Investment Appraisal

When buying stocks, you are investing cash today in expectation of future returns.

There should  be a process to evaluate opportunities to see if their benefit is greater than their cost and also which stocks should recevie priority where capital is limited.

This process is known as "investment appraisal".

The main benefits from an investment are its future net cash inflows.  

Its two main costs are

• the amount of the actual investment (capital outflows) and 
• the cost of financing the investment over the long term (the cost of capital).

The non-financial benefits and costs of an investment as well as its risk are also releveant considerations.

There are several ways to appraise investments:

1.  Payback period

2.  Annual yield

3.  Measures which use discounted cash flows.

Investment Decisions

Some investment decisions are easy to make.

• Perhaps, a government safety regulation makes an item of capital expenditure compulsory.
• Or perhaps, an essential piece of machinery breaks down and just has to be replaced.

Many other investment decisions are not nearly so clear cut and hinge on whether the proposed expenditure will generate sufficient future cash savings to justify itself.

There are many very sophisticated techniques for aiding this decision.  Here are three techniques that are commonly used:

• Payback
• Return on investment
• Discounted cash flow.

Payback

This has the merit of being extremely simple to calculate and understand.  It is a simple measure of the period of time taken for the savings made to equal the capital expenditure.

Return on investment

This takes the average of the money saved over the life of the asset and expresses it as a percentage of the original sum invested.

Discounted cash flow.

This technique takes account of the fact that money paid or received in the future is not as valuable as money paid or received now.  For this reason, it is considered superior to payback and to return on investment.  However, it is not as simple to calculate and understand.  Discounted cash flow involves bringing the future values back to its Net Present Value.

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.

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.]

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

Finance for Managers - Discounted Cash Flow Valuation Method

One big problem with the earnings-based methods just described is that they are based on historical performance - what happened last year.  And as the oft-heard saying goes, past performance is no assurance of future results.  If you were making an offer to buy a local small business, chances are that you'd base your offer on its ability to produce profits int he years ahead.   Likewise, if your company were hatching plans to acquire Amalgamated Hat Rack, it would be less interested in what Amalgamated earned int he past than in what it is likely to earn in the future under new management and as an integrated unit of your enterprise.

We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method:  discounted cash flow (DCF).  The DCF valuation method is based on the same time-value-of-money concepts.  DCF determines value by calculating the present value of a business's future cash flows, including its terminal value.  Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.

For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:

1.  The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow.  They would use EBITDA and make some adjustment for taxes and for changes in working capital.  Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.

2.  Your analysts would then estimate future annual cash flows - a tricky business to be sure.

3.  Next, you would estimate the terminal value.  You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows).  That net figure after taxes will fall into the final year's cash flow.  Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:

Present value = Cash Flow / Discount Rate

Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity).  This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.

4.  Compute the present value of each year's cash flow.

5.  Total the present values to determine the value fo the enterprise as a whole.

We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2).  Our calculated value there is $4,380,100.  (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)

In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business.  All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager.  Such determinations are best left to the experts.  What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.

Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)

               Present Value                  Cash Flows
              (in $1,000, Rounded)       (in $1,000)

Year 1    446.5                               500
Year 2    418.5                               525
Year 3    398.7                               500
Year 4    381.6+2,734.8                 600+4,300

   Total    4,380.1



The strength of the method are numerous:

-  It recognises the time value of future cash flows.
-  It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
-  It accounts for the buyer's cost of capital.
-  It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
-  It is based on real cash flows instead of accounting values.

The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.

Simple 10-Year DCF Valuation Model (Morningstar)

http://www.stock-picks-focus.com/intrinsic-value.html

The longer you have to wait and the less certain you are that you'll eventually receive a set of cash flows, the less they are worth to you today.

Cyclicality

Is the firm in a cyclical industry (such as commodities or automobiles) or a stable industry (such as breakfast cereal or beer)? Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases.

The company’s intrinsic value is the net present value of projected future cash flows.

http://rcrawford.wordpress.com/2008/08/05/teva-pharma-teva-august-4-2008/
The company’s intrinsic value is the net present value of projected future cash flows.
We will take the free cash flow rate and project it out over the next decade, followed by an assumed 5% growth rate in the second decade.



Valuing a firm using Free Cash Flows

Valuation of Cash Flows from Stocks

Valuation of Cash Flows from Stocks

Stocks have value only because of the potential cash flows that investors receive. These cash flows can come from any distribution (such as dividends or capital gains realized on sale) that stockholders expect to receive from their share of ownership of the firm, and it is by forecasting and valuing these expected future cash flows that one can judge the investment value of shares.

The value of any asset is determined by the discounted value of all expected future cash flows.

Future cash flows from assets are DISCOUNTED because cash received in the future is not worth as much as cash received in the present. The reasons for discounting are:

1. the innate TIME PREFERENCES of most individuals to enjoy their consumption today rather than wait for tomorrow,

2. PRODUCTIVITY, which allows funds invested today to yield a higher return tomorrow, and

3. INFLATION, which reduces the future purchasing power of cash received in the future.

4. UNCERTAINTY associated with the magnitude of future cash flows.

These factors 1, 2, and 3 also apply to both stocks and bonds and are the foundation of the theory of interest rates. Factor 4 applies primarily to the cash flows from equities.

The fundamental sources of stock valuation are the dividends and earnings of firms.