If you wanted to distill down investing in stocks to its essence, you’d have to start with valuation. Investing in stocks for the long term can be summed up in one sentence – buying companies for less than they’re worth.
Essentially, you look at a company and figure out how much earning power and growth potential it has. This should indicate how much the company is worth. Because you can’t be completely sure of anything, you decide to buy the company for less than you think it’s worth and hold onto it forever. It’s that simple.
But, of course, the most complicated part of this strategy is figuring out the true value of the company. I’m going to leave aside all the other factors and focus on valuation here so that you can really get to grips with professional investment techniques. Although these skills are not hard to master, applying them takes a healthy dose of courage and intuition. Let’s start with the basics.
The fundamental assumption when you look at a company is that it must be worth something. There’s a nifty term the Wall Street guys use for this unknown factor is ‘intrinsic value’. Intrinsic value is the actual value of the company. While market value is how much it would cost you to buy the company outright today, intrinsic value is how much the company is actually worth over the long term.
Academics will tell you that the intrinsic value of any company is a culmination of several factors. How much the company earns today, how much it saves and reinvests, how much it pays out in dividends, how much growth it can expect, and how much debt it has, are all factors that need to be considered.
We’ve already discussed factors such as dividend yield, free cash flow, debt-to-equity ratio, and payout ratio. Now’s the time to apply these metrics to figure out a company’s intrinsic value.
There are three ways of finding intrinsic value:
Essentially, all three methods lead to a single number that serves as the ideal price per share. However, if you try all three methods on the same company, you will end up with slightly different figures. Professional investors figure out a single method that works best for them and then stick with it.
Here’s what you need to know about each:
Discounted cash flows:
DCF analysis is the cornerstone of all value-investing theory. This method treats the company like a giant machine that churns out cash, specifically free cash that isn’t needed within the company. DCF involves estimating the free cash flows the company is likely to generate over a period of time and discounting them back to present value. That present value is the intrinsic value of the company.
Dividends are the most free cash flows you can imagine. They have been paid out to investors, which means they are surely not needed for the continued operations of the firm. Some investors prefer using dividends because they are more predictable, tangible and stable than free cash flows. You have physical evidence of a dividend, whereas you have to figure out how much free cash flow a company generates. If you find a company with a high dividend payout, use the same tactic as the DCF – figure out future dividends and discount them back to present value. That present value is, again, the intrinsic value of the company.
Earnings multiples are the most most popular business valuation tools. This could be because they are the most straightforward valuation tools available. Most of these multiples are published in investor reports and magazines. You take the earnings per share of a company and use it to divide the price per share on the market. This earnings multiple can be compared to other companies in the same industry, the broader market, and the company’s own history to see if the price is too high or too low.
Let’s apply these methods on a public company to see how it would work:
T (NYSE) US$40.38 (09 December 2016)
AT&T is a straightforward company with a well known brand. It’s also one of the largest public companies on the planet, which makes it easier to analyse for our purpose here. Let’s apply all three methods to see how much the company is worth:
Discounted Cash Flow: Assuming the required return for one AT&T stock is 7.14% and the growth rate is -3.9% every year, the intrinsic value of each AT&T stock is estimated at $44.08. Since this rate is nearly 10% higher than market price ($44 / $40), the stock is a BUY. (follow this link to see the calculation)
Dividend Discount: AT&T pays a fairly high dividend. It paid nearly $2 per share in dividends this year, which means the yield is close to 5%. If you assume dividends will grow at 6% every year and the required rate is 10%, the dividends can be discounted by 4% (10% – 6%). Which means the intrinsic value is $48 ($1.92/0.04). That’s 20% higher than the market price, which means the Dividend discount method also rates the stock as a BUY.
Earnings Multiple: AT&T’s Price-to-Earnings ratio is currently 17.11x. That means the price is 17 times higher than the earnings. That may sound like a high multiple, but it’s actually lower than many of its competitors. Comcast trades at 20x while T-mobile trades at a whopping 36x. Only Verizon is lower at 14x. T trades at a lower multiple than even the S&P 500, which trades at 26x. This means the stock is at a discount from the rest of the market and a clear BUY.
All three valuation techniques place a higher value for AT&T stock than the market. It seems this stock offers great value at the moment. But that’s not the case with every stock. Some stocks are valued more on multiples than on discounted cash flow methods. Others don’t have any dividends or free cash flows to measure at all. How you use these valuation techniques is up to you. But now that you know stock valuation works you can apply it to everything you own and wish to own. Good luck!