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Stock Valuation: A Short Primer

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

how do you know if the price a stock is trading at is a good deal?

how do you know if the price a stock is trading at is a good deal?

Company Valuation Is Stock Valuation

When I first started investing in individual stocks, I asked myself the same question every value investor asks: What's the underlying value of the company whose stock I'm considering buying? After all, if you're not interested in what the company's doing, you're probably just speculating on whether other people will pay more in the future (as opposed to trying to determine what the business will be able to pay you).

At my back was the Oracle of Omaha with his words of wisdom. I had read every letter to shareholders Buffett had ever written, poring over some of the most concise investing advice of all time, so I felt I had internalized the intense focus on the underlying asset and the idea of ignoring all the noise from Mr. Market. I was ready to take advantage of good deals whenever they were available, and being inherently contrarian, bargain-hunting for stocks would come as naturally to me as breathing.

The last piece of the puzzle, though, still needed a bit of demystifying. Let's take a 30,000-foot view of how to determine a company's value so you can decide if it has a sufficient margin of safety to buy the stock today.

It's a good idea to calculate what you think the value of a stock is before checking to see what it's trading for.

It's a good idea to calculate what you think the value of a stock is before checking to see what it's trading for.

Reverse Engineering

In a perfect world, you don't want to look at the price of a stock in order to try to figure out if it's a good deal. This may sound nonintuitive. After all, bargain-hunters at the grocery store simply take a look at the price of two or three different comparable products and select the one with the lowest price.

There are three main problems with simply applying this approach to stocks. First, not all stocks are commodity-like, and no two companies are identical in the way they run their businesses (even if the products they sell are similar). It's simply not an apples-to-apples comparison.

Second, the reason you might do this at the grocery store—because a box of corn flakes is on your shopping list—doesn't apply to stocks. As Buffett is fond of saying, you don't have to swing at every pitch. In fact, you can go a really long time without swinging at pitches, taking a look at dozens of different companies before pulling the trigger on any one business. Whatever you buy doesn't even need to be a type of cereal, much less corn flakes!

The third reason you don't want to look at the price of a stock first is psychological, and it's probably the most compelling of all reasons. Investors face a lot of landmines out there when researching stocks, but our own minds can often be the source of the majority of these traps.

If you take a look at the price, a phenomenon called anchoring causes you to think you have a rough idea of what the company might be worth before you even start calculating the value. Don't do this. Instead, reverse engineer what the price should be by calculating the value of the company first and then dividing by the number of shares to get an idea of what you might pay for one share.

Cash Flows

One of the easiest ways to understand what a stock's worth is to take a look at a dramatically simpler example than what we'll usually come across in real life. Imagine owning a bond that pays you $100 a year to own it for 10 years, and then you get the initial price you paid for the bond back.

Now, ask yourself what you'd pay for this bond. Things get interesting right away with this real-world example. You'd probably be willing to pay a lot more than $100 for such a thing, but there has to be some upper limit on the amount you'd be willing to spend.

A company produces free cash that it can then reinvest in the business or pay to shareholders (either via dividends or buybacks). This means that instead of you getting paid $100 a year, you might get paid $50 a year while $50 is reinvested in the company so it can continue to grow.

The downside to this is that you don't get the $100 right now. The upside is that the company may be able to turn that $50 into a lot more money over time. In fact, that might be a key reason why you wanted to invest in the company in the first place—because you think they're going to intelligently use your money to grow their business. Unlike the bond example, when a company's business grows, the stock price has a tendency to go up over enough time, albeit in unpredictable ways, especially over shorter time horizons.

The general idea here is that you can get paid while you wait for the stock to grow (dividend payments), or the company might reinvest all of that cash, in which case you're banking on the company's ability to grow a lot more. In a case like this, you might be willing to forego a dividend entirely. After all, if the company can turn your $50 into $500 at a much faster rate than you can, why not give them the opportunity to do so by letting them keep your money (for now)?

The Discount Rate

In the $50-to-$500 example, it's clear to us that the company would be a smart place to hold our money since we probably can't turn $50 into $500 as quickly as they can. This one's a no-brainer, but what if the company would turn your $50 into $100 during the same time frame?

Maybe there's a tipping point where they can't do any better than you can do on your own, perhaps with a so-called high-yield savings account. Maybe you're a small business owner and you could add an expanded room to your business and turn $50 into $200 during the same time frame if you just invested and built the space out.

This touches on what's called the discount rate, and understanding it is crucial to understanding any style of value investing. The main idea is to only buy something that's going to give you a better return than what you could get somewhere else (the risk-free rate, if you're buying something where you're 100% confident you'll be paid the agreed amount, like a savings account or treasury bond).

Since money is worth more now than it is in the future (and since you can make a certain guaranteed amount on your money somewhere else), it makes sense to discount whatever cash the company's going to pay you back to today's values. It's also important to do this even if you don't have any great alternatives due to inflation. Your money is very likely to be worth considerably less in the future than it is today simply because everything will cost more. This discount rate concept is one key component to determining the value of anything.

Beginning With the End in Mind

After receiving your payments in the bond example, you get paid whatever you paid for the bond at the end of the term after receiving all the payments. That makes determining what you'd pay for the bond pretty simple if you know what discount rate you're applying.

While discounting the regular payments in order to get a value is important, it's even more crucial to do this for the amount you get paid at the end of the term, since that money is sitting there for the longest. In discounted cash flow (DCF) valuation models, we use a phrase to describe what a business is worth at the end of your projections: terminal value.

Since the company might go on producing cash for you long after the term in which a fixed bond will pay you, it's important to estimate all the cash flows you'd get between now and judgment day . . . but this isn't really practical since projecting more than a few years out can become more and more tedious (not to mention speculative).

It makes sense to view the business like a bond, meaning the value comes from the cash flows and from what the business is worth at the end. This terminal value can be determined in a number of ways (some better than others), including multiplying the cash flows at a certain year by whatever analysts normally use for that industry (an industry multiple) and adding up all of the assets you think will be in the company and determining what you could sell them for.

At any rate, breaking the business into the cash flows and the terminal value will give you the value of the business, and if you divide that by the number of shares, you'll have a fair price for the stock.

Aswath Damodaran Discusses Terminal Values

Removing the Curtain

Stock prices aren't just numbers on a screen or imaginary pieces of paper cranking out of the ticker at irregular intervals. Instead, these shares represent a quantifiable slice of an underlying business, and these businesses hope to produce a certain amount of cash each year.

This amount of cash is one component of a business's value, and the other is whatever the business itself is worth (either in terms of future cash it might produce or in terms of whatever you could sell the assets for). Internalizing this can help you come up with a fair value for a stock, and then you can use a margin of safety to make sure you're buying the business for a lot less than it's worth.

When fickle Mr. Market offers you more than the company's worth, you can sell it back to him, or you can continue to hold the stock . . . but that's another conversation for another day. For now, knowing about cash flows and terminal value will help you demystify your investing research and hopefully lead to an incredible upside.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

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