As our second educational article, the portfolio management division decided to introduce the topic of value analysis. There are many ways to analyze the value of a company; some serve the purpose of obtaining a figure representing the total value of a firm, whilst others are purely for the use of traders and retail investors, like us. Today, we will look into three different types of analysis: discounted cash flow modeling (a.k.a. DCF), comparative analysis and then fundamental analysis.
Discounted Cash Flow Modelling:
Discounted Cash Flow models are used to value companies based on how much cash they will generate in the foreseeable future. The basic assumption of this model is that a dollar today is worth more than a dollar tomorrow, meaning that the forecasted cash flows (a.k.a. FCF) of a company are “discounted” using a rate called weighted average cost of capital (a.k.a. WACC). The WACC is a metric, calculated by financial institutions on behalf of companies, which accounts for the cost of issuing equity and debt. Free cash flows are calculated using operating cash flow (a metric for how much cash a company generates from their business), and subtracting capital expenditures (a.k.a. Capex). We will explore further these metrics and acronyms at a later date, but for now it is important to understand that this valuation technique is used solely by professionals, takes 4 to 5 months to complete, and is usually done by teams with years of experience (so it is okay to feel a little overwhelmed). Once we have found the Free Cash Flow of a business, the most tedious part begins: predicting what will come in the next few years (usually from 5 and up to 30 years depending on the industry). This is done through months of research, predictions, and data scrutinization. Once all the forecasted cash flows have been predicted, they are discounted. This links back to the underlying assumption that a dollar today is worth more than a dollar tomorrow. This assumption can be seen in the figure below, assuming 10% yearly growth of cash flows and 5% WACC:
Figure 1: The effect on discounting on the value of businesses.
As you can see, in just 9 years discounting decreases future value by around $3.5 million. This process is to account for possible risks and for the opportunity cost of not investing in treasuries. Moreover, once all Free Cash Flows have been discounted and added together, a further lump sum is added, called terminal value. This sum is based on 3 different assumptions. Firstly, a prediction of what the last FCF will be, which we can see for example in the chart above being about $2.4 million. Then we divide these $2.4 million by the WACC in the long run minus the predicted average growth rate. The prediction of these two figures are the second and third assumption we are making with this model. As aforementioned, the research and time that goes into building these figures to render them as accurate as possible is hard to grasp, even though the concepts are relatively easy to understand. Once these figures are put together to calculate the terminal value, we add the final figure to the sum of all discounted FCFs and we have our discounted cash flow model. This can now be used to divide up into shares to understand what the appropriate share price could be, or for Investment Bankers working in Mergers and Acquisitions who need to find the value of a company for a client who would like to purchase it. It is the golden standard for valuation and the result of hard work and research.
Comparative Analysis:
Secondly, comparative analysis is a comparison between the prices of stocks related to a common metric from the financial accounts of the firms being compared, which may be: earnings, book values, dividend yield or sales. The underlying concept behind this technique is to compare companies from similar industries and similar sizes, so it isn’t as varied and useful as the DCF model showcased above, but it is far simpler to build. We can use all of these models in order to understand whether stocks are over, or undervalued. We will always try to purchase stocks that to us are undervalued, given it is essentially like purchasing a stock at a discount. By doing this, we are hoping that in the near or medium term, other investors will see the same value we see in the stock, and will purchase it themselves, increasing the stock price and creating value for us. There are several ratios we can work with, such as:
- P/E (Price/Earnings)
- EV/S (Enterprise Value/Sales)
- P/B (Price/Book)
- P/S (Price/Sales)
The first ratio (P/E), looks at the price of a stock against the company’s earnings per share (EPS). There are two types of P/E ratios; the first one is called trailing P/E, which essentially determines how high the price of a company is, compared to their earnings in the past. This is the most popular way of calculating the P/E ratio, as it uses concrete data from the past and the present. The second option, which is much less popular, is the future P/E. The future P/E is made up of the current stock price (like the trailing P/E), and then the forecasted EPS from the company. Now, this method is unpopular exactly because of that, forecasted EPSs from companies tend to be on the lower side, in order to beat expectations and get a sudden boost in the stock price, so the future P/E is usually not used because of that exact reason. Normally, a high P/E implies a high stock value, so the stock should not be bought, and should be sold, unless it is a specific instance. Instead, when the P/E is low, the stock should be bought (as long as the fundamentals of the company are solid, but that’s next up).
Secondly, we have EV/S, and its little brother P/S. EV/S is calculated by adding Market Cap (which is share price x number of shares issued), debt (because it does add value to the company) and subtracting cash, which doesn’t actually account for concrete value, and then dividing it by the quantity of shares the company issued and then again by the annual sales. Now, P/S is the same concept, except we just calculate it using Market Cap and dividing it by the annual sales. This digit will be slightly smaller than EV/S, therefore the two aren’t comparable. However, their function is the same. If the EV/S is high, the company is overvalued (sometimes in our articles we might say overbought), whilst if it is a low figure, the share is undervalued (underbought).
Lastly, P/B is a similar metric to the ones we’ve analyzed, except it is much different at the denominator. B stands for book value per share, which is a value consisting of assets plus intangible assets (assets that do not have a specific value like patents and branding) minus liabilities, essentially giving us a figure for net assets. We then divide the digit by the number of shares (like we do for the market cap on the numerator), and we obtain P/B, which can show either overvaluation, or undervaluation.
Comparative valuation metrics like the ones discussed above are easy to find and simple to use, but they only work really well in extremely specific cases, such as: Amazon (AMZN) and Walmart (WMT), or Pfizer (PFE) and Merck (MRK). All these companies have comparable business models, all that changes is the scale at which they are operating, but there aren’t many companies we can use this valuation method on, so we are now going to delve into fundamental analysis.
Fundamental Analysis:
Fundamental analysis is based on the identification and prediction of economic and financial variables and is used in finance to evaluate the intrinsic value (the real worth) of a security. It is often used in the context of stocks, but it can be applied to other financial instruments like bonds and commodities as well. The main goal of fundamental analysis is to determine whether an asset is overvalued or undervalued.
Sources for Fundamental Analysis
Fundamental analysis uses publicly available financial data to determine the value of an investment. This information is documented in economic and financial statements, including quarterly and annual reports, as well as filings like the 10-Q (quarterly) or 10-K (annual). The 8-K filing is crucial as well, as public companies are required to submit it whenever a significant event takes place, such as an acquisition or a change in upper-level management.
The main tools of fundamental analysis
Financial statements: study a company’s financial statements include the study of the income statement, balance sheet, and cash flow statement. These statements provide insights into the company’s profitability, financial health, and cash flow.
Industry and Market Analysis: Fundamental analysts consider the industry and market conditions that a company operates in. Changes in the broader economic environment can impact a company’s performance.
Macroeconomic indicators: gross domestic product growth, inflation, and unemployment rates are examples of macroeconomics indicators that are used to understand the economic environment in which a company operates. These indicators can affect consumer behavior and, consequently, a company’s performance.
Interest rates: Central bank interest rates can significantly affect an investment’s value. Higher interest rates generally lead to lower stock prices, while lower rates boost stock prices.
Qualitative information: information such as management and governance quality (Skilled and transparent management is generally seen as positive), competitive advantage, and other non-quantifiable factors that affect a company’s stock.
News and events: Company news for example earnings reports, new contracts, and regulatory changes, affect stock prices.
By conducting this fundamental analysis, an investor can make more informed decisions about whether to invest in a company or not. If the financial health is strong, management is capable, and the industry outlook is favorable, it may be an attractive investment opportunity. It’s important to note that Fundamental analysis is a useful tool for long-term investments but is less adaptable to short-term moves. It offers a balanced approach by considering qualitative and quantitative factors, although interpreting them can be subjective.
Authors: Diego Russo and Stefano Rizzi