“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
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.
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.