- Discounted Cash Flow (DCF): With the discounted cash flow model, you project 10 years or so of future cash flows. You then discount the numbers because money you have now is worth more than money you might have in the future. The sum of the projected future cash flows is the intrinsic value.
- Multiples: Multiples such as price/earnings, price/sales, or price/book allow you to compare the stock with its competitors, its own historical numbers, or the market as a whole. If the subject stock has a lower multiple than comparable stocks or the overall market, it could have a margin of safety.
- Liquidation value: For some stocks, the only way to value them is to discount some of the assets to fair market value and determine what the whole company would go for if broken up and sold.
In value investing, you look for a quality, easy-to-understand business with good management, value it, and only buy with a sufficient margin of safety. Then you wait for the stock price to revert to its intrinsic value.
Growth investors have a harder time valuing stocks. It’s not unusual for a high-flying growth stock to have a P/E of 350 while the market is at 20 and still outperform over the next 10 years. Any discounted cash flow estimate is bound to look so outlandish as to be useless.
When I worked for a venture capital fund in college, we would value prospects by projecting what the total market for its industry could be in 10 years and then trying to figure out what level of market share it may have.
Another way is to use what Expectations Investing authors Michael Maubossin and Alfred Rappaport call price implied expectations analysis. Instead of running a DCF with crazy numbers, you figure out what amount of growth is needed to justify the current stock price.
Let’s say you’re looking at a growth stock with a high P/E but 100% annualized earnings growth over the past five years. When you run a DCF, it says the company needs to increase earnings at a 40% clip for the next five years to justify the current stock price.
To determine if you have a margin of safety, you need to figure out if that is doable. Forty percent per year for five years would turn earnings of $1 million into close to $5.4 million. That’s more than 400% over five years.
That level of growth is hard, but it isn’t unheard of. If the business is strong enough, it may be doable.
