that are associated with Time value of money are “Present value” & “Future value”.
Important tip: In the world of stock market investing, growth is usually referenced as Year-over- Year (YOY) or annualized. This is compound growth. Only in bonds markets do investors use simple interest formulas. Hence, I will only be writing down the Compound growth formula.
Applying TVM formula to find the intrinsic value.
Going back to the Factory Example, as you might recall we have a 5.3% and 5% forecast annualized dividends growth for A & B. Applying the TMV PV formula, we DISCOUNT the value of future earnings back to its Present value.
We then proceed to sum up all the Present Value of forecasted dividends and the current market price of the factory. This is also known as your basic model for Intrinsic value.
Important note: the intrinsic value derived from this case study is a very basic model. As you advance, using more complicated models that include variables like discount rate, and risk factor the intrinsic value will change.
What is the importance of TIME VALUE OF MONEY in pricing stock value?
The time value of money is a very basic model that serves to teach us how to DISCOUNT FUTURE EARNINGS back to present value. Therefore, we have the reasons why all the higher-level models are called Discounted cash flow model, Discounted dividend model.
LEVEL 3: Intrinsic valuation: DDM & DCF
The dividend discount model & Discounted cash flow are the basic valuation model that almost all other valuation is based upon.
- DDM analysis states that the current value of a company’s stock price is based on the sum of all of its future dividend payments, discounted back to their present value
- DCF analysis states that the current value of a company’s stock price is based on the sum of all its future cash flow discounted back to their present value.
Both DDM & DCF are also grouped under Intrinsic valuation methods. What this means is if you are to apply DCF or DDM model, we should get the fair value of the company! However, DCF is only applicable to profitable & DDM is only applicable to companies that issue dividends.
DCF is preferred over DDM to gauge the fair value (intrinsic value) because,
- DCF is a measurement of profitability (that excludes non-cash transactions)
- Companies might reduce Dividends to increase retained earnings for reinvestment purposes. In theory, this meant higher future growth.
- DDM is a poor measurement of the company’s performance.
Another important note: In real life, most companies are priced based on relative valuation (we will get to that later). The intrinsic value should be viewed as an anchoring point of reference. It serves as an indicator that a stock is undervalued significantly and maybe it’s a good buying opportunity. Or if it is overvalued and we should be wary/ take profits.
The above image is from “simply wall st” DCF fair value model. As we can tell base on their model the price of the stock should be in the range of $65. The current stock price is trading at $40. This could be a buying opportunity for us investors or at least look into the company more deeply.
Formula for DCF
A quick google search would give you this DCF formula.
Yes, this formula if rewritten in English would mean “The present value of a company is the sum of all its Future Free Cash Flow discounted back to their present value.”
Can you see that DCF & TVM are the same?
However, if you have been reading carefully you would have realized in our TVM example, we used the
“Intrinsic value = current market price + Present value of all future earnings”.
So how do we account for the “current market price” for DCF Model?
Let me introduce you to a concept called Terminal value.
DCF TERMINAL VALUE
“DCF fair value = present value of forecasted FCF + present value of Terminal value”
The definition of Terminal value (TV) is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated.
A terminal value would contribute 50%~75% of the company’s fair value. It depends on the number of years you planned to forecast FCF value.
What is the challenging part of using the DCF model?
If you are attempting to work through a DCF model you might find yourself asking, how do you find FCF, r, or the terminal value? That’s the challenging part! There are many different methods to forecast this variable.
Important tip: No matter how deep of a rabbit hole you dug to find the PERFECT DCF MODEL for your stock analysis, it is worthless. Because
- Everything is a forecast/projection AKA “Calculated Speculation”
- In real life, everything uses relative valuation because of macroeconomics and other market participants with different objectives like short-sellers, swing trading, and hedge funds. Therefore intrinsic value which your DCF should be viewed as an anchoring point of reference to gauge risk and reward.
DCF: What works for me
Now, this is something that works well for me in my personal investing life. When using DCF, just sticking to a basic model works is fine enough, forecast the explicit period to 5 years and update the model input every year.
DCF is not suitable if you are looking to trade your position frequently. It is best used for investment that you have the intention for 5 years and longer.
Level 4 relative valuation model
A relative valuation model compares a firm’s value to that of its competitors to determine the firm’s financial worth.
The relative valuation assumes that the market prices would correct themselves eventually. The job of the investors is to find opportunities in the market inefficiency through all the measurable financial ratios.
Operating cash flow ratio
|Financial Leverage Ratios
Debt to Equity Ratio
Interest coverage Ratio
Debt Coverage Ratio
Asset Turnover Ratio
Inventory Turnover Ratio
Account Receivable Turnover Ratio
Gross Margin Ratio
Return on Asset Ratio
Return on Equity ratio
Price to Sales
|Enterprise value Multiple
Using the relative valuation, we can use all the above metrics and more to:
- compare the company’s current metrics with its competitor
- compare the current metrics with their historic value.
Level 5: Option valuation models
Congratulations, if you have made it here. If you are interested in investing, I would suggest picking up a college textbook regarding this topic or studying high finance in college/ university.
The basic premise of option pricing theory uses probabilistic & statistical approaches to analyze
- the likely hood of a certain event happening given the current company’s health
- Find out how it would affect the enterprise value of the company and the current market price
I cannot provide you any real value at this level, other than show you what Investopedia’s definition of Option pricing theory is. By the way, the most common models are Black-Scholes, binomial option pricing, and Monte Carlo simulation.
If you want a real-life example of how Option valuation is used by professional fund managers, here’s a model done by arkk invest on tesla