Valuation With the Right Attitude

All investing is about risk and potential return. Valuation is the term investors use to describe the process of determining whether a business represented by its stock price is currently over or undervalued in terms of its risk and potential return. Beginning investors may underestimate the importance of valuation, while advanced investors may overestimate it. Use it, but hold it lightly.

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By Tom Jacobs (TMF Tom9)
January 14, 2002

Last week, I highlighted four criteria for determining whether a stock is a bargain. The most important one? Estimate the value of the business today relative to your desired returns. But listen up: It's fantasy. Quoth economist and speculator John Maynard Keynes:

"If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amount to little and sometimes to nothing." 

That's the right attitude to approach valuation with today, too. If we're honest, we don't have Clue One what the world's largest software maker, semiconductor fabricator, brown bubbly water confectioner, home repair center, pharmaceutical manufacturer, our 1975 Chevy, or house will be worth in ten years. We can speculate. We can even run some fancy equations using all sorts of complex variables. But our knowledge amounts "to little and sometimes to nothing."      

Yet we must perform a valuation analysis. Before buying any stock, you must know what you think it is worth and what potential it offers you for your risk. But because any estimate is based on the character of the inputs -- assumptions about the future that we cannot possibly know -- valuation really is nonsense. By varying the inputs, you can achieve whatever result you want.

Perform valuation, but take it with a grain of salt.

Why does valuation matter?
Valuation lets us know whether a stock has a realistic chance of providing certain returns in a period of time, but it begs the question of what kinds of returns we want. One investor may be happy to match the broad market averages, and may choose simply to invest in a stock index mutual fund that mimics the S&P 500 or Wilshire 5000, with historical returns of 11% for 20 year periods. Another investor may figure that if a stock at its current valuation will not provide a 15% return per year, it's not worth the risk.

Or consider an investor using some of our investing strategies. Our Rule Maker strategy seeks large, financially sound companies that dominant their industries and can return "2x/5y," a double in five years, for a compound annual growth (CAGR) rate of 14.87%. Our much riskier Rule Breaker strategy aims to identify the leading companies in important, emerging industries, seeking the possibility of 10x/5y returns -- a ten-bagger in five years, or a compound annual growth rate of 58.49% -- to compensate us for great risk. To know if you have a shot at those returns, you have to at least eyeball current and future value.

What techniques do investors use to value a company? There are library shelves and computer Foolabytes (Coming soon to tech glossaries everywhere.) devoted to the subject, and I'm hardly going to do it justice in one column. But I can provide some simple truths and point you to other resources.

Price-to-earnings ratio (P/E)
There are a number of ratios that investors use to express how the company is valued. Beginning investors usually are quite pleased to learn about the share price-to-earnings (P/E) ratio, which expresses the company's value as a multiple of its earnings per share (EPS) over a given 12-month period. Armed with that number, investors try to determine whether it's fairly valued relative to other companies in general or competitors, for example, or its own history.

But what about the future?
Armed with P/E, some investors try to guess a growth rate for a company's earnings, and extrapolate. Let's take TenAnyone? (Ticker: TENS), a perfect ten of a company:     

               Growth      Share  
         EPS    Rate  P/E  Price 
Today    $1.00  10%   10   $10.00 
+1 year   1.10  10    10    11.00
+2 years  1.21  10    10    12.10
+3 years  1.33  10    10    13.30
+4 years  1.46  10    10    14.60
+5 years  1.61  10    10    16.10

You can already see how speculative this is. Even if we hazard a future growth rate, rarely do companies grow in a straight line. What if the first year is 5% growth rather than 10%? The reduced value for the first year reduces all future values. What if the company issues more shares, diluting our ownership?

Deficiencies aside, this little model lets you look at a possible share price at the end of five years -- $16.00 -- and determine if a simple 60% return, or a compound annual growth rate of 10% is acceptable to you. Of course, five years is a short period of time, and you will want to figure longer term returns. But the farther out you look, the more speculative your estimates, and the more Keynes is right, and our knowledge may amount "to little and sometimes to nothing."      

The P/E presents other problems, too. Company management knows all about the attention paid to this ratio and its effect on stock price and the company's market cap (valuation), and then on management's stock-based compensation. No wonder that companies employ all sorts of legal and illegal tricks to spruce up earnings on the company's income statement. Investors expanding their education increase their valuation arsenal beyond the P/E.

Free cash flow mojo
Most of us here at The Motley Fool prefer the cash flow statement to the income statement. It's less easy to manipulate than any other part of the financials, and it gives you a quick way to see whether the business is generating cash from its operations or not. For beginning investors, it often comes as a shock that EPS don't necessarily mean that a company's business operations (say, selling computers) is generating more cash than is going out (buying the computer components from suppliers).

Free cash flow is net cash from operating activities minus capital expenditures, both numbers taken from a company's cash flow statement. (Remember when you read a cash flow statement that the quarterly numbers are cumulative for the year so far, rather than for that quarter only, so you have to look at two quarters together to see the change from one quarter to the next.). For companies that produce free cash flow, one way to value a company relative to another is to look at its price to free cash flow. Here, "price" refers to market capitalization. You can extrapolate P/FCF forward, just as we did above with the P/E ratio.

But armed with knowledge of free cash flow, you can perform a valuation that while also speculative, may well be more helpful than extrapolating the P/E or P/FCF ratio to the future.

Discounted cash flow (DCF) analysis
You will often read that the current value of a company is the sum of future free cash flows, discounted to present value. To calculate this requires all sorts of assumptions, but it's quite neat, because it wraps up the question of potential return in your calculation. If you use a discount rate of 15%, you're saying that's the annual return you want  -- the amount you need to earn from an investment to compensate you for the risk. 

When you get the sum of free cash flows for a given period discounted to present value per share, you compare it to the current price. That tells you whether the stock is undervalued or overvalued -- but, of course, only according to whatever highly speculative inputs you employ. Common trips-ups include projecting out too high a growth rate in free cash flows, using too low (or too high) a discount rate, and failing to consider share dilution.

Foolish investors discuss discount rates and all other aspects of valuation on our valuation strategies discussion board and other boards, such as New Paradigm Investing. Check out George Runkle's Drip column for a great step-by-step explanation. And in two weeks, I'll perform a DCF analysis for ImClone Systems (Nasdaq: IMCL), a highly risky biotech drug maker. In the meantime, you can check out Jeff Fischer's Drip Portfolio DCF analysis of Paychex (Nasdaq: PAYX).

Until then, stay Foolish and prosper!

Tom Jacobs (TMF Tom9) is overvalued on a DCF basis. At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy. Tom reserves the right to be wrong, stupid, or foolish (small "f"). So there.