Foolish Fundamentals: Valuation

Valuing a company on your own might seem intimidating. Companies are large, complex entities, and each seems to have its own nuance. So how are you supposed to look at all of the operations of a company and determine what it is worth?

One of the preferred methods we use at Motley Fool Inside Value is to figure out how much cash will come our way in the future, and then put a price tag on it today.

Why bother?
All investors should care about valuation -- even those investing in exciting growth stocks. Even if you believe that a genius design in consumer electronics will ensure the company's success, that doesn't mean that shareholders will profit from that success. For example, suppose that a company's stock was trading at a level equivalent to the worldwide gross domestic product. Clearly, anyone buying shares at those levels would be almost certain to lose money, regardless of how great a company it is.

Most companies are obviously nowhere near such prices, but the example shows that, regardless of what you think about the prospects of a company, there exists a price at which that company is too expensive. To determine whether a stock is an attractive investment, you must be able to calculate the value of that company.

How to calculate value
One way of valuing companies is based on their assets, a method of valuation that is particularly appropriate for real estate investment trusts (REITs), which earn revenue roughly proportional to their assets. For instance, some REITs own office buildings that they rent to tenants. These companies can be valued using their net asset values (NAV) by calculating how much money they'd have if they sold all their buildings and paid off all their debt. Determining the true worth of a particular building is a challenge, so, while this method is easy to understand, it's not practical for the average investor.

Another way of valuing companies that pay regular dividends is using the dividend discount model. This model is based on the idea that a stock is worth the money that it will distribute to shareholders. In other words, the value of a company is the sum of the present value of future dividends.

A third way of valuing a company, usable by any investor, is the discounted cash flow (DCF) model. This model assumes that the value of a company is the sum of the present value of all the cash that the company will make in the future. We use this model extensively at Inside Value to identify undervalued companies that are likely to provide investors with exceptionally high returns.

Discounted cash flow
Probably the trickiest part of the DCF model is the concept of discounted value or present value. This concept becomes clearer when you consider how the value of money changes over time.

Suppose that we're willing to give you $20 either today or in 10 years. Most likely, you'd choose to have the money today. After all, there will likely be inflation over the next decade, so you'll be able to buy more hamburgers with that $20 now than you'd be able to buy in 10 years. Or perhaps you like money more than you like hamburgers, so you decide to invest that $20 in bonds earning 5% annual interest. In 10 years, that $20 will have grown to $32.58. Thus, $20 now is worth 63% more than $20 in 10 years.

Now turn the question around. What is the present value of $20 in 10 years? In other words, how much money would we have to leave in 5% bonds to have $20 at the end of 10 years? The answer is $12.28 ($20 divided by 1.05 to the power of 10). Ten years in the future, you could consider an IOU for $20 as worth only about $12 today, because the discounted value of $20 is $12. In this case, 5% would be the discount rate.

The DCF model uses this method to calculate a company's value by discounting to present value the money that the company will make in the future. For instance, suppose that Motley Fool Inside Value recommendation Coca-Cola (NYSE:KO) will earn $1,000 every year for the next 30 years. You could calculate the value of that company, using a 5% discount rate, as follows:

If the company had 1,000 shares outstanding, the value of a share would be about $16.

The fine print
If you play around with a DCF model, you'll find that the company's value can change dramatically depending on the inputs. This is normal and acceptable. As Warren Buffett has said, "It's better to be approximately right than precisely wrong." Regardless, it's worthwhile discussing the inputs to the model.

The core of the calculation is an estimation of the cash that the company is likely to produce in the future. To calculate free cash flow (FCF), use the cash flow statement in an annual report and subtract capital expenditures from the operating cash flow. FCF includes ongoing revenue and expenses, but not one-time benefits such as cash received from selling a division of the company. Free cash flow also does not include cash received from financings, since money received from selling bonds is not cash that the company earned.

If the most recent year has unusually high or low free cash flows, you can use an average of several years, or just a reasonable estimate. This could be justified if, for instance, the most recent year had unusually large capital expenditures. When doing these calculations, remember that we're making an estimate, and that precision has little value. We just want to be roughly right, so don't stress out over trivial details.

Of course, cash flows do not remain constant but often grow over time. We typically assume that the company will grow at a particular rate for the next 10 years and then continue to grow at the rate of inflation. After all, it's difficult to estimate what cash flow will be 10 years in the future, and as a company gets bigger, it becomes increasingly difficult to grow. A simple way of estimating growth rates is to start with analysts' estimates and discount them by 10% to 20%, since analysts tend to be unrealistically optimistic. If analysts think a company will grow by 15%, I'd use 13%. Be wary of estimated growth rates of more than 25% -- companies have a difficult time sustaining such levels.

The discount rate should reflect inflation, your confidence in the sustainability of the company's growth, and the price of no-risk investments. The riskier the business, the higher the discount rate should be. We can usually use discount rates between 9% and 16%, with most companies falling near the high end of the range.

A better way
To quickly perform these calculations, you can create a spreadsheet on which you can easily specify the inputs for any stock. At Inside Value, we spend a lot of time discussing which stocks are overvalued and which are dirt-cheap. We created a DCF calculator that anyone can use to estimate how much a stock is worth. Subscribers can access the DCF calculator here. Non-subscribers can try it out by taking a 30-day free trial.

Richard Gibbons, Shruti Basavaraj, and Adrian Rush contributed to this article.