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Monday, September 11, 2006

Valuing a Stock

From The Average Jor Investor

I got a question about this a while back so I wanted to write a little something about how I go about valuing a stock. Right up front, though, I do want to point out that my Click Commerce call that one reader pointed out (I said in a previous article that Click was worth about $22.50 and it was acquired for $22.75) is a pretty unusual outcome. The fact is that valuation is more of an art than a science. While there is definitely a lot of analytics around determining a stock's value there are also many ways to value a company and many ways to interperet certain numbers so people often come up for very different values for the same stock.

The other thing that I'd point out as far as valuation goes is that if you're really interested in figuring out what a stock is worth you better have a long term view towards investing. Investing based on value, aka "value investing" (funny how that works), calls for a lot of patience as you're basically coming up with a value for the company and then sitting back and waiting for the rest of the market to come to the same conclusion. If, on the other hand, you plan to take a shorter term approach to investing/trading, then spending a lot of time figuring out the value of a stock will often not give you a heck of a lot of return for your time.

As a quick example here, imagine you're looking at Maxim Integrated Products (Nasdaq:MXIM). They're an analog and mixed signal semiconductor company and part of the overall semi industry. Now the semi industry is one that is notorious for its cycles, and if you decide that Maxim is worth 20% more than what the market is valuing it at and we're just heading into the downswing of the cycle then you're likely going to be out of luck if you're holding period is, say, three to six months. However, taking the same situation, if you have a longer term approach it is very possible that when the next up cycle comes around Maxim could hit your valuation mark or even exceed it.

In short, as Benny Graham put it "in the short term the market is a voting maching and in the long term it's a weighing machine." So I wouldn't pin your hopes on quick riches from finding undervalued stocks.

There are actually a few postings that I've put up in the past on valuation techniques, and it probably couldn't hurt to check those out as well. They're mostly focused on using market multiples as valuation benchmarks.

Valuation Techniques
PEG Ratio
The Theory of Valuation
Price to Earnings Multiple

What I'll focus on briefly here is what I like to use a lot, and that's a discounted cash flow (DCF). Basically what a DCF does is it tracks a company's expected cash flow out into the future and then discounts the value of those cash flows back to what they're worth today and, based on that, gives you a value for a share of the stock.

As with any other valuation technique, there are definite advantages and drawbacks to the DCF. One of the reasons I really like the DCF is that it seems more analytically driven than, say, a P/E multiple. Drawbacks of the DCF include the fact that it often only seems more analytical - there are aspects of it that can be toyed around with to get to much different results.

To pull off a DCF you need the following:

1) Estimates of future cash flows - this is one of the primary reasons that a DCF can be more art than science. Estimating future cash flows for a company can be a tricky endeavour and even the very well paid Wall Street analysts are wrong much more often than they're right. I typically use free cash flow as my cash flow number which is calculated as EBIT minus taxes plus depreciation and amortization minus additions to working capital minus capital expenditures. You'll generally want to have estimated cash flows out at least ten years.

2) Discount rate - each company will have a different rate at which you will discount their cash flows and this is dependent on the company's cost of capital. I typically use a weighted average cost of capital (WACC) which averages the company's cost of equity and cost of debt based its debt / equity capitalization weightings. Good descriptions of a WACC and the capital asset pricing model (CAPM), which is used for calculating the cost of equity, can be found at Investopedia. The company's cost of debt can be found by reading through their SEC filings.

3) Share count.

4) Amount of cash and debt.

While a full walk-through of the mechanics of the DCF would take a more ambitious venue than I have here, the basic idea is that you take each year's cash flow and discount it back to what it's worth today using the discount rate and how many years out that cash flow is. Using a perpetuity growth rate, which I typically set as around the rate of inflation, you calculate an end value and add that to the sum of all the other discounted cash flows. That result is your enterprise value which you can then add to your net cash (cash minus debt) and divide by your number of shares to get to a current per-share price.

The actual equations that you use for these exercises can be found at Investopedia or other on-line resources. In some places, such as The Motley Fool, they have ready-made DCF calculators.

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