Valuation and Downside

I'm at Northwestern University attending the 2006 Financial Analyst Seminar, an annual pow-wow sponsored by the CFA Institute. Some of the best minds in finance gather each year at this seminar to talk stocks and keep current on the latest topics. (Why they let me in, I'm not quite sure.) Some of the topics might put any Fool to sleep, but there are definitely some useful ones that can help Fools better manage their portfolios, especially with today's uneven markets.

Yesterday, I had the opportunity to hear Professor Robert Parrino, CFA, a former professor of mine at the University of Texas at Austin, speak. I was able to talk with him briefly about managing uncertainty in a portfolio while working with the main ways to value a stock.

The three key ways to value a stock
Parrino's presentation covered the basic valuation approaches for valuing securities. Although his experience lies more in valuing the private companies that private-equity buyers are interested in acquiring, he said the primary valuation techniques can be applied to private and public firms alike. As such, a general familiarity with these approaches is a necessity for Fools who take a hands-on approach to their portfolios.

There are three key ways to value a company. Here's a brief overview of each.

1. Discounted cash flow
This is a highly recommended Foolish approach. The discounted cash flow method, or DCF, requires an estimation of a company's free cash flow and discount rate to arrive at a firm value. Now, as you might expect for a professor who has mastered the realm of firm valuation, Parrino highlighted multiple ways to perform a DCF valuation, including free cash flow to the firm, free cash flow to equity holders, and an adjusted present value, or APV, method. You can learn the ins and outs of the differences among these methods by grabbing a finance textbook, but just knowing the basic DCF nuts and bolts will serve you well as you pick stocks.

2. Comparing similar companies and transactions
Most investors rely on a comparative approach that consists of inferring a value based on where other similar companies' multiples are trading. If you've ever compared the P/E ratios of Google (NASDAQ:GOOG) and Yahoo! (NASDAQ:YHOO), you've performed what's known in academic circles as a guideline multiple analysis. The most important thing to remember is that you are assuming the stock you use as a comparison is appropriately valued in the market, and that isn't always the case! Plus, it's not always easy to find a close competitor.

There is another comparative approach that's equally useful but hard to put into practice because of the limited data available: guideline multiple analysis. This method involves finding information on the acquisition price of similar companies by, say, the private-equity guys or a competitor. The sticky issue here is that very little information exists for private companies, or for public companies after they get bought out.

3. The last approach: If things really go wrong
Finally, there is a third approach not commonly used, because it's a scenario that most investors don't want to even think about -- bankruptcy or firm liquidation. This method, called "adjusted book value," consists of moving through a company's balance sheet and estimating a market value for all assets and liabilities. The difference is what theoretically would be left over for equity holders after a company ceased to exist. This method could prove useful in the automotive industry to see whether anything might be left if General Motors (NYSE:GM) or Ford (NYSE:F) ever get run over by a slowing economy or rising interest rates. Not a pleasant thought, but it's a useful segue into considering the downside potential in your holdings.

Downside risk
After the presentation, I asked Parrino how to best manage downside risk when valuing a company. He recommended determining a stock's biggest risks, then performing a sensitivity analysis around those key inputs. Consider Dell (NASDAQ:DELL): What key risks could ruin either its operations or its share price? In a DCF valuation, that may include tweaking Dell's gross margins or sales growth to see what a worst-case scenario might include. For instance, how much market share could a revitalized Hewlett-Packard (NYSE:HPQ) potentially steal?

Parrino also suggested using beta as a good risk measure. Some leading value investors consider determining a company's beta a purely academic exercise with little real-world appeal. But since it is literally a calculation of a stock's volatility compared with a market index, it does have some practical use. For instance, if you expect the market itself to become more volatile, then a company with a high beta will likely prove even more unpredictable.

There's no foolproof way to completely eliminate risk in a portfolio. But with some legwork, you'll find that there is a way to at least identify key items that may torpedo a stock holding or increase the risk of your portfolio -- holding only volatile semiconductor stocks, for example. By integrating these potential pitfalls into your valuations, you may find useful ways to better identify and protect against unfortunate investment losses.

Dell is a Stock Advisor and Inside Value recommendation. Try out any of our investing newsletters services free for 30 days.

Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. Feel free to email him with feedback or to further discuss any companies mentioned. The Motley Fool has an ironclad disclosure policy.