When you walk in super markets, you’ll see the retail values keep changing on different days across different stores. But you kind of know the value of those things you buy every day, though their prices fluctuate depends on time and location. In other words, you know the intrinsic values of those things in super markets.
The same goes with stock market, with a market of stocks. How do you know the intrinsic values of each stock?
- P/E Multiple method
- DCF model
- Return on equity valuation method
Let’s briefly talk abour each of those evaluation methods. I will provide more details in future blog posts so stay tuned.
- P/E Multiple method
You determine stock’s five-year price target based on P/E valuation.
a. EPS (ttm): Earnings per share for the trailing twelve months is usually included in the stock information of a given stock in most financial websites such as morningstar.
b. the median historical price-earning multiple. We look at the past five years.
c. Expected growth rate
This is the rate a stock is expected to grow its profit in the next 5 years.
Next, we put all those together to get the price target for the next 5 years:
EPS*avg hist P/E ratio*growth rate
This is the price target in 5 years for this stock.
However, we are most interested in the intrinsic value of this stock so assuming stock market returns 9% annually, here we calculate the intrinsic value of the stock (or we call it Net Present Value, NPV):
5-year price target / (1+9%)^5
You can replace it with other numbers instead of 9% if you want to achieve say 20% per year for the next 5 years.
2. DCF model
We take the trailing twelve months FCF, project it 1o years into the future by multiplying it with an expected growth rate. It then takes the NPV of these cash flows and adds them up.
We assume the company will be sold after 10 years from now. – so we have the Year 10 FCF * factor (12, a number b/w 10-15)
a. Free cash flow, FCF: the trailing twelve month FCF, shown in Cash Flow statement.
b. Cash and cash equivalents: shown in the company’s latest quarterly Balance Sheet report.
c. Total liabilities: all debts
d. Growth rates: as we used in Method 1, but we may apply 25% discount for the margin of safety.
Just as in Method 1, we may use 9% as our discount rate.
e. Shares outstanding: We need to know the intrinsic values per share.
The total NPV PCF is the sum of all the cash flows.
Year 10 FCF value: Year 10 FCF multiplier (12) * NPV of FCF in Year 10
3. Return on equity (ROE) valuation method
Warren Buffet’s favorate metric of profitability ROE.
Net income / shareholder’s equity.
15% ROE or higher is good.
All inputs:
a. Return on equity
b. Shareholders’ Equity
c. Dividend Rate