How to Value a Company in 3 Easy Steps

How to value stocks and shares

This article shows how you can value any security - if you know how much it will pay, when it will pay it and the return you want to make.

Time value of money

The principle is known as the 'time value of money' and we can flesh it out with an example. We'll assume that all money earns interest at 8% a year and costs the same to borrow. On that basis, if I have $100 now, what will it be worth in 10 years' time?

The answer is: 100 x 1.0810 = $215.89. Now, if someone offered you $215.89 in 10 years' time, how much would you pay them now for it? The answer goes like this. The money you pay now is either money that won't be earning interest for you at 8% a year for the next 10 years, or it's money that you've borrowed and on which you must pay interest at 8% for the next 10 years. Either way, paying out money now costs you 8% a year until you get it back. So, to buy a cash flow of $215.89 in 10 years' time, you'd pay up to $100 because, if you'd kept the $100 (or not borrowed it), you'd have turned it into $215.89 over 10 years (or saved yourself that amount).

So the $215.89 in 10 years' time has a value of $100. If you paid more than that then you'd make a loss; if you paid less, then you'd make a profit; and if you paid a lot less, then you'd make a really good profit. That's value investing.

Why 8%, though? Good question. It was nothing more than a stab in the dark really. People will argue until the cows come home about the right figure to use. Essentially, it should represent the 'opportunity cost of capital'. So you'd come up with a different figure depending on what you might otherwise plan on doing with the money. If you would otherwise have put it into a term deposit paying 5%, you'd use 5%. If you might otherwise have put it to work in an exciting business venture on which you expected to make 15% a year, then you might use that figure (although anticipating a return of more than 10% is pretty optimistic by most standards).

Of course most securities have more than one cash flow to consider, which means that to get the total value you have to work out the value of each individual cash flow and then tot them all up. How much would you pay for a bond that promised to pay $7.50 at the end of each of the next nine years, and then $107.50 at the end of the tenth, assuming you wanted to make 6% a year? Looking at things from the other direction, what would be your annual return if you paid $106.73 for the bond?

Principle always the same

Doing all the sums is beyond the scope of this article (but the answers are $111.04 and 6.56% in case you want to check your working and, if you're hungry for more, take a look at the Investor's College articles of issue 110/Aug 02 and issue 163/Oct 04). But the principle is always the same: all cash flows have a value according to when they are going to be received and the 'opportunity cost' (otherwise known as the 'discount rate') you ascribe to them. To get the value of a set of cash flows, you just tot up the values of the individual components.

When you get a cash flow that repeats every year, forever, something really handy happens: the sum of all the individual cash flows simplifies down to just one cash flow divided by the discount rate. So if you have a security paying 10 cents a year, forever, and you decide you want a return of 8% a year, then the security's value is 10 cents divided by 8%, which is 125 cents.

And the sums even have the decency to remain pretty simple if you assume growing cash flows - at least if you assume that they grow at the same rate each year. In this case, you just divide the first cash flow by the difference between the discount rate and the growth rate (the growth effectively offsets part of the discount rate). So if you have a security paying 10 cents this year, growing forever at 4% per year, and you decide that you want a return of 8% per year, then the security is worth 10 cents divided by 4% (that is, the difference between 8% and 4%), which is 250 cents.

Paradox

So if you're aiming to make 8% a year, then an annual payment of 10 cents growing at 4% a year is worth exactly double the value of a flat 10 cents a year. A payment growing forever at 6% would be worth four times (250 cents) as much and, somewhat paradoxically, a payment growing at 8% or more would be worth an infinite amount.

This curious result is arrived at because you've assumed an opportunity cost below the growth you expect from your investment, even though that investment is itself an opportunity.

Paradoxes aside, this is hopefully beginning to sound rather like companies paying dividends - precisely because it is rather like companies paying dividends. But companies introduce problems because the cash they pay out is neither predictable nor grows steadily. And some companies don't pay out dividends at all.

http://www.intelligentinvestor.com.au/articles/198/How-to-value-stocks-and-shares.cfm

Cash flow is what matters, not earnings.

Cash flow is the true measure of a company's financial performance, not reported earnings per share.

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At the end of the day, cash flow is what matters, not earnings.

For a host of reasons, accounting-based earnings per share can be made to say just about whatever a company's management wants them to, but cash flow is much harder to fiddle with. 

The statement of cash flows can yield a ton of insight into the true health of a business, and you can spot a lot of blowups before they happen by simply watching the trend of operating cash flow relative to earnings.  One hint:  If operating cash flows stagnate or shrink even as earnings grow, it's likely that something is rotten.



Also read:
Using Yield-based measures to value stocks: Say Yes to Yield
http://myinvestingnotes.blogspot.com/2010/01/using-yield-based-measures-to-value.html

Reading a Cash-flow Statement

Reading a Cash-flow Statement

The purpose of the cash-flow statement is to explain the movement in cash balances or bank overdrafts held by the business from one accounting period to the next.

What is a cash-flow statement?

Over an accounting period, the money held by a business at the bank (or its overdrafts) will have changed. The purpose of the cash-flow statement is to show the reasons for this change. The cash flow statement is the link between profit and cash balance movements. It takes you down the path from profit to cash. The figures are derived from those published in the annual accounts, and notes will explain how this derivation is arrived at.

What does a cash-flow statement not show?

In the same way that a profit and loss account does not show the cash made by the business, a cash-flow staetement does not show the profit. It is entirely possible for a loss-making business to show an increase in cash, and the other way round too.

Learn to interpret the figures

The cash-flow statement is a 'derived schedule', meaning that the figures are pulled from the profit and loss account and balance sheet statements, linking the two.

Its purpose is to analyse the reasons why the company's cash position changed over an accounting period. For example, a sharp increase in borrowings could have several explanations - such as a high level of capital expenditure, poor trading, an increase in the time taken by debtors to pay, and so on. The cash-flow statement will alert management to the reasons for this, in a way that may not be obvious merely from the profit and loss account and balance sheet.

The generally desirable situation is for the net position before financing to be positive. Even the best-run businesses will sometimes have an outflow in a period (for example in a year of high capital expenditure), but positive is usually good. This become more apparent when comparing figures over a period of time. A repeated outflow of funds over several years is usally an indication of trouble. To cover this, the company must raise new finance and/or sell off assets, which will tend to compound the problem, in the worst cases leading to failure.

Cash is critical to every business, so the management must understand where its cash is coming from and going to. The cash-flow statement gives us this information in an abbreviated form. You could argue that the whole purpose of a business is to start with one sum of money and, by applying some sort of process to it, arrive at another and higher sum, continually repeating this cycle.

COMMON MISTAKES

Confusing 'cash' and 'profit'

As mentioned previously, the most common mistake with cash-flow statements is the potential confusion between profit and cash. They are not the same!

Not understanding the terminology

It is clearly fundamental to an understanding of cash flow statements that the reader is familiar with terms like 'debtors', 'creditors', 'dividends', and so on. But more than appreciating the meaning fo the word 'debtor', it is quite easy to misunderstand the concept that, for example, an increase in debtors is a cash outflow, and equally that an increase in creditors represents an inflow of cash to the business.

Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)

Introduction to financial statements

Learn about stocks


Stocks 107: Introduction to financial statements


You don't need to be a CPA to understand the basics of the three most fundamental and important financial statements: The income statement, the balance sheet, and the statement of cash flows.


[Related content: stocks, stock market, investments, investing strategy, bonds]


By Morningstar.com


Although the words "financial statements" and "accounting" send cold shivers down many people's backs, this is the language of business, a language investors need to know before buying stocks. The beauty is you don't need to be a CPA to understand the basics of the three most fundamental and important financial statements: the income statement, the balance sheet, and the statement of cash flows. All three of these statements are found in a firm's annual report, 10-K, and 10-Q filings.


The financial statements are windows into a company's performance and health. We'll provide a very basic overview of each financial statement in this lesson and go into much greater detail in Lessons 301-303.


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The income statement



The income statement tells you how much money a company has brought in (its revenues), how much it has spent (its expenses), and the difference between the two (its profit or loss). It shows a company's revenues and expenses over a specific time frame such as three months or a year. This statement contains the information you'll most often see mentioned in the press or in financial reports -- figures such as total revenue, net income or earnings per share.


The income statement answers the question, "How well is the company's business performing?" Or in simpler terms, "Is it making money?" A company must be able to bring in more money than it spends or it won't be in business for very long. Companies with low expenses relative to revenues -- and thus, high profits relative to revenues -- are particularly desirable for investment because a bigger piece of each dollar the company brings in directly benefits you as a shareholder.


Each of the three main elements of the income statement is described below.


Revenues. The revenue section is typically the simplest part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period, although big companies sometimes break down revenues in ways that provide more information (for instance, segregated by geographic location or business segment). Revenues are also commonly known as sales.


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Expenses. Although there are many types of expenses, the two most common are the cost of sales and SG&A (selling, general and administrative) expenses. Cost of sales, which is also called cost of goods sold, is the expense most directly involved in creating revenue. For example, Gap (GPS, news, msgs) may pay $10 to make a shirt, which it sells for $15. When it is sold, the cost of sales for that shirt would be $10 -- what it cost Gap to produce the shirt for sale. Selling, general, and administrative expenses are also commonly known as operating expenses. This category includes most other costs in running a business, including marketing, management salaries, and technology expenses.


Profits. In its simplest form, profit is equal to total revenues minus total expenses. However, there are several commonly used profit subcategories investors should be aware of. Gross profit is calculated as revenues minus cost of sales. It basically shows how much money is left over to pay for operating expenses (and hopefully provide profit to stockholders) after a sale is made.



Using our example of the Gap shirt before, the gross profit from the sale of the shirt would have been $5 ($15 sales price - $10 cost of sales = $5 gross profit). Operating profit is equal to revenues minus the cost of sales and SG&A. This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. Net income generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings."


The balance sheet



The balance sheet, also known as the statement of financial condition, basically tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets," "stockholders' equity," or "net worth."
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The balance sheet provides investors with a snapshot of a company's health as of the date provided on the financial statement. Generally, if a company has lots of assets relative to liabilities, it's in good shape. Conversely, just as you would be cautious loaning money to a friend who is burdened with large debts, a company with a large amount of liabilities relative to assets should be scrutinized more carefully.


Each of the three primary elements of the balance sheet is described below.


Assets. There are two main types of assets: current assets and noncurrent assets. Within these two categories, there are numerous subcategories, many of which will be explained in Lesson 302. Current assets are likely to be used up or converted into cash within one business cycle -- usually defined as one year. For example, the groceries at your local supermarket would be classified as current assets because apples and bananas should be sold within the next year. Noncurrent assets are defined by our left-brained accountant friends as, you guessed it, anything not classified as a current asset. For example, the refrigerators at your supermarket would be classified as noncurrent assets because it's unlikely they will be "used up" or converted to cash within a year.



Liabilities. Similar to assets, there are two main categories of liabilities: current liabilities and noncurrent liabilities. Current liabilities are obligations the company must pay within a year. For example, your supermarket may have bought and received $1,000 worth of eggs from a local farm but won't pay for them until next month. Noncurrent liabilities are the flip side of noncurrent assets. These liabilities represent money the company owes one year or more in the future. For example, the grocer may borrow $1 million from a bank for a new store, which it must pay back in five years.


Equity. Equity represents the part of the company that is owned by shareholders; thus, it's commonly referred to as shareholders' equity. As described above, equity is equal to total assets minus total liabilities. Although there are several categories within equity, the two biggest are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares. Retained earnings represent the total profits the company has earned since it began, minus whatever has been paid to shareholders as dividends. Because this is a cumulative number, if a company has lost money over time, retained earnings can be negative and would be renamed "accumulated deficit."


The statement of cash flows



The statement of cash flows tells you how much cash went into and out of a company during a specific time frame such as a quarter or a year. You may wonder why there's a need for such a statement because it sounds very similar to the income statement, which shows how much revenue came in and how many expenses went out.


The difference lies in a complex concept called accrual accounting. Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. While that explanation seems simple enough, it's a big mess in practice, and the statement of cash flows helps investors sort it out.


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The statement of cash flows is very important to investors because it shows how much actual cash a company has generated. The income statement, on the other hand, often includes noncash revenues or expenses, which the statement of cash flows excludes.


One of the most important traits you should seek in a potential investment is the company's ability to generate cash. Many companies have shown profits on the income statement but stumbled later because of insufficient cash flows. A good look at the statement of cash flows for those companies may have warned investors that rocky times were ahead.


Because companies can generate and use cash in several different ways, the statement of cash flows is separated into three sections: cash flows from operating activities, from investing activities and from financing activities.


The cash flows from operating activities section shows how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing. Investors should look closely at how much cash a company generates from its operating activities because it paints the best picture of how well the business is producing cash that will ultimately benefit shareholders.


The cash flows from investing activities section shows the amount of cash firms spent on investments. Investments are usually classified as either capital expenditures -- money spent on items such as new equipment or anything else needed to keep the business running -- or monetary investments such as the purchase or sale of money market funds.


The cash flows from financing activities section includes any activities involved in transactions with the company's owners or debtors. For example, cash proceeds from new debt, or dividends paid to investors would be found in this section.


Free cash flow is a term you will become very familiar with over the course of these lessons. In simple terms, it represents the amount of excess cash a company generated, which can be used to enrich shareholders or invest in new opportunities for the business without hurting the existing operations; thus, it's considered "free." Although there are many methods of determining free cash flow, the most common method is taking the net cash flows provided by operating activities and subtracting capital expenditures (as found in the "cash flows from investing activities" section).
Cash from Operations - Capital Expenditures = Free Cash Flow


The bottom line



Phew!!!



You made it through an entire lesson about financial statements. While we're the first to acknowledge that there are far more exciting aspects of investing in stocks than learning about accounting and financial statements, it's essential for investors to know the language of business. We also recommend you sharpen your newfound language skills by taking a good look at the more-detailed discussion on financial statements in Lessons 301-303.

Cash Flow Statement Value

Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF

Cash Flow Statement Value

Cash flow based valuation techniques (DCF analysis): High Subjectivity

The reason value investing emphasizes the balance sheet and income statement is that to resort solely to the cash flow statement can be deceptively simple.

Cash flows alone disguise important metrics. Cash is not exactly the bottom line. True, cash flows drive value, but some portion of cash flows will be needed to reinvest in capital resources necessary to sustain business production and results.

Thus to arrive at a cash flow figure by adjusting net income for noncash expenditures is only a partial step. Step two is to further adjust that figure by probable future cash commitments to capital expenditures.

Step 1: Adjust earnings for noncash charges
Suppose a company generates net income of $1 million. Part of the expenses recorded to generate the $1 million consisted of net noncash charges of $200,000. Cash flow is thus $1.2 million. That is step one.

Step 2: Free cash flows
Then this figure must be adjusted to reflect the amount the company will need to disburse in cash to maintain its property, plant and equipment at levels sufficient to sustain business productivity. Suppose this figure is either $0.1 million or $0.3 million. Adjusted, cash flows are now either $0.9 million or $1.1 million. This is the bottom line figure, and may be called free cash flows. (Buffett calls it owner earnings to designate that these are the free flows of results allocable to the common stock.)

Too often analysts fail to take this additional step of adjusting for the probable costs of required reinvestment. It would be more accurate for these analysts simply to stick with the net income figure. After all, the noncash charges to earnings that produce the net income figures are at least, in part, intended as a proxy to estimate such required reinvestment.

In this example, the bookkeeping allocation of noncash charges of $0.2 million may be as reasonable an estimate of required cash reinvestment as the separate estimates of either $0.1 million or $0.3 million. But zeroing in on this figure is a crucial value investing exercise.

Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF