Valuation is a strange mix of science and art. The mechanics are simple enough, but the inputs that go into the equation, and the interpretation of the results are subjective.
Yes, a little bit of elbow grease can take some of the subjectivity out of the process, but in the end it's the inputs -- projected growth rates, future free cash flow, share dilution rates, etc. -- that determine whether, for example, Adobe Systems (NASDAQ:ADBE) is an attractive investment today at $36 (or not until it hits $28 or $25). Those inputs are entirely up to the analyst, and when humans are involved, there is always room for bias and misjudgment. Adobe is an interesting example. While analysts are projecting 15% earnings growth for the next five years, the company has averaged only 13.7% growth over the past five years. The correct growth rate to apply isn't clear.
The problem with traditional valuation thinking
To account for this, investors and analysts will make low, middle, and high assumptions and attempt to assign a probability to each case.
I recently did this for Outback Steakhouse (NYSE:OSI), using a discount rate of 10% on various growth rates. I came up with low, middle, and high estimates of $39, $46, and $48 a share. Doing the same analysis for ServiceMaster (NYSE:SVM) at a discount rate of 10% yielded prices between $15 and $21.
Since growth rates are not easy to estimate, this is a perfectly valid way of thinking, and it's one I use myself.
Turn the equation around
But I think there is yet another way to go about performing a valuation. Since the most interesting opportunities are those that trade below my lowest estimate of growth, I often turn the equation around to determine the rate of growth that matches a company's current share price -- a technique that Legg Mason Chief Investment Strategist Michael Mauboussin also recommends. Then it becomes a matter of determining whether or not a company can exceed that rate of growth, rather than an exercise in trying to determine specific growth rates.
Instead of looking at Apple (NASDAQ:AAPL) and determining that the stock is worth $95 if Apple grows 20% a year for the next five years and 5% thereafter -- it would mean saying that Apple's current price has growth of approximately 15% for each of the next five years, priced in with 4% growth after those first five years. It's a subtle change, but it tilts the thinking process away from potential gains and toward whether the growth priced into a company's shares is achievable in the first place.
Determining the growth rate by itself -- without making any kind of assumption about the possible future value for a company -- is also flawed, because then the decision of when to sell becomes a bit more arbitrary and tough to figure out. Still, I like to solve for growth along with share price targets, because it can highlight when a company such as Inside Value selection Pfizer (NYSE:PFE) or chicken producers Tyson Foods (NYSE:TSN) and Pilgrim's Pride (NYSE:PPC) trade at valuations that assume no growth or a declining business -- as I believe they do today.
Foolish final thoughts
Moving toward any form of a discounted cash flow analysis from a price-to-earnings or price-to-free cash flow method is certainly beneficial and worth the extra effort. This is particularly true when evaluating small, fast-growing companies that are just turning profitable, because P/E ratios can be horribly misleading when combining strong short-term growth with later, more normal rates of long-term growth. Just be sure to look at companies from a number of angles and with a number of possible outcomes. That way, surprises will be few and far between.
Philip Durell, analyst of Motley Fool Inside Value , scours the markets looking for attractively valued investment opportunities. In a little over a year, Philip has outperformed the market (as measured by the S&P 500) 13.9% to 8.9%. If you'd like to join the hunt for the market's hidden values, test-drive a 30-day trial to Inside Value for free. You'll get two stock picks per month, access to all the selections to date, and a Foolish community of like-minded investors in pursuit of a bargain.Clickhereto learn more.
Nathan Parmelee owns shares in Outback Steakhouse and recently ordered a MacBook Pro, but he has no financial interest in any of the companies mentioned. The Motley Fool has a disclosure policy .
