Discounted Cash Flow:
The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders.
A company’s present value of future cash flows is compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.
There are several different techniques within the discounted cash flow method of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, re-investments and debt repayments have been made. But conceptually they are the same, as it is the present value of these streams that are taken into consideration.
A considerable number of estimates and assumptions that go into the model and forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult. Nevertheless, DCF is a valuable tool used by both analysts and investors to estimate a company’s value.
Ratio Valuation
Financial ratios are mathematical calculations using figures mainly from the financial statements, and they are used to gain an idea of a company’s valuation and financial performance. Some of the most well-known valuation ratios are price-to-earnings and price-to-book. Each valuation ratio uses different measures in its calculations.
The calculations produced by the valuation ratios are used to gain some understanding of the company’s value. The ratios are compared on an absolute basis, in which there are threshold values. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.
Earnings:
Most investors want to know about the earnings of a company. How much money the company is making and how much it is going to make in the future are the key areas of interest. Earnings are profits and influence investors’ decisions on company stocks. Increasing earnings generally lead to a higher stock price and, in some cases, a regular dividend.
When earnings fall short, the market may respond adversely to the stock. Every quarter and annually, companies report earnings. Analysts follow major companies closely looking at their quarterly and annual reports and if they fall short of projected earnings, sound the alarm.
The Earnings Per Share ratio:
Earnings Per Share = Net Earnings / Outstanding Shares
There are three types of EPS numbers:
Trailing EPS – last year’s numbers and the only actual EPS
Current EPS – this year’s numbers, which are still projections
Forward EPS – future numbers, which are projections
Price to Earnings Ratio:
The P/E looks at the relationship between the stock price and the company’s earnings. It is calculated by taking the share price and dividing it by the company’s EPS.
P/E = Stock Price / EPS
The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.
A low P/E may indicate a vote of no confidence by the market, or it could mean this is a sleeper that the market has overlooked. It may be a value stock, which is something many investors make wealth spotting before the rest of the market discovered its true worth.
Projected Earnings Growth (PEG):
The P/E compares the relative value of stocks based on earnings by taking the current price of the stock and dividing it by the Earnings Per Share (EPS). This reflects whether a stock’s price is high or low relative to its earnings.
Some investors may consider a company with a high P/E overpriced and they may be correct. A high P/E may be a signal that traders have pushed a stock’s price beyond the point where any reasonable near-term growth is probable. However, a high P/E may also be a strong vote of confidence that the company still has strong growth prospects in the future, which should mean an even higher stock price.
The market is usually more concerned about the future than the present; therefore, it is always looking for some way to project out. Another ratio used to look at future earnings growth is called the PEG ratio. The PEG factors in projected earnings growth rates to the P/E. PEG can be calculated by taking the P/E and dividing it by the projected growth in earnings.
PEG = P/E / (projected growth in earnings)
The lower the number the less you pay for each unit of future earnings growth. A stock with a high P/E, but high projected earnings growth may still be a good value. However, looking at a low P/E stock with low or no projected earnings growth, what looks like a value may not turn out to be good value. For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be an expensive investment.
It is important to note that PEG is about year-to-year earnings growth and relies on projections, which may not always be accurate.
Price to Sales Ratio:
This metric looks at the current stock price relative to the total sales per share. The P/S is calculated by dividing the market cap of the stock by the total revenues of the company. The P/S can also be calculated by dividing the current stock price by the sales per share.
P/S = Market Cap / Revenues
or
P/S = Stock Price / Sales Price Per Share
The P/S number reflects the value placed on sales by the market. A lower P/S may represent better value of a stock. It is advisable not to use this ratio in isolation.
The Price to Book ratio or P/B:
This measurement looks at the value the market puts on the book value of the company. The P/B is calculated by taking the current price per share and dividing by the book value per share.
P/B = Share Price / Book Value Per Share
Like the P/E, the lower the P/B, the better the value. Value investors will use a low P/B is stock screens, for instance, to identify potential candidates.
Dividend Pay-out Ratio:
The Dividend Pay-out Ratio measures what a company pays out to investors in the form of dividends. This is calculated by dividing the annual dividends per share by the Earnings Per Share.
DPR = Dividends Per Share / EPS
Growing companies will typically retain more profits to fund growth and pay lower or no dividends. Companies that pay higher dividends may be in mature industries where there is little room for growth and paying higher dividends is the best use of profits. The DPR must be viewed in the context of the company and its industry as it tells very little when used in isolation.
Dividend Yield:
This measurement tells what percentage return a company pays out to shareholders in the form of dividends. Older, well-established companies tend to pay out a higher percentage than do younger companies and their dividend history can be more consistent. The Dividend Yield is calculated by taking the annual dividend per share and dividing it by the stock’s price.
Dividend Yield = annual dividend per share / stock’s price per share
Book Value:
A company’s stock price reflects how much it is worth/ its value. There are several ways to define a company’s worth or value. One of the ways you define value is market cap or how much money would be needed to buy every single share of stock at the current price.
Another way to determine a company’s value is to look at the Book Value. The Book Value is simply the company’s assets minus its liabilities.
Book Value = Assets – Liabilities
A company that is a viable growing business will always be worth more than its book value for its ability to generate earnings and growth. Book value appeals more to value investors who look at the relationship to the stock’s price by using the Price to Book Ratio.
The best way to compare companies is by converting to book value per share, which is simply the book value, divided by outstanding shares.
Return on Equity:
Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. ROE is calculated by dividing Net Income by Book Value. A healthy company may produce an ROE in the 13% to 15% range. It is advisable to compare companies in the same industry to get a better picture of how well a company is doing.
The ROE is a useful measure, but it has some flaws that can give a false picture to investors and analyst, so it is not to be used in isolation. For example, if a company carries a large debt and raises funds through borrowing rather than issuing stock it will reduce its book value. A lower book value means you’re dividing by a smaller number, so the ROE is artificially higher.
It may also be more meaningful to look at the ROE over a period of the past five years, rather than one year to average out any abnormal numbers. ROE is a useful tool in identifying companies with a competitive advantage. All other things roughly equal, the company that can consistently make more profits with their assets, will be a better investment in the long run.