Equity Valuation

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, whereas stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall.
In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of their intrinsic value of the stock, based on predictions of the future cash flows and profitability of the business. Fundamental analysis may be replaced or augmented by market criteria – what the market will pay for the stock, without any necessary notion of intrinsic value. These can be combined as "predictions of future cash flows/profits (fundamental)", together with "what will the market pay for these profits"? These can be seen as "supply and demand" sides – what underlies the supply (of stock), and what drives the (market) demand for stock?

The most theoretically sound stock valuation method, called income valuation or the discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future and a final value on disposal. The discounted rate normally includes a risk premium, which is commonly based on the capital asset pricing model.

There are many different ways to value stocks. The key is to take each approach into account while formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other similar stocks, then the next step would be to determine the reasons.

Earnings Per Share (EPS)

EPS is the net income available to common shareholders of the company divided by the number of shares outstanding. They usually have a GAAP EPS number (which means that it is computed using all of mutually agreed upon accounting rules) and a Pro Forma EPS figure (which means that they have adjusted the income to exclude any one time items as well as some non-cash items like amortization of goodwill or stock option expenses).

The most important thing to look for in the EPS figure is the overall quality of earnings. Make sure the company is not trying to manipulate their EPS numbers to make it look like they are more profitable. Also, look at the growth in EPS over the past several quarters / years to understand how volatile their EPS is, and to see if they are an underachiever or an overachiever. In other words, have they consistently beaten expectations or are they constantly restating and lowering their forecasts?

The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net income that excludes any one-time gains or losses and excludes any non-cash expenses like stock options or amortization of goodwill. Then divide this number by the number of fully diluted shares outstanding. Historical EPS figures and forecasts for the next 1–2 years can be found by visiting free financial sites such as Yahoo Finance (enter the ticker and then click on "estimates).

Through fundamental investment research, one can determine their own EPS forecasts and apply other valuation techniques below.

Price to Earnings (P/E)

Now that you have several EPS figures (historical and forecasts), you'll be able to look at the most common valuation technique used by analysts, the price to earnings ratio, or P/E. To compute this figure, take the stock price and divide it by the annual EPS figure. For example, if the stock is trading at $10 and the EPS is $0.50, the P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at, be sure to look at the historical and forward ratios.

Discounted Cash Flow

Valuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream after the forecast period.

Value of firm =
in which

FCFF is the Free Cash Flow to the Firm (that is Operating cash flow minus capital expenditures)
WACC is the Weighted Average Cost of Capital
t is the time period
n is the number of time periods
g is the growth rate
value of firm is enterprise value

Factors required for Discounted Cash Flow Analysis:

1. Determine Forecast Period: The forecast period is the time period for which the individual yearly cash flows are input to the DCF formula. Cash flows after the forecast period can only be represented by a fixed number such as annual growth rates. There are no fixed rules for determining the duration of the forecast period.

Example: ‘ABC’ is a medical ICT startup that has just finished their business plan. Their goal is to provide medical professionals with software solutions for doing their own bookkeeping. Their only investor is required to wait for five years before making an exit. Therefore ABC is using a forecast period of five years.

2. Determine the yearly Cash Flow: Cash flow is the difference between the amount of cash flowing in and out a company. Make sure to consistently include the different types of cash flows.

Example: ABC has chosen to use only operational cash flows in determining their estimated yearly cash flow: In thousand €

3. Determine Discount Factor / Rate: Determine the appropriate discount rate and discount factor for each year of the forecast period based on the risk level associated with the company and its market.

Example: ABC has chosen their discount rates based upon their company maturity.

4. Determine Current Value: Calculate the current value of the future cash flows by multiplying each yearly cash flow by the discount factor for the year in question. This is known as the time value of money.

Example:

5. Determine the Continuing Value/Terminal value: Calculating cash flows after the forecast period is much more difficult as uncertainty, and therefore the risk factor rises with each additional year into the future. The continuing value, or terminal value, is a solution that represents the cash flows after the forecast period.

Example: ABC has chosen the perpetuity growth model to calculate the value of cash flows after the forecast period. They estimate that they will grow at about 6% for the rest of these years.
(182*1.06 / (0.25-0.06)) = 1015.34 This value however is a future value that still needs to be discounted to a current value: 1015.34 * 1/(1.25)^5 = 332.72

6. Determining Equity Value: The value of the equity can be calculated by subtracting any outstanding debts from the total of all discounted cash flows.

Example: ABC doesn’t have any debt so it only needs to add up the current value of the continuing value and the current value of all cash flows during the forecast period:
62.14 + 332.72= 394.86. The equity value of ABC: € 394.86

Advantage of Discounted cash flow analysis:

The DCF method is forward-looking and depends more future expectations rather than historical results.
The DCF analysis is focused on cash flow generation and is less affected by accounting practices and assumptions.

Shortcomings of DCF:

The accuracy of the valuation determined using the DCF method is highly dependent on the quality of the assumptions regarding FCF, TV, and discount rate. As a result, DCF valuations are usually expressed as a range of values rather than a single value by using a range of values for key inputs. It is also common to run the DCF analysis for different scenarios, such as a base case, an optimistic case, and a pessimistic case to gauge the sensitivity of the valuation to various operating assumptions. While the inputs come from a variety of sources, they must be viewed objectively in the aggregate before finalizing the DCF valuation.
The Continuing value often represents a large percentage of the total DCF valuation. Valuation, in such cases, is largely dependent on continuing value assumptions rather than operating assumptions for the business or the asset.

Conclusion

Discounted Cash Flow model is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.

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