What is a company worth?
At what price should I buy?
At what price should I sell?
These are the questions that every serious investor should be asking themselves before investing in any stock. However, how do we know what is the right price?
The world famous investor Warren Buffet insists that buying companies that are undervalued and selling them once they become overvalued is the only way to make money in the stock market over the long run. That makes great intuitive sense and is the view that we at M3 subscribe to ourselves.
Now that we have the framework of how we are going to buy and sell, the most important part is determining the value of the company. Because only when we know what a company is worth can we determine whether or not it is under or over-valued.
Unfortunately the most important part is also the most difficult. Valuation is not really a science – there is no set formula that provides us with a company’s valuation. It is more of an art, where seasoned professionals such as ourselves, use various methods to approximate a company’s value.
There are two broad ways of looking at a company’s value:
- Discounted Cash Flows (“DCF”) and
- Valuation Multiples
The DCF approach
The DCF approach basically views the value of a company as the sum of the present value of the future cash flows that will be produced by that company. In order to understand the DCF approach, it is important to recognise that money also has a time value, i.e. I would always prefer to receive a dollar today than a dollar a year from now – a dollar today is worth more than a dollar tomorrow. Because there is a time value to money, that means cash flows occurring in the future need to be discounted to the present at the cost of money.
So under this approach we need to first forecast the company’s future cash flows and then estimate the cost of money. If our valuation of the company is greater than the current market valuation, then the company is undervalued and is a buy (and vice versa it is a sell).
Whilst conceptually simple, it is quite difficult in practice. Predicting future cash flows with imperfect information is quite difficult and the cost of money is also quite a subjective determination as there is no pre-set number.
The Valuation Multiples approach
With a Valuation Multiple approach, we apply the Valuation Multiple to a relevant earnings or other financial metric (e.g. Earnings, EBITDA, book value etc.) to yield the company’s value. Some common Valuation Multiples used include the Price to Earnings (P/E), Enterprise Value to Earnings Before Interest, Tax, Depreciation and Amortisation (EV/EBITDA) and Price to Book Value (P/B).
E.g. If a company is expected to have earnings of $100 next year, and we believe the relevant P/E Multiple should be 10, we would value the company at $100 x 10 = $1,000. If the market value is $800 (trading at 8x earnings) then this company can be seen as undervalued (and theoretically we should buy), and if the market value is $1,200 (trading at 12x earnings) then this company is overvalued (and theoretically we should sell).
The Valuation Multiple attempts to capture a company’s many operating and financial characteristics (e.g. current profit margins and growth prospects) in a single number. When using the Valuation Multiple approach we are required to identify a set of companies that have similar characteristics (known as the peer group) and use the Valuation Multiples of this peer group to guide our determination of the appropriate Valuation Multiple.
The Art of Valuation
As outlined above, in no way is valuing a company a clear and certain exercise. There is much subjectivity involved in determining the assumptions used to forecast future cash flows and in determining the appropriate Valuation Multiple.
The Art of Valuation is in knowing the strengths and weaknesses of each approach and using both approaches simultaneously to cross-check and ultimately ascertain a more accurate picture of valuation. Sometimes this is helped by a greater understanding of or insight into the company/industry, and sometimes by professional instinct.
It is important to note that value is a fluid concept which constantly changes due to a variety of factors, some specific to the company (earnings outlook) and some which are broader in scope (lower interest rates which decreases the cost of money, which increases DCF valuation).
The team at M3 is on top of these and always on the look-out for new developments, so that we can continue to look for undervalued stocks with the goal of achieving consistent returns over the long run
Please note this article has been prepared without taking into consideration any individual’s particular objectives, financial situation and needs. This article only expresses the opinion of the author(s) and does not constitute and should not be taken as formal advice.
If any advice is given by M3 Investment Group Pty Limited (M3) or any of its representatives, it is GENERAL advice, as the information or advice given does not take into account your particular objectives, financial situation or needs. You should, before acting on the advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition or possible acquisition of a particular financial product you should read any relevant Product Disclosure Statement or like instrument. M3 Investment Group Pty Limited is a Corporate Authorised Representative (1239571) of BR Securities Australia Pty Ltd (AFSL 456663) which is regulated by the Australian Securities and Investment Commission (ASIC). M3 does not warrant the accuracy of any information it sources from others. M3 and its representatives declare that they may hold interests in securities mentioned in reports from time to time.