Today we cover (or atleast try to) one of the more important aspects of investing, arguably the most important, which is valuations. You may have heard of stocks being labelled as overvalued or undervalued, so let’s clear the air on that.
As the name suggests, valuation essentially means finding out what roughly is the worth of the asset or company you are looking at. One thing to note: there is no way you can find out exactly what a firm is worth today. There are tons of different methods and models used by analysts to arrive at calculated estimates of a firm’s true value. So you can’t really know the true value of a stock in the markets, otherwise everybody would have been rich and we wouldn’t be here discussing this stuff today.
Why valuations matter?
Coming on to the more important question, why do we need to do all this in the first place? Aha, you see we tend to forget the fundamental meaning of investing along the journey sometimes, which is essentially finding out great businesses that are selling for much less than what they are really worth. And there is no point investing in a firm if you buy it for much more than what it really should be costing you. This is one mistake that we believe all investors make at some point. We see that the company shows great promise everything looks great, but when you buy it, for some reason the stock refuses to go up above a certain point. Or even worse, you incur heavy losses on it. This is why it is so important to learn about valuations and atleast have a basic idea as to how the market (or rather all investors) value the stocks.
The Discounted Cashflow Model
Alright then lets take a closer look at one of the most popular methods to value a company, the discounted cashflow model (DCF).
The concept of DCF is pretty simple and logical. What we are essentially doing here is we forecast the future free cashflows of a company and discount them to the present. Free cashflow (FCF) is essentially cash you could take out from the company without affecting any of its operations or capital expenditure, i.e., FCF = Cashflow from Operations – Net Capex. In short, Free Cashflow is the really good stuff you are looking for in any good investment. Why? Because a firm producing a lot of free cashflow has a lot of financial flexibility as it need not rely on anything else for its expansion. Firms with negative free cashflow usually have to take up debt or find other sources of funding, thus raising their risk quotient.
So we forecast the company’s future free cashflows (lets say for 10 years) assuming a modest growth rate (maybe the average of last 3 years). Now we discount those future cashflows to the present by assuming a discount rate. This is done because future cashflows are worth less than the money you can receive today (since you can invest it now to earn returns) and have an uncertainty associated with them as well since we have a slight chance of not receiving them at all. Assuming a discount rate is a little vague, you could take the government bonds interest rate as a benchmark and then adjust the discount rate according to the risk associated with the firm. The riskier the investment, higher the discount rate you would want to assume for it. Basically assume a discount rate and adjust according to the results it shows.
Ok now that we are done with the Discounting of cashflow part of the model, we come to the final step. We calculate the perpetuity value which you could think of as the value of cashflows till after the initial 10 years we forecasted. Then discount this as well to the present and add it to the earlier calculated discounted cashflows. This gives you the total equity value. Simply divide that by the no. of shares outstanding of the company in the market and Voila you have an estimate of the per share value of the company!
Even if you don’t understand everything we just discussed not to worry, the key thing to note about DCF is that it simply takes into account the future cashflows of the company and arrives at an estimate by discounting them to the present. And cashflows are just one key factor out of the numerous different ones that influence the growth of a company. This is why we have tons of different models like DCF and none of them can give you the exact worth of a company. But then again it does give you a solid estimate and having even just that is a big advantage than going in blind in the stock market 😉