This guide is for investors willing to spend significant time assessing and valuing stocks. It is for investors who prioritise a small number of high-quality stocks in their investment strategy. Quality in this context is measured by the depth of analysis, not by how undervalued it is.
Qualitatively, investors must understand, or at least be interested in learning about, the business of the stock. This article focuses on the quantitative analysis aspect of investing. Specifically, it will focus on determining a company’s intrinsic value.
The investor should complete the steps leading up to quantitative financial analysis before determining the company’s intrinsic value. The most important one is stock filtering, which was discussed in detail in the previous issue of this series. Assuming a stock has passed all tests, the final step is to compute the company’s intrinsic value. This is important because it indicates whether a stock is undervalued or overvalued relative to its current share price.
There are five quantitative methods for determining a company’s intrinsic value; a combination of one or more is recommended. The five methods are discounted cash flow analysis, margin of safety analysis, price-to-value analysis, sensitivity analysis and comparables analysis. For each method, compute the best-case and worst-case fair prices.
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1. Discounted Cash Flow analysis
The Discounted Cash Flow (DCF) method is a powerful way to compute a company’s intrinsic value and can serve as a standalone valuation method. The investor should familiarise themselves with the main components of a DCF: future cash flows, terminal value and discount rate.
Future cash flows are the expected cash flows from the business over a clearly defined, predictable period and the growth rate of these cash flows should be determined. This is where understanding the business is essential; both an optimistic and a conservative forecast should be used, based on the expected volatility and consistency of cash flows.
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The terminal value is the forecast value beyond the projection period, and a growth rate that reflects the period when the business is expected to grow stably can be used. The goal is to discount both the future cash flows and the terminal value to present value using the discount rate.
The discount rate reflects the business’s risk profile; higher values indicate greater risk and larger discounts to value. Usually, the weighted average cost of capital (WACC) is used as the discount rate, reflecting the required rate of return for shareholders and bondholders. In other words, it is the opportunity cost.
Again, both an optimistic and conservative discount rate should be used. The inputs should be subjective, based on how well the investor understands and can justify the figures. There are online tools investors can use to compute DCF values, and investors must use both best-case and worst-case scenarios to arrive at a range of fair price valuations.
2. Margin of Safety analysis
The Margin of Safety (MoS) analysis in this context should not be mistaken for other analyses which have the same term.
MoS is a valuation metric specific to the company’s financial health and safety. It is used to determine how much the investor would receive if the stock or company were dissolved at this moment.
Firstly, every item in the asset section of a balance sheet should be discounted. Liabilities are reported at the amounts recognised, and any contingent liabilities are included. The goal is to arrive at a discounted or adjusted net asset value (NAV).
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The less liquid an asset is, the greater the discount or adjustment applied to it. One thing to note is that there is no discount for cash because it is the most liquid asset. However, for property, plant and equipment, there can be significant discounts based on the difficulty of selling the asset, taking into account factors such as salvage value and fire-sale prices.
Also, intangible assets such as goodwill can be difficult to value and discount, so that they may be ignored or discounted by 100%. As with DCF, a range of optimistic and conservative discount rates should be used in the MoS analysis.
When the investor arrives at the adjusted NAV or book value per share, they should consider additional financial safety metrics and further discount or adjust the adjusted NAV. This includes, but is not limited to, the company’s liquidity and solvency.
Liquidity can be measured using the quick and current ratios, while the interest coverage ratio (ICR) and the proportion of debt in the capital structure can measure solvency. Other factors, such as the Altman Z-score, debt grade rating, and likelihood of default, can be incorporated into the final range of adjusted NAV per share.
If the worst-case scenario happens, after settling what the company owes and selling what the company owns, the margin of safety is the difference between how much an investor would pay (reflected by the share price) and how much they are expected to get if the company winds up (reflected by the adjusted NAV).
3. Price-to-value analysis
The price-to-value analysis covers what an investor would do under the checklist approach discussed in the previous issue of this series. Essentially, it is the difference between price growth and the company’s value growth.
Specifically, use a few periods rather than one. For example, comparing the growth in value against the growth in price over a one-year, three-year, five-year and 10-year period. Since price growth is fixed, only value growth can be adjusted.
The value in this context is subjective and can be any financial metric the investor deems vital in determining a company’s value. As a guide, the revenue, net income, operating cash flow (OCF) and free cash flow (FCF) are used, and each component can be weighted to arrive at a final weighted value. For example, OCF is likely to be a more accurate measure of a company’s value than net income and should therefore be weighted more heavily.
If there is a difference between price growth and value growth, then the average percentage difference can be added to the company’s current share price. There should be a valuation range, but there will not be any optimistic or conservative inputs. The valuation range should be set by the weights each investor assigns to each component in valuing the company. Also, the investor can add or adjust variables or financial metrics to determine the company’s growth in “value”.
For example, using revenue, net income, OCF and FCF, an investor would see a weighted-average growth rate of 15%, whereas using only OCF and FCF would yield 30%. If the share price growth is 20%, the fair price range under the price-to-value analysis would be between –5% (15%–20%) and +10% (30%–20%) of the company’s current share price.
4. Sensitivity analysis
The sensitivity analysis is the most straightforward one and is essentially a what-if analysis.
Investors can use a range of business-specific variables to assess how they affect revenue, net income, and cash flow. This way, worst-case and best-case valuations can be computed easily.
Separately, investors can use management’s estimates to assess how the share price performs after the results announcement. In other words, it is about selecting the variables or business metrics that most affect share price movement, and weighting them accordingly.
Sentiment can also be incorporated into the sensitivity analysis. Analyst estimates, calls and target prices can sometimes have a significant impact on share prices, so they can be utilised in the sensitivity analysis.
5. Comparables analysis
The comparables analysis assesses the company’s relative valuation against its own performance and that of its peers.
Usually, price multiples are used in comparable analysis, where current and forward price ratios, including price-to-earnings (P/E), price-to-book (P/B), and enterprise value-to-earnings before interest, taxes, depreciation and amortisation (EV/Ebitda), are used.
These current and forward price ratios are compared against the peer or curated group average to determine whether the stock trades at a discount or a premium. If the stock trades at a discount, it is undervalued and would have a higher fair value than its current share price.
Also, the company’s price ratios can be compared against historical levels, such as the number of standard deviations it is currently trading at relative to the three-year or five-year average. Again, anything lower implies it is undervalued and would result in a higher fair price.
The range of fair price valuations under this analysis would be determined by the various comparable price ratios, since there are no best-case or worst-case inputs.
6. Calculating the intrinsic value
These five methods can be weighted according to how investors perceive the importance of each analysis. To determine the final intrinsic value, use the midpoint of the best-case and worst-case fair prices for each method. The following example will illustrate this for Company A, which currently trades at $50.
For the DCF, the best-case valuation is $100, the worst-case valuation is $40 and the midpoint is $70. The midpoint of the margin of safety is $60, since the best-case valuation is $70 and the worst-case is $50. For price-to-value, sensitivity, and comparables analyses, the mid-valuation is $50, $40 and $30, respectively. The weights for DCF, margin of safety, price-to-value, sensitivity, and comparables analyses are 30%, 25%, 20%, 15% and 10%, respectively.
Hence, the final intrinsic value is ($70 x 30%) + ($60 x 25%) + ($50 x 20%) + ($40 x 15%) + ($30 x 10%), totalling $55. Since the share price is $50, the stock is undervalued by 10%.
