How to value stocks
Any investment is profitable if and only if it is bought at the right price. Stocks are no exception. A stock should be purchased at a price that justifies the current profits of the company and has room to grow.
So, the most important thing to determine the right price is how much the company is earning from its operations. The next important thing is how quickly the profits are expected to grow.
So far we have seen that there are two parameters to determine the stock price of a company:
1) The profits 2) The growth rate of the company's sales and profits.
However, there are some more parameters that are not so obvious. They are :
1) The profit margin of the company
2) The debt owed by the company and the interest it is paying on it.
3) The amount of cash and other assets owned by the company.
4) How long the company can maintain its current profit margins.
5) The break up of long / short term assets and liabilities.
6) How much additional cash intake is required by the company to maintain its growth?
7) Ho much money can be made by simply investing the money in an indexed fund?
8) What is the <Beta> or the volatility of the stock?
Why are all these factors important? Read on.
What matters is not only how much money the company is making, but also how efficiently it is making that money.
The whole financial theory behind this can be expressed in two words: "Opportunity Cost". In other words, "how much the company would have made by simply investing its capital in stock market ?". This leads to the following two metrics to determine the performance of the company:
1) Return on Assets (ROA) 2) Return on Equity (ROE)
For the sake of understanding let us do this:
Imagine you wanted to buy a rental property to make some money by renting. However, let us say, you have only 20% of the price of the house. So you use that 20% as a down payment and borrow the remaining money. You have to pay certain interest or mortgage on this borrowed money.
Is it a good buy or not? In order to answer this, you should ask the following questions:
How much rent is this property earning? How much is the mortgage, insurance, taxes and other expenses? How much money you could have made by simply investing your 20% down payment in stock market? Was it a good decision to buy this rental property?
Now a company is similar to this rental property. The company's earnings are like the rent. The assets are like the down payment on the house. And so on!
Valuing Stocks based on Abnormal earnings
What does "abnormal earnings" mean ?
First we should under stand the concept of "opportunity cost". Simply speaking, opportunity cost is the money that could have been made by investing the capital in an indexed fund.
Let us say a company has $100 million in assets. Let us assume that the company could have earned $7 million a year by simply investing its assets in an indexed fund. This $7 million is the opportunity cost. Now, if the actual earnings of the company are $10 million a year, then the abnormal earnings are $3 million only. (Subtract $7 million from $10 million).
In this method, the future abnormal earnings of the company are discounted at the rate of cost of equity to arrive at the stock price.
What is discounting?
A dollar in hand today is worth more than a dollar received a year later. So, in order to calculate the current stock price we have to adjust the future earnings to get the real worth in today's dollars.
Valuing Stocks Based on Free Cash Flow
Free cash flow is the cash in flow to the company. The free cash flow is the difference between the net operating profits after taxes (NOPAT) and the increase in the Net Operating Working Capital (NOWC).
NOPAT = Net Income + After Tax Interest Expense
NOWC = Current Assets - Current Liabilities (Non interest bearing)
Every company needs some working capital to operate its business. In order to grow the business, the company has to invest more in working capital. The stock price of the company can be determined by estimating the future cash flows and discounting them at cost of the assets.
Using this method needs certain amount of financial knowledge.