A Dividends-and-Earnings (D&E) Approach - Finding the Value of Non-Dividend-Paying Stocks

What about the value of a stock that does not pay dividends and is not expected to do so for the foreseeable future?

The D&E approach can be used.

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

Using the above equation, simply set all dividend to 0.  

The computed value of the stock would come solely from its projected future price.

The value of the stock will equal the present value of its price at the end of the holding period.



Example:

Stock XYZ pays no dividends.
Investment period 2 year holding period.
Estimates this stock to trade at around $70 a share at end of this period.
Required rate of return 15%.

Using a 15% required rate of return, this stock would have a present value of
= $70 / (1.15^2)
= $52.93

This value is the intrinsic value or justified price of the stock.

So long as it is trading for around $53 or less, it would be a worthwhile investment candidate.

A Dividends-and-Earnings (D&E) approach to Stock Valuation

A Dividend-and-Earnings approach

One valuation procedure that is popular with many investors is the so-called dividends-and-earnings (D&E) approach, which directly uses future dividends and the future selling price of the stock as the relevant cash flows.

The value of a share of stock is a function of the amount and timing of future cash flows and the level of risk that must be taken on to generate that return.

The D&E approach (also known as the discounted cash flow or DCF approach) conveniently captures the essential elements of expected risk and return and does so in a present value context.


Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.



The D&E estimates the future stock stock price by multiplying future earnings times a P/E ratio.

Because the D&E calculation does not require a long-run estimate of a stock's dividend stream, it works just as well with companies that pay little or nothing in dividends as it does with stocks that pay out a lot of dividends.



Finding a viable P/E multiple is critical in the D&E approach

Using the D&E valuation approach, we focus on projecting 

• future dividends and 
• share price behaviour 

over a defined, finite investment horizon.

Especially important in the D&E approach is finding a viable P/E multiple that you can use to project the future price of the stock.

This is a critical part of this valuation process because of the major role that capital gains (and therefore the estimated price of the stock at its date of sale) play in defining the level of security returns.

Using market or industry P/E ratios as benchmarks, you should establish a multiple that you feel the stock will trade at in the future.

The P/E multiple is the most important (and most difficult) variable to project in the D&E approach.



Estimates required

Estimate its future dividends
Estimate its future earnings per share
Estimate a viable P/E multiple
Estimate its future price ( = P/E multiple x future earnings per share)
Estimate your required rate of return

Using the above estimates, this present value based model generates a justified price based on estimated returns.

You want to generate a return that is equal to or greater than your required rate of return.




Example

Company ABC
Our investment horizon - 3 years
Forecasted annual dividends  Yr 1 $0.18       Yr 2 $0.24      Yr 3  $0.28
Forecasted annual EPS           Yr 1 $3.08       Yr 2  3.95       Yr 3  $4.66
Forecasted P/E ratio                Yr 1 20.0         Yr 2 20.0        Yr 3  20.0
Share price at year end of        Yr 1 $61.60     Yr 2 $75.06    Yr 3  $93.20

Given the forecasted annual dividends and share price, along with a required rate of return of 18%, the value of Company ABC stock is:

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

Value
= {[$0.18/(1.18)] + [$0.24/(1.18^2)] + [(0.28/(1.18)^3]}    +     [$93.20/(1/18^3)]
= {$0.15 + $0.17 + $0.17}    +    $56.72
= $57.22

According to the D&E approach, Company ABC's stock should be valued at about $57 a share.


Comments on the above example:

1.  Assuming our projections hold up and given that we have confidence in the projections, the present value figure computed here means that we would realize our desired rate of return of 18% so long as we can buy the stock at no more than $57 a share.

2.  If Company ABC is currently trading around $41, we can conclude that the stock at present price is an attractive investment.  Because we can buy the stock at less than its computed intrinsic value, we will earn our required rate of return and then more.

3.  Note:  Company ABC would be considered a highly risky investment, if for no other reason than the fact that nearly all the return is derived from capital gains.  Its dividends alone account for less than 1% of the value of the stock.  That is only 49 cents of the $57.22 comes from dividends.

4.  If we are wrong about EPS or the P/E multiple, the future price of the stock would be way off the mark and so too, would our projected return.

Determining a Satisfactory Investment

Time value of money techniques can be used to determine whether an investment's return is satisfactory given the investment's cost.

Ignoring risk at this point, a satisfactory investment would be one for which the present value of benefits (discounted at the appropriate discount rate) equals or exceeds its cost.



The three possible cost-benefit relationships and their interpretations follow:

1.  If the present value of the benefits equals the cost, you would earn a rate of return equal to the discount rate.

2.  If the present value of benefits exceeds the cost, you would earn a rate of return greater than the discount rate.

3.  If the present value of benefits is less than the cost, you would earn a rate of return less than the discount rate.



You would prefer only those investments for which the present value of benefits equals or exceeds its cost - situations 1 and 2.

In these cases, the rate of return would be equal to or greater than the discount rate.

PE multiple is rooted in discounting theory

Valuation using multiples has its fundamentals rooted in discounting.  It is a shortcut to valuation.

In this method, all factors considered in a general DCF including cost of capital and growth rates are compressed in one figure, namely the multiple figure.  Multiples are also market-based.


Let's look at PE in detail.

PE =  Price / Earnings

Price
= PE x Earnings
= Earnings / (1/PE)


Compare this with the time-value of money equation:

PV = FV / (1+r)^n

or the dividend growth model:

PV = Div1 / (r-g)


Thus a PE multiple of 5 should nearly imply a discount rate of 20%.

The same goes for other kinds of multiples used in the financial markets:
EV/EBITDA multiples
EV/Sales
Price/Cash flow.

They are all short cuts for discounting.  The EBITDA, Sales and Cash flows are all proxies of the free cash flow.

DEFINITION OF 'DISCOUNTED CASH FLOW - DCF'

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

Also known as the Discounted Cash Flows Model.

Reference:  Finance for Beginners  by Hafeez Kamaruzzaman

How to Value a Company in 3 Easy Steps

How to Value a Company in 3 Easy Steps - Valuing a Business Valuation Methods Capital Budgeting


Valuing a Business
How much is a business worth?
Don't care about the 'asset value' or 'owner equity' of the business.
We look at the present value of its net free cash flows (FCF) plus present value of its horizon value".



Step2 - How to Value a Company for Valuing a Business Valuation Methods Capital Budgeting



Step3 How to Value a Compay for Valuing a Business Valuation Methods Capital Budgeting

Uploaded on 15 Mar 2010

Clicked here http://www.MBAbullshit.com/ and OMG wow! I'm SHOCKED how easy.. 

Just for instance I possessed a company comprising of a neighborhood store. To put together that center, I invested $1,000 one year ago on apparatus along with other assets. The equipment in addition to other assets have depreciated by 10% in a single year, so now they're valued at only $900 inside the accounting books. In case I was going to make an effort to offer you this company, what amount would an accountant value it? Relatively easy! $900. The cost of the whole set of assets (less liabilities, if any) can give accountants the "book value" of a typical organization, and such is systematically how accountants observe the worth of an enterprise or company. (We employ the use of the word "book" because the worth of the assets are penned within the company's accounting "books.") 
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However, imagine this unique company is earning a juicy cash income of $2,000 annually. You would be landing a mighty incredible deal in the event I sold it to you for just $900, right? I, on the flip side, might be taking out a pretty sour pact in the event I offered it to you for just $900, on the grounds that as a result I will take $900 but I will shed $2,000 per annum! Due to this, business directors (dissimilar to accountants), don't make use of merely a company's book value when assessing the value of an organization.So how do they see how much it really is worth? To replace utilizing a business' books or even net worth (the market price of the firm's assets minus the business enterprise's liabilities), financial managers opt to source enterprise worth on how much money it gets in relation to cash flow (real cash acquired... contrary to only "net income" that may not generally be in the format of cash). Basically, a company making $1,000 "free cash flow" monthly having assets worth a very small $1 would remain to be worth a great deal more versus a larger company with substantial assets of $500 in the event the humongous company is attaining only $1 yearly.So far, how do we achieve the exact value of your business? The simplest way would be to mainly look for the net present value of the total amount of long run "free cash flows" (cash inflow less cash outflow).Needless to say, you will come across much more sophisticated formulas to find the value of a company (which you wouldn't genuinely need to learn in detail, since there are numerous gratis calculators on the web), but practically all of such formulas are in a way driven by net present value of cash flows, plus they are likely to take into consideration a few factors for example growth level, intrinsic risk of the company, plus others.

Alternative to Discounted Cash Flow Method

What do you use if you don't want to or can't use the discounted cash flow (DCF) method of valuing a stock?  

There are other methods for valuing a stock (not valuing the company).  The most popular alternative uses various multiples to compare the price of one stock to a comparable stock.

The price earnings ratio (P/E) is the most popular multiple for these comparisons.

You can use the P/E formula to find the price based on comparable stocks.

For example, three stocks in a particular industry had an average P/E of say 18.5.  If another stock ABC in the same industry had earnings of $2.50 per share, you could calculate a stock price of $46.25 per share (= 2.5 x 18.5).  This is just an approximation, but it should put stock ABC on a comparable basis with the other three stocks in the same industry.



This strategy has several flaws.

1.  The P/E is not always the most reliable of value gauges.
2.  The process depends on the three comparables being priced correctly and there is no guarantee of that.
3.   Its biggest flaw is that the process tells you nothing of the future value of the company or the stock.

If you use this method, and many investors do, you will need to watch the stock more closely and continually measure it against comparables.  However, it does not require you to estimate anything or consider multiple variables, which is why it is so popular.

This method is best used for a quick decision on whether the stock is under-priced or over-priced.
Although you can arrive at a stock price based on the P/E formula, it is not nearly as accurate as the DCF method.



You can also use other key ratios in valuation.

These include the followings:
1.  Price/Book - Value market places on book value.
2.  Price/Sales - Value market places on sales.
3.  Price/Cash Flow - Value market places on cash flow.
4.  Dividend Yield - Shareholder yield from dividends.



So, which method should you use - DCF or multiples?

In the end, you will have to decide which method is for you.

There is no rule against using both.

Whether you calculate your own DCFs or use the estimates from others, reputable websites or analysts estimates, make sure you have the best guess available on the variables the formula needs.

Either way, make a conscious decision to buy a stock based on the valuation method of your choice and not a "feeling" for the stock.

Intrinsic Value using Discounted Cash Flows

The most common method of arriving at the intrinsic value of a stock is using the discounted cash flows (DCF) method.

DCF models are used to price a number of different assets.

The model that most stock analysts use is the DCF method.


Understanding the reasoning behind using this process.

The DCF method for valuing stocks rests on the principle of a stock is worth the sum of its future discounted cash flows.

The DCF model uses projections and estimates to arrive at a fair market value for the stock.

This is the method preferred by most stock analysts.

DCF is the favoured method of most stock investors.


The weakness of DCF model.

The weakness of the DCF model is you (and me).

The model only works if you have realistic estimates to include on future cash flows, estimated future revenues, how much risk is involved, industry analysis, and so on.

The outcome is only as good as the data you enter.

The outcomes will be tainted by the estimates you enter.

It is possible to find estimates for many of the variables on the internet; however, it is not always possible to verify how the author arrived at these conclusions.

Among industry professionals there are often wide differences in estimates and risk factors.


The strengths of the DCF model.

The model produces actionable numbers if the inputs are from professional analysts who study the market and study the stock you are researching.

The intrinsic value is still subjective because of the estimates, and other professional analysts may see the company differently.

However, your best bet for finding a reliable estimate of a stock's intrinsic value is from an expert.

[If a commentator is touting a stock, he or she should disclose if they have any financial interest in the stock or stand to gain if the price rises.]

Growth or the lack of it, is integral to a valuation exercise

The value of a business, a share of stock or any other productive asset is the present value of its future cash flows.

However, value is easier to define than to measure (easier said than done).

Valuing a business (or any productive asset) requires estimating its future performance and discounting the results to present value.  The probable future performance includes whatever GROWTH (or SHRINKAGE) is ASSUMED.

SO GROWTH (OR LACK OF IT) IS INTEGRAL TO A VALUATION EXERCISE.

This supports the point that the phrase value investing is redundant.  Investing is the deliberate determination that one pays a price lower than the value being obtained.  Only speculators pay a price hoping that through growth the value  rises above it.

Growth doesn't equate directly with value either.  

Growing earnings can mean growing value.  But growing earnings can also mean growing expenses, and sometimes expenses growing faster than revenues.  Growth adds value only when the payoff from growth is greater than the cost of growth.

A company reinvesting a dollar of earnings to grow by 99 cents is not helping its shareholders and is not a value stock, though it may be a growth stock.

Value investing is conventionally defined as buying companies bearing low ratios of price-to-earnings, price-to-book value, or high dividend yields.  But these metrics do not by themselves make a company a value investment.  It isn't that simple.  Nor does the absence of such metrics prevent an investment from bearing a sufficient margin of safety and qualitative virtues to justify its inclusion in a value investor's portfolio.

How do you value company DEF?

Company DEF

This company is in a business sector with durable competitive advantage and economic moat.  Its management has delivered many years of consistently good performance.  Its long term shareholders have been richly rewarded.


Financial data

ttm-Earnings $ 367 million
DPO 48%
Dividends paid $ 177 million
Market cap $ 5100 million


PBT Margin 36%
PAT Margin 27.3%
ROE  22.1%

ttm-PE 13.9x

EY  7.2%
DY 3.47%

Risk free interest rate 4%


How much would you pay to own this company?

Based on earnings stream:   Asset value = $ 9175 million
Based on dividends stream:  Asset value = $ 4425 million

At present market capitalization of $ 5100 million, the reward: risk ratio is as follows:

Upside = $ 4075 million
Downside = $ 675 million

Upside reward :  Downside risk = 6 : 1


Now, this company has been growing its earnings at 15% per year for the last 10 years.  It has also paid growing dividends over these years.  It is also predicted to a high degree of confidence that this company can continue to deliver such growth.

For those with a long term horizon in their investing, is this company under-valued, fairly valued or over-valued?

Present Value is the discounted value of all its future cash flows, and remember that growth is a factor in the calculation of Present Value.

Remember also the three important words in investing - Margin of Safety.

Do you have a margin of safety in your investing into this company at today's price?

How do you value this company XYZ?

I have been looking at this company.  Its business is doing very well.  It has grown its revenues, profit before tax and earnings consistently over the last few years.  Its business is growing and it is opening new branches in various towns/cities in our country.

Its net profit margins are high (>20%), its ROE is high (> 25%) and it pays about 30%+ of its earnings as dividends.

Its trailing-twelve months earnings was $113.1 million and its market capitalisation recently was $1642 million.


How would you value the earnings and dividends of this company?

Using the thinking similar to that of Buffett:

1.  The risk free interest rate offered by the banks is 4% per year.
2.  How much deposit would you need to put in the bank to earn $113.1 million per year?
3.  Answer:  $113.1 million / 4% = $2827.5 million.
4.  This company pays out 30%+ of its earnings as dividends, i.e. about $40 million.
5.  How much deposit would you need to put in the bank to earn $40 million at present prevailing interest rate of 4% per year?
6.  Answer:  $40 million / 4% = $1000 million.
7.  A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8.  On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9.  Assuming that this company can grow its earnings at a very low 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10.  Let's continue with the analogy above.
11.  With its earnings of $ 113.1 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of $ 113.1 million / (4% - 2%) = $ 5655 million.
12.  With its dividend of $ 40 million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of $ 40 million / (4% - 2%) = $ 2000 million.


To summarise:

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of $ 2827.5 million.
- the dividends stream is the equivalent to an asset of $1000 million.

When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is $ 5655 million.
- the dividends stream is $ 2000 million.

This company's market capitalization was $ 1642 million recently.  Assuming no growth in the earnings of this company, the value of this company is anywhere between $1000 million (this price is supported by its dividend yield) and $2827.5 million (supported by its earning yield).

At $ 1642 million, its reward:risk ratio = 64.9%: 35.1%.


Conclusion:

Since, this company is projected to grow its earnings with a high degree of predictability, at its present price of $ 1642 million, those who are buying into this company at the present price, enjoy a large margin of safety.

How to Determine the VALUE? Illustrated by Buffett's investment in GEICO.

GEICO

1976

When Buffett started buying GEICO, the company was close to bankruptcy.

But he says GEICO was worth a substantial sum, even with a negative net worth, because of the company's insurance franchise.

In 1976, the company had no earnings, and this defied a mathematical determination of value as put forth by John Burr Williams.

Williams postulated that the value of a business is determined by the net cash flows expected to occur over the life of a business discounted at an appropriate rate.  

Despite the uncertainty over GEICO's future cash flows, Buffett was sure that the company would survive and earn money in the future.  

How and when was open to speculation.

1980

In 1980, Berkshire Hathaway owned one-third of GEICO, invested at a cost of $47 million.   That year, GEICO's total market value was $296 million.  

Even then, Buffett estimated that the company possessed a significant margin of safety.

In 1980, the company earned $60 million on $705 million in revenues.  Berkshire's share of GEICO's earnings was $20 million.

According to Buffett, "to buy a similar $20 million in earnings in a business with first class economic characteristics, and bright prospects would cost a minimum of $200 million" - more if the purchase was for a controlling interest in a company.

Let's look at Buffett's $200 million assumption.  Is it realistic, given the theory by Williams?

Assuming that GEICO could sustain this $60 million in earnings without the aid of any additional capital, the present value of GEICO, discounted at the then-current 12% rate for a thirty-year U.S. government bond, would have been $500 million - almost twice GEICO''s 1980 market value.

PV (no growth)

= $60 / 12% 

= $500 million.

IF the company could grow this earnings power at 2% real, or at 15% before current inflation, the present value of GEICO would increase to $600 million, and Berkshire's share would equal $200 million.  

PV (2% earnings growth rate)

= $60 million / (12%-2%) 

=  $60 million / 10% 

= $ 600 million.

Conclusion

In other word, in 1980, the market value of GEICO's stock was less than half the discounted present value of its earnings power.

Are you truly operating on the principle of obtaining value for your investments? Carry out the discounted-flows-of-cash calculation.

All the shorthand methods - high or low price-earnings ratios, price-to-book ratios, and dividend yields, in any number of combination, Buffett says, in determining whether "an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investments...............Irrespective of whether a business grows or doesn't, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase."  

How to Value a Company in 3 Easy Steps

Valuing a Business:
How much is a business worth?
Don't care about the 'asset value' or 'owner's equity' of the business.
We look at the present value of its net free cash flows (FCF) plus present value of its "horizon value".

Understanding Valuation Principles

The basics of valuation are:

1.  The Time Value of Money:  This states that $1 received today has a different value from $1 received a year ago or $1 received a year from now.

2.  Present Value:  This is the concept that money spent tomorrow must be worth less today because of the time value of money.  It is calculated by using the formula

PV = CF  /  (1+r)^n

where

PV = present value
CF = cash flow for the period
r = discount rate
n = period


Methods of valuation are:

1. Replacement method
This method tends to be the simplest to explain but the most time-consuming to produce.

This method would measure all the costs involved in creating an exact duplicate company.  Those costs might include:
Land
Buildings
Machinery
Equipment
Working capital.

2.  Capitalization of Earnings
This is one of the more common and relatively straightforward methods of valuation.This method uses a risk rate to assess the value needed to generate the same amount of income as the business being valued.

A company is expected to generate exactly $10,000 each year in income indefinitely.  Assuming that the buyer can earn a guaranteed rate of interest of 5% elsewhere, an investment of $200,000 would earn $10,000 in interest each year.  Therefore, the company has a value of $200,000.

Unfortunately, such risk-free situations rarely exist.  Thus, with increased risk, a higher capitalization rate would have to be assessed to estimate fair value.  These rates vary, and some might argue that they are entirely arbitrary.  The result will prove highly sensitive to this rate.  As a result, many believe the capitalization of earnings method is problematic.


3.  Discounted Cash Flow Valuation
This is one of the most commonly used methods.

The entire process can be condensed into four steps:
1.  Calculate projections for future cash flows.
2.  Calculate the cost of capital, or the discount rate.
3.  Calculate the present value for each year's cash flow.
4.  Finally, take total of those present value cash flows.

Completing these four steps provides a very close estimate of the valuation for the company.  The sum of these discounted cash flows is the company's valuation ... well, almost.

However, the company doesn't simply dissolves at the end of the DCF study period.  The company continues to operate long after those projections end, meaning there is residual value that has to be considered.

To account for what happens after the projections end, the concept of terminal value is employed.  Terminal value is a concept used to calculate the value of an asset that continues after the projections end, or into perpetuity.

The method of choice involves using the present value of a perpetuity.  A perpetuity is an instrument that makes payments year after year without end.  You can use the formula to calculate a perpetuity that assumes growth or a simpler formula to calculate one without growth.  The two formulas are given here:

Perpetuity without growth = CF / r
Perpetuity with growth = CF / (r - g)

where

CF = cash flow
r = discount rate
g = growth rate


For example:

• Given the 5 year cash flow projections.  
• Find the present value of these 5 year cash flows.
• The next step is to get a year 6 cash flow estimate.  Having this cash flow estimate, assume it stays constant each year after that or it grows at a low rate.  
• Then calculate the present value of that perpetuity.  The present value of this perpetuity is treated as the value at the beginning of year 6.  
• Then calculate the present value of that perpetuity in today's dollars by discounting it back 5 years by using the present value formula.  
• Add the present value of perpetuity to the total discounted cash flows for the first five years. 
• That results in the company valuation and at this point, the analysis of this company has concluded.  

A simple 10-Year Valuation Model
A step by step DCF model for calculating the equity value of a company (Source: Morningstar, Inc.)


Step 1:  Forecast free cash flow (FCF) for the next 10 years.

Step 2:  Discount these FCFs to reflect the present value.

Step 3:  Calculate the perpetuity value, using the FCF of the 10th year, and discount it to the present.

• Perpetuity Value = FCF(10th Year)  x  (1 + g)  /  (R - g)
• Discounted Perpetuity Value = Perpetuity Value / (1 + R) ^ 10

Step 4:  Calculate total equity value by adding the discounted perpetuity value to the sum of the 10 discounted cash flows (calculated in step 2)

• Total Equity Value = Discounted Perpetuity Value + 10 Discounted Cash Flows

Step 5:  Calculate per share value by dividing total equity value by shares outstanding:

• Per Share Value = Total Equity Value  / Shares Outstanding

4.  Comparable Multiple Valuation

The final method of valuation is the most commonly used and probably the easiest to use as well.

It is based on benchmarking one company against an industry-average multiple such as the P/E (price-to-earning) ratio.  This could also be applied to other variations on this multiple, such as P/EBIT or P/EBITDA.

Generally speaking, if a company's P/E ratio is greater than the industry average, it is fair to say that the company is overvalued.  If the company's P/E ratio is less than the industry average, it is fair to say that the company is undervalued.  However, be caution, no rules are without exception.    Many companies are seemingly undervalued, but for good reason.  For example, a company might be a party in a pending lawsuit, and the market has undervalued the company because it is unclear what the ruling will be.

The comparable multiple method of valuation forms at least a starting point for making some basic assumptions about a company's value.  

Morningstar's Equity Valuation Methodology

Stock Strategist

Introducing Changes to Morningstar's Equity Valuation Methodology 

We've enhanced our methodology, which could result in modest fair value changes.

By Matthew Coffina, CFA | 05-17-12 | 

At Morningstar, we assign fair value estimates to around 1,800 companies across the globe. Each of these fair value estimates is based on a rigorous discounted cash flow (DCF) model built by one of our analysts using a standard Morningstar template. Occasionally, we find ways to improve our methodology. Over the next several months, we will be rolling out the sixth generation of our internal DCF template. In this article, we describe some of the key features of our updated valuation methodology.

Changes to our methodology may require adjustments to some of our fair value estimates, which you may notice in the coming months as analysts transition their companies to the new model. Some of these changes will tend to increase our fair value estimates, while others will cause our fair value estimates to decline.

Morningstar's Three-Stage Discounted Cash Flow Valuation
Our DCF model includes three stages of analysis. The first stage includes our forecasts for the next five to 10 years. In the first stage, analysts make explicit forecasts for all of a company's important financial statement items, such as revenue, operating costs, capital expenditures, and investments in working capital.

In the second stage, analysts are more limited. We take earnings from the last year of Stage I and assume that they grow at a constant rate. We determine the investment needed to achieve this growth by assuming a constant return on new investment. Analysts are responsible for choosing the growth rate, the rate of return on new investment, and the length of Stage II, but otherwise don't need to make explicit forecasts for individual financial statement lines.

Stage II assumptions are the primary vehicle for incorporating our analysis of economic moats in our fair value estimates. Companies with wide and narrow moats are expected to earn returns on new invested capital that exceed their cost of capital in Stage II. The wider the moat, the longer Stage II is likely to last. In general, we assume narrow-moat companies can earn excess returns on capital for at least 15 years, while wide-moat companies can earn excess returns on capital for at least 20 years.

Our model concludes with a third stage. In Stage III, all companies are assumed to be the same. Return on new invested capital is set equal to the weighted average cost of capital; every moat is eventually eroded--no company can earn excess returns forever. We also assume returns on existing invested capital remain constant in Stage III.

Our latest model includes several alternative Stage II-III methodologies, as well. These include terminal multiples (such as EV/Sales and EV/EBITDA) and the ability to enter the total value of cash flows beyond Stage I directly. These alternative approaches should only be used in special circumstances where the standard three-stage method would be inappropriate.

A change to our formulas for valuing Stage II and Stage III cash flows will have the largest downward effect on our fair value estimates, particularly for companies where a significant portion of value is concentrated in these later periods. This is because of more conservative assumptions for long-run reinvestment needs relative to previous versions of our model.

Estimating the Cost of Capital
We discount future cash flows using the weighted average cost of capital, which incorporates the cost of debt, equity, and preferred capital. The discount rate is a key assumption in any DCF model. While the cost of debt and preferred stock can be observed in the marketplace, the cost of equity presents a significant challenge. In the past, analysts have been allowed significant discretion in choosing a cost of equity (COE), but we have formalized our approach in the latest model.

The most common methodology for estimating the COE in practice is the Capital Asset Pricing Model (CAPM). However, we find that the CAPM raises more questions than it answers by replacing one unobservable input (the cost of equity) with three (the risk-free rate, the equity risk premium, and beta). Even among experts, there is significant disagreement about appropriate values for the equity risk premium and beta.

Since we believe our analytical advantage is in estimating cash flows rather than making precise estimates of inherently unknowable quantities, we have chosen a greatly simplified approach that still captures the essence of the CAPM. We will be assigning each of the companies in our coverage universe to one of four "systematic risk buckets." For companies based in the U.S. and several other developed markets, below-average systematic risk will correspond to an 8% COE, average to a 10% COE, above average to a 12% COE, and very high to a 14% COE. Some international markets will require that a premium be added to these values, currently ranging from -1% for Japan to +11% for Greece.

Holding all else equal, we expect our enhanced cost of capital methodology to result in modest increases to most fair value estimates. However, in some cases where companies are deemed to have above-average systematic risk, it is possible that the new methodology could result in slight downward pressure on some fair value estimates.

Accounting for the Time Value of Money
The final significant change to our methodology involves the time value of money. Discounted cash flow valuation produces an estimate of a company's worth as of a specific point in time. That value tends to increase over time as cash flows are earned and future cash flows are discounted less.

In the past, fair value estimates in our models have adjusted continuously, with the published fair value estimate representing the valuation as of the day of publication. Unfortunately, this means that our fair value estimates can become stale as time elapses between report updates. It can also make it difficult for analysts to parse the causes of a change in a fair value between altered assumptions and the time value of money.

We are enhancing our time value of money methodology so that in the future, our fair value estimates will refer to the end of the current fiscal year. Fair value estimates will be updated for time value of money only once per year, when we roll our models. This should make our fair value estimates more forward-looking as well as provide better clarity around the causes of fair value changes. In isolation, this change would tend to increase our fair value estimates modestly.

http://news.morningstar.com/articlenet/article.aspx?id=553332&pgid=stockarticle

Equity Valuation Methods

Insightful discussion on valuation methods from a blog.

http://www.theequitydesk.com/forum/forum_posts.asp?TID=2029&PN=7

Posted: 22/Feb/2009 at 9:31pm
Originally posted by kanaka_basi

Originally posted by kannanravi1


Hi Srini,
Discount rate is typically what you think you should earn for taking the risk of owning stocks. Typically many fund managers add a risk premium over the treasury bond rates (treasury rates are thought to be zero risk). Eg: If treasury rates are 5%, some may think that 10% should be the risk adjusted rate. Buffett always goes by the treasury rates because he believes that his picks have zero risk! So, I guess one has to find his own comfortable rate.

Kannan

PS: Any suggestions about how wrong/ right this method is??

Hi Kannan,

I saw this link http://www.moneychimp.com/articles/valuation/buffett_calc.htm which uses the discount rate as an opportunity cost of not investing in the least riskiest of asset classes (treasuries).

I thought that the expected confidence percentage (or probability that the earnings growth would be met) and the fact that my opportunity cost would be the treasury rate gave me the worst case scenario in trying to find the intrinsic value of the stock... and also the assumption that the compnay would grow only 5 years into the future...

Your opinions??


Hi,
I too use the very same link for my DCF calcs!! Good to see I am not alone! I typically use a confidence margin ranging from 50% to 75% (for companies with extremely strong moat I use 75%). I use the opportunity cost as the treasury rate (I don't track the rates religiously but use 6 to 8%). I also predict growth only for 5 years and love to get stocks with no growth priced in. Even if I assume growth I try to keep at or below the GDP growth rates. Don't know if this gives me worst case scenarios but hopefully I am being conservative enough so that I have cushions for any mistakes in my valuation. Also personally I think that the best way to be conservative and risk-free is through buying companies with significant moats. This is a qualitative factor though unfortunately. Buffett once stated that he uses risk-free treasury rates because he believes that the companies he buys in are as stable and risk free as a treasury bill!!

Intrinsic Value: There are two fatal weaknesses of any DCF model.

Why Stock "Value" Systems Have No Value

John Price, PhD

We regularly get asked how Conscious Investor is different from the countless "value" based software products and books available. The vast majority of "value" approaches are based upon a standard discount cash flow (DCF) model. They all purport to find what is called the intrinsic value or true value of a stock. This is the value the proponents claim that all rational investors should pay for the stock. Many of the authors and investment websites claim to base their intrinsic value approach upon the methods of Warren Buffett. In fact, it is actually very unlikely that he really uses any of these methods in anything vaguely resembling a formal approach. For example, Charlie Munger, the old friend of Buffett and the Vice-Chairman of Berkshire Hathaway, says that he has never seen Buffett do any discount value calculations. This is consistent with the answer he gave when asked about intrinsic value at the annual meeting of Berkshire Hathaway in 1996. "There is no formula to figure it out." He replied. "You have to know the business." Until recently, Buffett had never used a computer for anything, let alone for implementing any value models. Now he only uses it to play bridge on-line. When people write about Buffett I usually agree with most of the general observations made about his approach. The one area where Conscious Investor differs from the majority of Buffett followers (but quite likely not with Buffett himself) is in relation to the "valuation" model used. There are large numbers of DCF models. Stable growth models, two-stage models, three stage models and so on. Each of these models calculate the intrinsic value of the stock by discounting back to present time the stream of "cash" that is generated by the business. All I can say is that it is hard to believe that such simplistic and unreliable material is still taught in universities and promoted by stock analysts. The main problem is that people think that just because they can put some numbers into a formula they have found a useful and realistic model. Here we are talking about all the academics and writers who have limited understanding of the interface between mathematics and the real world. Two Fatal Weaknesses There are two fatal weaknesses of any DCF model. The first is that DCF models are unstable — small changes in the input values can lead to such large changes in the output that almost any number can be obtained. Here is a simple example showing just how unstable intrinsic value calculations are. The model uses the standard two-stage approach. We assume that the company spends ten years in the initial stage during which the cash per share (generally the free cash flow) that it generates grows by the rate given in the second column. After the initial stage comes the steady state period. During this period the cash is assumed to grow at the rate described in the third column. Finally, everything is discounted back to present time using the rate given in the fourth column. With small changes in the input variables, the output can shift from $23 to $58. I can't help getting the image in my mind of the host of an old television show saying, "Would the real intrinsic value please stand up?" Current Cash Initial Growth Rate Final Growth Rate Discount Rate Intrinsic Value $1.00 10% 4% 11% $23.09 $1.00 11% 5% 10% $33.50 $1.00 12% 6% 9% $58.00 And then you have to do the same estimate for the discount rate. If a model with this level of instability was proposed in a science class, it would be thrown out of the window. The second fatal weakness is that just because some model says it is generating something called intrinsic value does not mean that it is providing anything that really is "intrinsic value". And it certainly does not mean that it is giving something useful for investors. For example, just because a stock is undervalued (by some model or other) does not mean that it won't stay undervalued. This is quite different from saying that if a company has a strong economic performance, then eventually the market will acknowledge this by increased stock prices. Another weakness The instability described above is compounded by the fact that it is impossible to confirm the accuracy of two of the input variables. For example, the entry for the final growth rate requires that you estimate the growth rate of the cash not for another ten years, or even twenty years, but out to infinity! This is despite large studies showing that analyst forecasts for earnings over five years are no better than random. In contrast, in Conscious Investor we don't try to calculate the mythical concept of intrinsic value. We don't talk about whether a stock is undervalued or overvalued, whatever that may mean. Rather we define value in terms of the return you will get on an investment. Instead of intrinsic value, we talk about investment value or investment return. This is calculated using the proprietary tools STRETTM and STRETD®. STRET is a calculation of the annualized percentage profit or rate of return from owning the stock. STRETD is similar except that it assumes that dividends are reinvested. By calculating the actual return you can anticipate on your purchases, you get practical criteria whether it is worthwhile buying stock in a particular company or not. So in a nutshell, if you were to compare the stocks selected by Conscious Investor with other "value" models freely available on investor websites, you are unlikely to find much overlap between the selections. Despite the best intentions of would-be intrinsic value systems, the way that DCF models work either provide you with more or less random stocks or with stocks that you like and you (unconsciously) manipulate the data to make them appear undervalued. The Conscious Investor for more details ... The book The Conscious Investor: Profiting from the Timeless Value Approach by Dr John Price covers over 30 valuation methods including their assumptions, and their strengths and weaknesses.

http://www.conscious-investor.com/articles/articles/ar04value.asp

Using Discounted Cash Flow (DCF) Analysis to Value Stocks

Wall Street Prep Lessons: Cash Flow, DCF, WACC, LBO, M&A, Trading and Transactions

Discounted Cash Flow (DCF) Explained in Two Minutes