Before we proceed here, just note that everything is calculated for you (except the DCFs) in the excel spreadsheet of each company.
When it comes to valuing a company, there are two classes of methods you can choose from;
- Intrinsic Valuation – these methods find the true core value of a company. For low-growth companies (growth < 10%) we have the low-growth formula. For high-growth companies (growth > 20%) we have the discounted cash flow analysis (DCF).
- Multiples – this is the value of a company relative to similar companies in today’s stock market – we call this relative valuation. So this method reflects more so what a stock will be priced at rather than what it’s inherent value is. We have two types of multiples; free cash flow multiples, and sales multiples.
There’s two main factors which will influence which style you use;
- Time and Effort.
- Risk.
Let’s start with the first factor – time and effort. My spreadsheets are designed so that the multiples approach is pretty much done for you straight away. However, when it comes to doing a discounted cash flow analysis, while it isn’t that much extra effort, the main thing you need to do is figure out how big your company will ultimately become. This requires a bit of research into other companies in the industry, and so is technically more effort.
The second big factor is risk. The main difference between discounted cash flow (DCF) analysis and multiples (relative valuation) is this – multiples are dependent on the stock market whilst DCF is not. Multiples can change significantly based on superficial factors. For example, when the overall stock market is healthy, multiples are high across the board. When investors love a particular industry or sector, the multiples of all those companies rise. However, the opposite can also happen, with an unhealthy stock market and bad investor sentiment towards an industry causing multiples to drop. So if you use multiples to value a company, you may be using high multiples whilst the stock market is healthy or an industry is booming. This will lead you to put a high value on the company, which in turn will give you a high calculated stock price, and you’ll then buy the stock at that high price. If investor sentiment changes towards that industry, or the stock market becomes unhealthy, your stock could fall well-below what you paid for it and never return. Essentially, multiples can jump all over the place, so with multiples, it’s easier to lose money – especially if you don’t use a margin of safety which you’ll learn about in step 3.
On the other hand, our intrinsic valuation methods calculate the true core value of a company, and while a stock may temporarily fall below this number, in the long-run the stock will end up somewhere near to this value. So if you use intrinsic valuation methods to calculate the value of a stock, and you only buy stocks when they’re at or below this calculated number, then you will essentially never lose money. In the long run, a stock will always end up somewhere near to its intrinsic value – it’s true core value. The reason behind this is complicated but if you’re interested, then Google search ‘intrinsic valuation’.
So the path you wish to pursue is up to you – I’ve only thrown this in here just for your awareness of the differences. At the end of the day, nearly every investor out there uses multiples (relative valuation) to value a company – only the core die-hard value investors exclusively use intrinsic valuation. However, the most sure-fire way to succeed consistently is to rely on your intrinsic methods rather than your relative methods.
What I do is this:
- High-Growth (20+%) Companies – use a discounted cash flow analysis, as multiples won’t be able to encapsulate the long-term growth path that lies ahead.
- Medium-Growth (10-20%) Companies – use multiples (either sales multiples or free cash flow multiples).
- Low-Growth (< 10%) Companies – use the low-growth formula.
Once you’ve decided what approach you intend to use – we then need to value the company based on that approach. Note that its best to actually use all the approaches for every company you look at, and make your judgements based on that. For example, if you use every approach to value a company and you find that the stock is currently at a level that’s below what you calculated using every single approach – then that stock is a strong buy. Whereas if the stock is currently higher than all but one, then maybe its not a buy. You’ll also learn that some methods are more applicable than others for specific stocks, like I’ve illustrated above in my approach.
So the first thing to do is class your company into one of the two groups below. Click the link for the category that matches your company to proceed.