Is it inexpensive? Four different price metrics:

#Nothing is worth infinity. 

We can overpay for even the best of companies.

So even if we understand a business (first step) and find it to be good (second step) we can still make a bad investment by paying too much.

The third step in the value investing model asks a final fundamental question: Is it inexpensive?



Inexpensiveness can be detected with four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)



#Price metrics

1.  Times free cash flow. 

It equals a company’s market capitalization divided by its levered free cash flow. It’s abbreviated
MCAP/FCF.

The denominator, levered free cash flow. 

• It’s cash flow from operations minus capex. 
• Note that it captures the payment of both interest and taxes.

The numerator, market capitalization, is often shortened to market cap.

• It’s the number of shares outstanding times the current price per share.

Notice the consistency between numerator and denominator.

• Market cap is the price for the equity only. 
• Levered free cash flow is the cash thrown off by the business after debtholders have been paid their interest.  Hence levered free cash flow goes to the equity holders.

Theoretically, market cap is what it would cost to buy all of a company’s outstanding shares.

• But it’s actually an underestimate. 
• That’s because the current share price reflects only what some shareholders were—moments ago—willing to take for their stock. 
• Most are holding out for more.

2.  Enterprise value to operating income. 
It’s abbreviated EV/OI.

The denominator, operating income. 

• It’s revenue, minus cost of goods sold, minus operating expenses. 
• Note that it’s not net of interest or tax expenses.

The numerator, enterprise value, is the theoretical takeover price.

• It’s what one would fork over to buy the entire company, not just the outstanding shares.
• Paying it would leave no one else with any financial claim on the company. 
• There’d be no outside common stockholders, no preferred shareholders, no minority partners in subsidiaries, no bondholders, no bank creditors, no one.

Enterprise value is a tricky concept, for two reasons.

1.  First, it’s derived in part from current market prices.

• So in name, it defies the value investing distinction between price and value. 
• The term enterprise price would make more sense.

2.  Second, it’s harder to calculate.

• In essence, it equals market cap plus the market price of all of the company’s preferred equity, noncontrolling interest, and debt and minus cash.

Like market cap, the enterprise value of a particular company is given on financial websites. Such off-the-shelf figures are convenient. But if a company looks promising, it’s wise to calculate enterprise value longhand. To see why, consider its components.



3.  Price to book. 
It equals market cap divided by book value. It’s abbreviated MCAP/BV.

Book value, recall, equals balance sheet equity.


4.  Price to tangible book value, or MCAP/TBV. 
It’s MCAP/BV with intangible assets removed from the denominator.   Patents, trademarks, goodwill, and other assets that aren’t physical get subtracted.

MCAP/TBV is a harsher measure than MCAP/BV.

• It effectively marks any asset that can’t be touched down to zero. 
• Some situations are better suited to this severity than others. 

To see which ones, we revisit goodwill.

Recall that goodwill equals acquisition price in excess of book value.

• We gave the example of company B having book value of $1,000,000; company A acquiring it for $1,500,000 in cash; and company A increasing the goodwill on its balance sheet by $500,000.

Note the assumption embedded in this practice.

• Goodwill is an asset. 
• So in buying company B and goodwill, company A is swapping assets for assets. That’s how accounting sees it. 
• No expense is recognized on the income statement, and no liability is booked on the balance sheet. 
• Nothing bad occurs.

#What’s inexpensive, and what isn’t?

1.  MCAP/FCF and EV/OI

When we calculate price metrics, we get actual numbers. MCAP/FCF may be 5, or 50. EV/OI may be 3, or 30. What’s inexpensive, and what isn’t?

I like MCAP/FCF to be no higher than 8, and EV/OI to be no higher than 7.  

Before moving on to benchmarks for the other two price metrics, let’s understand what these first two multiples mean.

• Imagine that a company’s future operating income will be $1,000,000 for each of the next 100 years. Discounting that stream back at—say—10 percent yields $9,999,274.
• That quantity, $9,999,274, is nearly $10 million. Notice that $10 million is 10 times the forecasted annual operating income.
• So if one calculates a company’s EV/OI as 10, that could mean that the market thinks operating earnings will be $1,000,000 for each of the next 100 years, and 10 percent is the right discount rate.
• Or, it could be mean that the market thinks operating income for the next 100 years will grow 4 percent annually from a $1,000,000 base, and that 14 percent is the right discount rate.

In other words, multiples are shorthand. 

• They’re shorthand for a formal present value analysis. 
• In them are embedded beliefs about growth rates and discount rates.

Holding everything else equal, it’s better to own a company with income that’s growing than one with income that isn’t. 

So when I say that I want EV/OI to be no higher than 7, what I’m saying is that I’ll only buy a stream of future operating income when it’s offered to me at a high discount rate.

Of course one never knows just what future operating earnings will be. Same with free cash flow. And where the exact discount rates come from isn’t important.

What is important is this: 
"low price multiples signal buying opportunities to the value investor when they reflect unjustifiably high discount rates."

2.  MCAP/BV and MCAP/TBV

The other two price metrics, MCAP/BV and MCAP/TBV, are a little different. 

• They don’t reflect a stream of future anything. 
• They’re multiples of what a company has now.

I prefer both MCAP/BV and MCAP/TBV to be no higher than 3.

But these are just qualifiers for me. They’re not what I look for.

What I look for is MCAP/FCF and EV/OI. 

It’s worth exploring why.


#Why MCAP/FCF and EV/OI are preferred to MCAP/BV and MCAP/TBV?

I aim to own companies that continue as going concerns.

• I want them alive. 
• Profitable ones are worth more that way. 

But MCAP/BV and MCAP/TBV express price relative to the value of companies dead. 

• If a firm stopped operating and sold everything—if it liquidated—the total amount available to distribute to shareholders would have something to do with its book value. 
• But when I buy a stock, I don’t hope for a stake in some dead company’s yard sale. I’m buying a claim on future streams of income and cash flow.

This isn’t to say that MCAP/BV and MCAP/TBV are useless. They can uncover opportunities. 

• Say that a company’s EV/OI is 9, and that both MCAP/BV and MCAP/TBV are 6. 
• The company doesn’t look inexpensive. 
• But MCAP/BV and MCAP/TBV are the same. 
• This leads the astute investor to see if the company owns some juicy tangible asset like land that’s carried on the balance sheet at a tiny, decades-old purchase price. 
• Will the company sell the land for cash? 
• Will that cash be excess? 
• If so, all of the price metrics could plunge. That’s the kind of useful thinking that the dead metrics tease out.

#The first step is to understand a business and the second step is to find it to be good; then valuation

Putting forth my benchmarks so bluntly—8, 7, 3, and 3—is a little dangerous and potentially misleading.

It’s dangerous because it could be interpreted to mean that it’s OK to cut right to valuation without first understanding a business and seeing if it’s good.  Many investors do that. And it can work. But with that approach mine are not the benchmarks to use.





Summary

Inexpensiveness can be detected with four different price metrics:
1. Times free cash flow (MCAP/FCF)
2. Enterprise value to operating income (EV/OI)
3. Price to book (MCAP/BV)
4. Price to tangible book value (MCAP/TBV)

Analysing a company's future performance and estimating its value

Analysing a company's future performance and estimating its value 

• begin with examining historical and current data and 
• then making projections.

Several sets of forecasts or scenarios

Several sets of forecasts or scenarios should be made using different assumptions concerning

• the business environment and 
• the strategy of the firm.

A simple example is where only two or three scenarios are created, example,

• a business-as-usual scenario,
• an aggressive marketing or acquisition scenario, and 
• an operational improvement scenario.

Estimating Value

The value should be estimated using

1. various explicit forecast horizons and
2. different methods.

1.  Estimating Value using Various explicit forecast horizons

There are usually two periods to forecast:

• the explicit forecast period and 
• the period after that in which the challenge is to estimate the continuing value for that period.

2.  Estimating Value using Different methods

There is also the choice of using these methods for estimating value:

• the free cash flow (FCF) method and 
• the economic-profit method.

Both methods should be used and their results compared.

By estimating value using different explicit forecast horizons and methods,

• the robustness of the model and 
• the consistency of the assumptions can be verified.

Valuation Model should be tested for Validity and Sensitivity to Various Inputs and Economic Forecasts

Once the valuation model is complete, it should be tested for its

• validity, 
• sensitivity to various inputs and 
• sensitivity to various economic forecasts.

(a)  Validity

A model's validity can be questioned if there are mechanical errors or flaws in economic logic.


(b)  Sensitivity to Various Inputs and Economic Forecasts

Understanding how sensitive the valuations are to key input and economic conditions gives a more robust understanding of

• the long-term value drivers for a firm and 
• the potential for large swings in value.

Checks and Balances

Verifying valuation results involves checks and balances to see if the model is technically robust by addressing the following relationships:

• that the balance sheet balances and the correct relationships exist among income, retained earnings, and dividends;
• that the sum of invested capital plus nonoperational assets equals the cumulative sources of financing; and 
• that the change in excess cash and debt line up with the cash flow statement.

A good model will have automatic checks for these relationships.


Economic Consistency

Checking for economic consistency involves seeing if the results reflect appropriate value driver economics; for example, high growth and return should be reflected in value of operations higher than book value.

Check also to see if the patterns of key financial and operating ratios are consistent with economic logic and in general, check to see if the results are plausible.


Sensitivity Analysis

Sensitivity analysis aids in determining the impact of changes of key drivers, and scenario analysis allows for assessing results under a broad set of conditions.

Valuation can be very sensitive to small changes in assumptions, which is why market values fluctuate.

A good guide is to aim for a valuation range of +/- 15%, which is similar to the range used by investment bankers.

Cross-Border Valuation

U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have been converging over time.

The valuation of companies and subsidiaries in foreign countries has become easier.

Four issues need to be considered when analyzing foreign companies:

1. making forecasts in foreign and domestic currencies,
2. estimating the cost of capital in a foreign currency
3. incorporating foreign-currency risk in valuations, and 
4. using translated foreign-currency financial statements

For a given company, forecast the cash flows in the most relevant currency.

Use either the spot-rate method or the forward-rate method to convert the value of the cash flows into that of the parent company.

It is important to use consistent monetary assumptions in the process (e.g., concerning inflation and interest rates).

When estimating the cost of capital, use the equity premium from a global portfolio without an adjustment for currency risk.

When translating statements into another currency, there are three choices:

1. the current method, 
2. the temporal method, and,
3. the inflation-adjusted current method.

Using, the current method is the most appropriate approach.

Valuation

To get ahead, be creative.

No matter what a client desired, a good banker could always tweak the numbers a bit and could produce the numbers:

• a higher selling price,
• a lower purchase price, 
• stronger margins,
• lower capital costs.

Valuation Basics

Time Value of Money

Present Value   

Methods of Valuation

Valuation is far more of an art than a science.

"The value of that work is $1 million, because that is what the buyer and seller agreed on."

With detailed valuation models, the key factors that drove a company in the past, along with those which will continue to drive it in the future, can be examined.

Both sides are able to form a better picture of the potential as well as the risks associated with this company.

Through this process of dialogue, they hope to be able to build a consensus.  With a little luck, they just might close a sale.

There are numerous uses for valuation.   

A few of the more common ones are:

• Venture capital
• Initial public offerings
• Mergers and acquisitions
• Leveraged buyouts
• Estate and tax settlements
• Divorce settlements
• Capital raising.
• Partnerships
• Restructuring
• Real estates
• Joint ventures
• Project finance.

Even if you have no dealings in these types of transactions and more specifically, no interest in them, it is important to have at least a basic understanding of the underlying principles and techniques of valuation.

Why?   Because so much of what we do and so much of what governs out personal lives is driven by these principles.

• The simple decision to lease or buy a care is driven by valuation.
• The decision to own or rent an apartment is driven by valuation.
• Changes in the stock market that might affect your job are a function of valuation.

It is important that each one of us understand the basics of valuation because we no longer can rely on the experts on Wall Street, in corporate America, and at the big accounting firms.

Ultimately, we all bear some responsibility because we were the ones who failed to educate ourselves.

Various Methods of Valuation

• Replacement Method
• Capitalization of Earnings
• Excess Earnings Method
• Discounted Cash Flow Valuation
• Comparable Multiple Valuation
• Net Present Value
• Internal Rate of Return

How to Value a Stock in Order to Buy Long or Sell Short?

How to Value Stocks

How Buffett determined the combined value of Capital Cities and American Broadcasting

Murphy was named president of Capital Cities in 1964.  

Murphy agreed to sell Buffett 3 million shares of Capital Cities/ABC for $172.50 per share.

How Buffett determined the combined value of Capital Cities and American Broadcasting

Approximate yield of the thirty-year US government bond in 1985 = 10%.

Cap Cities had 16 million shares = 13 million shares outstanding plus 3 million issued to Buffett.

Market cap = 16 million x $172.50 = $ 2760 million

The present value (intrinsic value) of $ 2760 million of this business would need to have earnings power of $276 million.  ($2760 x 10%)

1984

Capital Cities earnings net after depreciation and capital expenditures = $ 122 million. 

ABC net income after depreciation and capital expenditures = $ 320 million.

Combined earnings power of these two companies = $ 442 million.

However, the combined company would have substantial debt:  the approximately $ 2.1 billion that Murphy was to borrow would cost the company $ 220 million a year in interest.

So, the net earnings power of the combined company = approximately $200 million.

Additional considerations

Capital Cities’ operating margins were 28%.

ABC’s operating margins were 11%. 

If Murphy could improve the operating margins of the ABC properties by one-third to 15%, the company would throw off an additional $125 million each year, and the combined earnings power would

= $ 200 million + $ 125 million

= $ 325 million annually.

The present value of a company earning  $ 325 million annually discounted at 10%

= ($325 million / 10%)

= $3250 million.

The per share present value of a company earning $ 325 million with 16 million shares outstanding

= $ 325 million / 16 million

=  $ 203 per share.

This gives a 15% margin of safety over Buffett’s $ 172.50 purchase price. 

The margin of safety that Buffett received buying Capital Cities was significantly less compared with other companies he had purchased.  So why did he proceed?

Murphy was Buffett’s margin of safety.   When Capital Cities purchased ABC, Murphy’s talent for cutting costs was badly needed.  With the help of carefully selected committees at ABC, Murphy pruned payrolls, perks, and expenses.  Once a cost crisis was resolved, Murphy depended on his trusted manager to manage operating decisions.  He concentrated on acquisitions and shareholders assets.

Appendix

The margin of safety that Buffett accepted could be expanded if we make certain assumptions.

1.  Buffett says that conventional wisdom during this period argued that newspapers, magazines, or television stations would be able to forever increase earnings at 6% annually - without the need for any additional capital.  The reasoning, explains Buffett, was that capital expenditures would equal depreciation rates and the need for working capital would be minimal.  Hence, income could be thought of as freely distributed earnings.  This means that an owner of a media company possessed an investment, a perpetual annuity, that would grow at 6% for the foreseeable future without the need for any additional working capital. 

Media company

Earned $ 1 million

Expected to grow at 6%.

The appropriate price to pay would be $25 million dollars for this business.

Calculation: 

Present value 

=  $ 1 million / (risk free rate of 10% - 6% growth rate)

=  $ 1 million / 4%

=  $ 25 million

Compare that, Buffett suggests, to a company that is only able to grow if capital is reinvested.  

Another business

Earned $ 1 million

Could not grow earnings without reinvested capital

The appropriate price to pay would be $ 10 million dollars for this business.

Calculation:

Present value 

=  $ 1 million / risk free rate of 10%

=  $ 10 million.

Apply the above to Cap Cities

Calculations:

6 million outstanding shares

Earned $325 million or $ 203 per share

Growth 6%

Risk free rate 10%

Present value = $325 million / (10% - 6%) = $ 8125 million

Per share value = $ 507 per share.

Present value increases from $ 203 per share to $ 507 per share.

Buffett paid $ 172.50 per share.  ($172.50 / $ 507 = 34%).  Therefore, he enjoyed a 66% margin of safety over the $172.50 price that Buffett agreed to pay.

But there are a lot of "ifs".

However, the margin of safety that Buffett received buying Capital Ciies was significantly less compared with other companies he had purchased. 

His ability to obtain a significant margin of safety in Capital Cities was complicated by several factors.  

1.  The stock price of Cap Cities had been rising over the years.  Murphy was doing an excellent job of managing the company, and the company's share price reflected this.  (So, unlike GEICO, Buffett did not have the opportunity to purchase Cap Cities cheaply because of a temporary business decline.  

2.  The stock market didn't help, either.  And, because this was a secondary stock offering, Buffett had to take a price for Cap Cities' shares that was close to its then-trading value.

How Warren Buffett valued Washington Post Company

Washington Post Company (WPC)

1973: 
Total Market cap $ 80 million.
Most security analysts, media brokers, and media executives estimated WPC's intrinsic value at $400 to $500 million.


Here was Buffett's reasoning.

1. Owner's earnings for that year:
Owner's earnings =
net income $13.3 million
+ depreciation & amortisation $3.7 million
- capital expenditure $ 6.6 million

Owner earnings = $10.4 million

Long-term U.S. government bond yield 6.81%.

The value of WPC = $10.4 / 6.81% = $ 152.7 million; this is almost twice the market value of the company but well short of Buffett's estimate.


Buffett's further reasoned that:

Over time, the capital expenditures of a newspaper = depreciation and amortization charges.

Therefore, net income = approximately to owner earnings.

Knowing this, the value of WPC
= net income / risk-free rate
= $ 13.3 million / 6.81%
= $ 195 million.


His other assumptions:

1. The increase in owner earnings will equal the rise of inflation.
2. However, newspapers in the 1970s have unusual pricing power; because most are monopolies in their community, they can raise their prices at rates higher than inflation.
3. If it is assumed that WPC has the ability to raise real prices by 3%, the value of the company is
= net income / (risk-free rate - 3%)
= $ 13.3 million / (6.81% - 3%)
= about $ 350 million.
4. WPC's pretax margins were 10%, which were below its 15% historical average margins. If pretax margins improved to 15%, the present value of the company would increase by $135 million, bringing the total intrinsic value to $ 485 million.



Buffett bought WPC at an attractive price.

Market cap $ 80 million.

Based on the above calculations, Buffett bought the WPC for at least half of its intrinsic value.

However, Buffett maintained that he bought the company at less than one-quarter of its value.

Either way, he clearly bought the company at a significant discount to its present value.

Buffett satisfied Ben Graham's premise that buying at a discount creates a margin of safety.

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.

Business value cannot be precisely determined: Be approximately right than be precisely wrong

Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined.

• Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value.  
• Projected results are less precise still.  

You cannot appraise the value of your home to the nearest thousand dollars.  Why would it be any easier to place a value on vast and complex businesses?

Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors.  So while investors at any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal.

Any attempt to value businesses with precision will yield values that are precisely inaccurate.  The problem is it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.

Common methods of valuing a business

There's a range of ways to value a business. Valuations based on multiples of future earnings and the capitalisation of future cashflows are the most common. There are a number of common valuation methods:

1.  Businesses with a record of sustainable profits are often valued at a multiple of earnings. Profits are adjusted for any unusual, one-off items to arrive at an estimate of 'normalised' earnings. Smaller businesses are usually valued at a lower multiple than similar, larger companies.

2.  Mature, cash-generating businesses can be valued in a similar way but based on cashflow. Future cashflows are estimated and discounted - this is known as discounted cashflow. Long-term cashflow is worth less than cashflow due shortly.

3.  An asset valuation might be appropriate for stable businesses with significant tangible assets - property or manufacturing businesses, for example. Your starting point is the value of assets stated in the accounts - known as the 'net book value'. These figures are then refined to reflect factors such as changes in the value of assets or bad debts.

4.  The cost of creating a business similar to yours can be used as a basis for valuation. Costs could include buying equipment, employing staff, developing products, attracting customers, and so on. It may be possible to estimate this 'entry cost' as a benchmark of your business' value. Of course, if the cost of entry is low there's little likelihood of you achieving a successful sale.

In some industries, there are established criteria for valuing businesses, eg by the number of branches an estate agency has.

A potential buyer may use more than one method to get a range of values for your business. In the end, however, any price will be a matter for negotiation.


Pneumonic:  MADE
Multiple of Earnings
Asset Valuation
Discounted Cashflow
Entry Cost


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Final answer to stock values

There is no such thing as a final answer to stock values.  A dozen experts will arrive at twelve different conclusions - Gerald Loeb

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.

Does the value of stocks depend on dividends or earnings?

Does the value of stocks depend on dividends or earnings?

Management determines its dividend policy by evaluating many factors, including:

• the tax differences between dividend income and capital gains,
• the need to generate internal funds to retire debt or invest, and,
• the desire to keep dividends relatively constant in the face of fluctuating earnings.

Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.

However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.

Dividend Payout Ratio

Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments.

The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.

Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.

How to value Stocks?

Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings.

Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)

John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote:

"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."


Ref: Stock for the Long Run, by Jeremy Siegel

**** Valuation: How much is a share of stock really worth?

How much is a share of stock really worth?
http://www.moneychimp.com/articles/valuation/stockvalue.htm

Not just in terms of analysts' opinions, but logically, based on facts?
In theory, the answer is simple: a company is worth the total amount of cash it will generate over its lifetime, discounted to its present value. (And don't panic if you don't really understand that last sentence, because the next page explains it. You do not need any background to read this article.)

This article presents a simple discounted cash flows calculator, along with some popular variations and shortcuts, to make stock valuation make sense.


Valuation Intro
A Little Theory
DCF Calculator
P/E Ratio
P/S Ratio
PEG Ratio
Graham Formula
Dividend Discount
Buffett Formula (?)
CAPM Calculator
Books & Links

How to Value Stocks

How to Value Stocks
By Motley Fool Staff May 23, 2008 Comments (3)

So just how do you value the shares of a company? Should you look at earnings, revenues, cash flow, or something else entirely? Do you need to apply one or several valuation methods to discern what the fair price for a share of stock would be?

In this series of informative articles, Fools can learn many ways to value a company's shares, as well as helpful methods to determine whether or not a stock is undervalued right now.

How to Read a Balance Sheet
These articles explore the mechanics of a balance sheet and define the items that go into one. Readers will understand how to use this knowledge most effectively to pick stocks.

Introduction to Valuation Methods
How do you value the shares of a publicly traded company? This helpful series details the many and varied ways one can understand the fundamentals about a company's business to value its shares. You can learn to use earnings, revenues, cash flow, equity, dividend yield, and subscribers to figure out how much a company is worth.

Return on Equity
Disarmingly simple to calculate, return on equity (ROE) stands as a crucial weapon in the investor's arsenal if properly understood for what it is. ROE encompasses the three main "levers" by which management pokes and prods the corporation -- profitability, asset management, and financial leverage. This series walks you through how to use ROE to value stocks.

A Look at ROIC
(Return on Invested Capital)It isn't profit margins that determine a company's desirability; it's how much cash can be produced by each dollar of cash that is invested in a company by either its shareholders or lenders. Measuring the real cash-on-cash return is what return on invested capital (ROIC) seeks to accomplish. This series is an introduction to how ROIC is calculated.

Read/Post Comments (3) Recommend This Article (76)

http://www.fool.com/investing/beginning/how-to-value-stocks.aspx

Value Measurements

Value Measurements

The value of any asset (stock, bond, business, or other) is a function of the cash inflows and outflows, discounted at an appropriate rate that an investor can reasonably expect it to generate during its remaining life.

Bonds

Bond values are easiest to measure.

Standard bonds bear a designated interest rate and a set maturity date.

The combination defines expected cash flows and appropriate discount rate.

Stocks

Common stocks have no such coupon, and their life is perpetual.

An analyst thus must estimate both components (expected cash flows and discount rate) of the valuation exercise.


Another crucial difference is that qualitative variables such as managerial probity and skill have a direct bearing on common stock values, but a limited effect on bond values.


Also read:
Valuation
1. Value Measurements
2. Hunting for good investment prospects
3. What data most reliably indicate value