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If you are new to investing, valuing a stock can add many question marks to your brain. I went through my Master’s program almost always confused on how to value stocks, and why it’s important to do it at all.
When you’re just starting out as an investor, you’ll learn very quickly that there are simple ways to value a stock and then there are more in-depth strategies. Some beginner investors will choose a company that is hyped on Wall Street or in the media. However, there are ways you can choose a stock that will save you a ton of money and time by using direct financial information, 10-K annual reports and reading analyst reports. Impulsive and random predictions will most likely yield losses, and cause major headaches for you down the road.
In this article, I will describe why using figures and factual information will make your world much easier when evaluating a company's stock for buying potential. There is a saying by Warren Buffet I refer to when investing, “Price is what you pay; value is what you get”.
So without further ado, let's jump in.
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When it comes to investing, everybody is different with how they choose a stock. Some individuals love thinking critically while others like getting right to the point to make a decision.
Think about absolute valuation as creating a detailed to-do list like you would for your chores. Lets say your grandmother comes over and undermines the work you perform and says to your parents, “He should only be getting $30 worth based on the chores he has done before.”
You have a lot of laundry, the trash to take out, cleaning the dishes, and making the bed. If I am your parent, I would make sure all of the chores are checked off in detailed accuracy. A couple hours later, you complete each task in vivid detail, meaning each piece of clothing is folded properly, there are clean dishes and a neatly made bed. Your return is $50 instead of the $30 your grandmother mentioned based on your high level of planning and attention to detail.
Your grandmother is a representation of the market, all of the hype saying the stock should be valued at X price. However, completing the chores in a meticulous process is the actual value of your work, the intrinsic value, which is based on what you actually did.
The next step in determining whether or not to invest in stock based on its value is by analyzing a company's 10-K annual report. Learning how to read a 10-K will give you insight on the company’s management style and financial goals and values.
Annual 10-K Reports
Reading 10-K annual reports is imperative when evaluating stocks. Daniel Kane of Artisan Partners Asset Management mentioned, “The footnotes are the most valuable source. In the footnotes is where the company will give you a good description of their debt structure and the different components of debt.” The balance sheet liabilities are hidden critical information to a company.
When I first saw 10-K reports, my eyes wanted to pop out of my head. How can an individual take in all of this information? A 10-K annual report is finding your way home if you got lost or stranded; think of it as your survival guide.
Every money-move a company makes is written down inside of this report, so reading it over will give you great insight into how the company is functioning and if the stock seems valuable to you.
Discounted Cash Flow Model
During my time completing my Master’s, this model was the basis for all stock valuation. Why? Because a DCF model estimates a company's intrinsic value and is compared to the company’s market value. In simple terms, it cuts out all of the hype with cold-hard facts, and boils everything down to what’s known as the stock’s discount rate.
Being completely lost when I first came across this model, I decided to break it down. I thought to myself, “If I invest $200 today at a 10% annual interest rate, the investment will be worth $220 in one year.” That interest rate is all you need to know. That was the discount rate that makes this investment worth more than today’s value.
Breaking it down further, say we opened up a hot dog stand and it's currently January 1st, 2020. We expect to generate $15,000 in 2020. If we expect a 5% growth rate in our cash flow, we would end up with $19,144 in cash flow by the end of year 5.
Regarding valuing stocks, most analysts covering the company will provide a discount rate of what they expect the company will do in the near future. The main point is to always look at how cash flow is doing for the company dating 5 years back (located in the cash flow statement) and what you expect cash flows will be in the future using a discount rate.
For those of you just starting out in the investing world, taking a course on corporate valuation is an important step in understanding a company’s cash flow.
The next type of valuation is the relative valuation technique. This is the easiest of all the valuation methods. Basically, one compares the value of four or five companies in the same industry.
Relative valuation is “relatively” simple. Imagine this scenario: You want to open a bar. However, before you even think about opening the bar, you must gather market research on the industry and demographic. You can research 3 or 4 bars in the same area, figure out their profit margins by visiting their establishment and analyzing their prices and compare them to your margins.
Figure out what types of expenses go into the bar (food and drink costs and overhead). From there, you can figure out what you expect to earn in revenue. Compare what other bars are earning compared to what you expect to earn based on expenses, loans needed and tax structure (tax rate should be around the same for small businesses in your area).
Using this model, you can value a stock in the same way by comparing a few different companies in the same industry, and evaluating whether or not the stock you’re interested in is valuable compared to the stock of other companies.
Comparables Company Model
This model is pretty straight forward. First, you would have to look up the company you are researching. Next, search for similar companies in the same industry (ie: industrials, energy, finance) that have similar product lines and geographical location.
The comparable model will consist of the company name, share price, market capitalization, debt, enterprise value, revenue, earnings before interest, taxes & depreciation or just EBITDA, earnings per share and what analysts expect earnings to be.
In-depth financial data across industries and multiple companies may not be available on Yahoo Finance. The best source for digging deep into a company's risk profile, management’s discussion and a breakdown of assets such as cash, inventory and liability accounts, is to head to sec.gov. There you can search for any small to large cap stock to evaluate.
Why Use These Models?
It is easy to just get hyped about a stock that is popular in the media. However, you are buying the stock at its market value rather than its intrinsic value. Market value is what the stock is trading at currently.
The intrinsic value of a stock is what the stock is worth based solely within the business; disregarding any external hype about stock. For example, how cash flows are being generated within the company is just one example of finding the intrinsic value.
These models, especially the discounted cash flow model, will give you an overall picture of the company. Instead of following public opinion, you are able to generate your own creative ideas through investing in a particular company.
It all boils down to your preference. I have always found that using ratios and figures to evaluate a company or stock always yields the best results.
The name of the game when it comes to valuing stocks is to never base your decision off just one valuation model or someone's opinion about the stock. Do your research and gather relevant facts from real time sources such as Yahoo Finance or Market Watch. The main objective is to reduce the amount of money spent on a stock while taking calculated risks.
If you never take risks, the reward will never be in sight. So reward your mind and wallet by using models like these to evaluate the next stock you’re interested in buying. Headaches and money troubles are never fun, so save yourself the future gripes and start planning ahead before you buy.
Contributor’s opinions are their own. Always do your own due diligence before investing.
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