“Risk comes from not knowing what you are doing.” – Warren Buffet

Buying stocks without understanding their value is like buying a (car, set of golf clubs, vacation) without asking the (price, model, location) first. How do you know you are getting a good deal if you don’t know the value?

This e-book is an overview of valuation. Its purpose is to help you understand how to value stocks. Picking stocks, once you know this, is an easier process as it gives you a level of confidence that you are purchasing stocks that have a value you have determined based on the risks you understand.

The material can be a bit dry at times; we’ll try and keep it light.

Who should read this book?
This book is an introduction to valuation so there is some level of understanding that will be needed (and can easily be obtained). The book is of value:
– If you are investing but are not sure how the stocks you own are valued
– If you are aware of financial statements, may recognize Revenue and Net Income but not much else and want to expand that knowledge as it pertains to the Stock Market

There are many other parts to understanding what stocks to buy (or sell) and we will cover some of those in future editions, specifically analyzing a company’s financial statements and ratios to understand what risks we need to be aware of (does the company have too much debt compared to its industry, does the company face a liquidity crunch in its short term financing…) We do touch on ratios here and introduce some limited financial statement analysis.

About the Author:
Brian is the President of StockCalc (www.stockcalc.com) a fundamental valuation website for retail Investors and Investment Advisors. Brian is a Chartered Business Valuator (CBV), a Canadian valuation designation (www.cicbv.ca)

The full PDF version is available here – no email required. Feedback is very much appreciated.

How do we calculate what a stock is worth – its intrinsic value?

I am going to provide an overview of how a stock’s value is calculated. Price is what we see traded on the exchange, value is what we calculate. We will use this introductory article to provide an overview and will go into more detail in later articles.

I use www.stockcalc.com for the calculations and for full disclosure am company president.

When we value companies we generally determine the value of the entire company then subtract the amount of debt the company owes. The result is what we call the equity value. So how do we calculate the value of the company?

There are a number of methods that can be used to value the company and they ultimately come down to how much cash flow will the company generate over time and what is that cash flow worth in today’s terms.

Using a simple example: if a company was generating $100 million in free cash flow (defined below) every year and we expected that to continue forever we would value the company as

$100 million/the cost to the company to raise capital (we call this WACC or weighted average cost of capital) . If that cost is 10% for example, the company would be valued at $1 Billion. If the company has $400 Million in combined short and long term debt (we refer to this as interest bearing debt) , we would calculate the value of the equity at $600 million. Assuming 60 Million shares outstanding we would value the company to have a share price of 10$ per share.

So from this example we see a few important pieces needed to calculate what a company’s stock price is worth:

Its cash flow – which may need to be projected into the future

Its cost of capital or WACC

The amount of interest bearing debt it has

The number of shares outstanding.

Two (2) of these we can get from the company’s financial statements (Debt, Shares) and 2 we need to calculate.

Calculating Free Cash Flow:

Free cash flow is the cash generated by the operations of the company with capital expenditures removed, i.e. the true cash available to the company.

The Free Cash Flows (FCF) for Apple Inc (AAPL), Facebook (FB) and Alphabet or Google Inc. (GOOG) for example can be found on the Cash Flow Statements on the Stockcalc site.

To calculate FCF on a go-forward basis we need to make some assumptions or obtain this from others who follow and report on the stocks (analysts). Here is a sample screen shot of Analyst data for Lowes Companies inc. (LOW)

If we are analysing a mature steady growth company, this would be as simple as understanding the annual growth rate we expect for that company and calculating the company value as

Free Cash Flow Current year / (WACC – expected growth rate)

If the company will not be growing at a steady pace (Technology, Mining, Pharma) we need to spend more time understanding what the free cash flow for the company will be. We will need to look at historic free cash flows and the economic environment the company was in to generate those cash flows then look at projected economic or company specific conditions (Pharma product approval for ex) and project.

For these company’s our formula looks more like

Present value of Cash flow year 1 +
Present value of Cash flow year 2 +
Present value of Cash flow year 3 +
Present value of Cash flow year 4 +
Present value of Cash flow year 5… +
Present value of Cash flow year n

Present value means we are calculating those future values back to today’s dollars.

For example in year 2 if we project Free Cash flow to be $125 million and WACC 10% we would discount the 125 to today’s terms as follows: 125 / (1.10)^2

Summary:
The value of a company is its future cash flow in today’s dollars. The value of a stock is the company value less any interest bearing debt, all divided by number of shares outstanding. (Note: each of these steps can have other considerations. That level of detail is beyond an introductory overview)

Other methods for Calculating the Value of a Company:
There are 3 other methods that are used to calculate the value of the equity in a company which we will cover in other blogs.

Comparables
Multiples
Adjusted Book Value

If you want to explore the Stockcalc software simply create an account at www.stockcalc.com and have a look around. Use the walk-throughs (click the walking man icon), videos (video icon on each page) or the help menu to help understand and navigate the site. Please contact us if you have any questions.

Determining what a stock is worth does not have to be a complicated process if you have the right tools to help you. There are 4 steps to generating a valuation using the Stockcalc website. www.stockcalc.com

In this we will dig a little more into the 4 steps: I am using the Stockcalc website to do these calculations and for full disclose am company President.

The 4 Steps (once you have selected a company)
1) Determine what the cost is for the funds needed to run and grow the business. We call this the Weighted Average Cost of Capital or WACC. Large, stable companies have a lower WACC than more speculative companies.
2) Forecast the company’s financials into the future based on assumptions you have or are able to get from Analysts that cover the company. We have a number of forecasting tools on the site starting with Analyst forecasts and Growth projections all the way to using a blank page and creating the forecast yourself.
3) Value the company using Valuation models such as a Discounted Cash Flow (DCF) where you include the financial forecasts, WACC and other calculations and assumptions such as Capital Expenditures needed and Debt levels. The site has a full DCF framework for you to calculate with and auto-populates each cell to get you started.
4) Test your assumptions, see how sensitive the company is to the inputs. Testing your assumptions is a critical part of valuation work. When you get a different valuation than you see a company is trading for on the stock exchange you need to ask why, and test. You may have uncovered an opportunity.

Valuation is part art, part science. The assumptions you make impact the company’s value. For example, if you think the WACC is 8% instead of 9% the company will calculate to be more valuable because its cost to service its capital will be lower.

Here is a tool you can use for free to quickly test your assumptions : www.stockcalc.com/dcf.aspx
Simply load a symbol or name into the Symbol text box and select the company from the dropdown. Test the valuation by changing the growth rates, WACC, Free Cash Flows etc.

Next Steps:
If you are not sure where to begin you can select a company you are familiar with (GOOG, AAPL) and work though the steps above on the Stockcalc site. Each of these steps are found on the Research Page which you can access either by clicking the Research Button or selecting Research from the dropdown menu next to the Stockcalc logo (both are on the Dashboard)

About Stockcalc: If you would like to explore the Stockcalc website and quickly run valuations like simply create an account at www.stockcalc.com (Start with a 14 day free trial) Use the walk-throughs (click the walking man icon), videos (video icon on each page) or the help menu to help navigate the site. The site has a number of tools for data query, backtesting, forecasting and valuation. We have a no restrictions Stockcalc 14 Day Free Trial available as well.
If you would like the above valuation to test simply send us a note from Stockcalc’s “Contact Us” on the dashboard.

I used the Stockcalc website (www.stockcalc.com) to run a fundamental analysis for Lowes Companies (LOW:NYS)

Process:
I ran a Weighted Average Cost of Capital with the WACC Tool
I loaded the Analyst Estimate Data and used it to generate an Income Statement Forecast for 2016 to 2018
I then ran a Discounted Cash Flow with that Data.

The following screens show the steps:

Calculation of WACC for LOW:NYS

This resulted in a WACC value of 8.78 for Lowes Companies Inc.

Next I loaded the Analyst Estimate Data and used it to generate an Income Statement Forecast for 2016 to 2018

I then loaded a Discounted Cash Flow using the above inputs

Note – Stockcalc provides default or historic values to generate the initial valuation calculation- the user can then adjust based on their expectations:

Adjustments:
The cash flow values were taken directly from the Analyst estimates. I reviewed the historic Capex figures and adjusted the ongoing Capital Expenditures to 0.9 billion from an average of 1.2 billion last 5 years based predominately on the last 2 years figures of 0.9 and 0.8 billion. I also adjusted the terminal growth rate from the default of 3.0 to 3.4 given the Analyst projection for the next 3 years are 11% growth in EBITDA. These 2 adjustments resulted in a value of $74 per share. I am not aware if there are redundant assets that would add to company value.

The Analyst Mean Target Price for 2017 is $80.86. This can be seen on the Average Analyst Estimates above. To achieve that value I would need to increase the terminal value to 4.0 % per year in the discounted cash flow model.

Company Information:
Lowe’s Companies Inc. was incorporated in North Carolina in 1952 and has been publicly held since 1961. It is a Fortune(r) 100 company and a home improvement retailer. As of January 31, 2014, Lowe’s operated 1,832 home improvement and hardware stores in the United States, Canada and Mexico representing approximately 200 million square feet of retail selling space. The Company serves homeowners, renters and commercial business customers (Pro customer).

About Stockcalc: If you would like to explore the Stockcalc website and quickly run valuations like simply create an account at www.stockcalc.com . Use the walk-throughs (click the walking man icon), videos (video icon on each page) or the help menu to help navigate the site. The site has a number of tools for data query, backtesting, forecasting and valuation. We have a no restrictions 14 day free trial available. If you would like the above valuation to test simply send us a note from Stockcalc’s “Contact Us” on the dashboard.

The talk of will they or won’t they raise rates has been ongoing for more than 2 years now. We have to expect either rates get raised at some point, we stumble along on the current path or we end up in deflationary times. I want to explore the more optimistic of these scenarios and its impact on stock valuations: the economy improves and rates start to rise.

To look at this in detail I am using www.stockcalc.com (Disclaimer: I am the President of Patchell Brook Equity Analytics and we created Stockcalc.com precisely for this type of analysis and valuation)

I will examine Caterpillar as it has with a 59/41 Equity to Debt in the Capital Structure

Using Stockcalc I first create and save a WACC for CAT: (Research Menu, Valuation, WACC). Stockcalc does a first pass on WACC using default values which results in a WACC of 8.93.

Cost of Equity (Ke) 13.63 (Using CAPM), After Tax cost of Debt : 2.17, 59% Equity, 41% Debt

Next I load the Quick DCF tool so I can run the analysis (Research, Forecast, Analyst) (Note – the quick DCF is a testing and teaching tool, the other tools are more detailed in their analysis)

Value Per Share ($) Calculations for Caterpillar (CAT:NYS) using the Quick DCF tool on Stockcalc.com

Each change in WACC (8.93 – 9.34 – 9.75) implies a 1 % change in Cost of Debt. Growth rates are next 3 years and thereafter (5% and 3% in the first row for ex)

WACC

8.93

9.34

9.75

Growth rates 5,3%

70.02

61.28

53.60

Growth rates 6,4%

97.40

84.92

74.21

Growth rates 4,2%

50.55

44.08

38.30

(Current Price at the time of valuation (October 2015) was $69.34)

A 1% change in the Cost of Debt results in a 12.5% change in value per share. A 1% change in Growth rates results in a 28% change in Value per Share. A 1% change in WACC results in a similar 28% change in Value per Share.

Message: if interest rates are rising, growth prospects need to be rising at half the rate to keep this share price holding steady.

If you want to explore the Stockcalc software simply create an account at www.stockcalc.com and have a look around. Use the walk-throughs (click the walking man icon), videos (video icon on each page) and help menu to understand and navigate the site. The site contains a number of tools including screens, queries, backtests, forecasts and a variety of valuation methods.

I often see on chat rooms and bullboards investors discussing small caps with phrases like “but it used to be a 6 $ stock – I’ll buy it and wait for it to get back there”

Should they be looking at Price or Market Cap?

Side note: Here is an overview of Price vs Market cap from Khan Academy:

In some sectors, notably junior mining companies, you need to look at Market Cap (Stock Price * Number of Shares outstanding) instead of share price as a potential upside if conditions return. Every time one of these junior companies does a reverse split it affects the market cap but may not be reflected in the price over time given their nature to fall off dramatically in tough times.

As a note, any company that goes through a reverse split falls for this math so if you think of buying a company because it “used to be a 6$ stock” please look to see if any reverse splits have occurred.

Here is a example of a small Canadian junior gold company that I ran using the www.stockcalc.com website – It hit a high of 12 Million market cap in 2008 and the adjusted stock price at that time was in the 1.20$ range (I say adjusted because as each reverse split occurs in order to have apples and apples the charts need to be adjusted to reflect the splits)

The company is currently trading at 13 cents with a market cap of less than 3.5 million.

Market Cap

Let look at 3 points in time here with the share consolidations accounted for:

Jan 1 2010: Market Cap 5.5 Million, Price 57 cents
Jan 1 2014: Market Cap 1.0 Million, Price 10 cents
Jan 1 2015: Market Cap 3.4 Million, Price 13 cents

From these we can calculate the (adjusted) # of shares as 10 Million each of 2010, 2014 and 26 Million in 2015. The company did a reverse split mid 2014 followed by a number of private placements.

Price – This chart shows the adjusted close prices for the company from 2008 to mid 2015.

Here is a zoomed in version of the price chart

So if we wanted to speculate thinking conditions were going to turn around for this junior mining company, how high could the share price go based on historical values?

If we look at the price chart we see the company would have been in the 50 to 60 cent range during 2010-2011 and may speculate it could return there if gold prices reverse higher. This would be a 4-5 times return compared to the 13 cents currently.

Conversely if we look at Market Cap: after the split Market Cap was 3.4 million. To return to the 5.5 million range we see a 60% return.

i.e if the company returned to full value as expressed by 2010-11 market cap it would only rise to 21 cents, not the 50 to 60 cent range it had seen previously.

Yes it is intuitive, just something to keep on your radar when looking at these smaller stocks.

If you want to explore the Stockcalc software simply create an account at www.stockcalc.com and have a look around. Use the walk-throughs (click the walking man icon), videos (video icon on each page) or the help menu to help understand and navigate the site.