Calculating Stock Values or How to Value Stock

Better to be approximately right than to be precisely wrong!

Calculating stock values or stock intrinsic value, has been a long journey for me that has followed a number of paths.

This has been partly caused by the lack of clarity, or conflicting direction provided by the information sources that one normally consults to learn more about how to value stock.

Common Valuation Measures

Continuing confusion in the financial press between stock price and what constitutes current stock value has led to common ratios such as the price earnings ratio being used to measure current stock value.

The book value of stock is also used as the denominator of the price book ratio as a measure of fair value.

These ratios provide a 'relative' measure of stock values only, and are useful to make (relative) comparisons between similar companies and with the market as a whole.

However, they do not provide what I call an 'absolute' measure of stock values that is based on the economics of the company itself, and not on its current price.

It was no surprise to read a remark of Warren Buffett that ...

"there has been no trend towards value investing in the 35 years that he has practiced it".

Perhaps the complexity of some valuation methodologies has something to do with this, or because of the confusion caused by the number of valuation approaches available.

Analysts are commonly employed to carry out the valuation task for brokers, fund managers, investment advisers - and for retail investors who often pay for the privilege!

But what the average investor commonly ends up seeing is usually distilled down to buy/reduce/sell/avoid recommendations with zero information as to how the stock market fair value recommendation has come about.

A discussion of how to value stock using the following four quantitative (numerical) approaches is provided ...

  • discounted cash flow analysis
  • dividend cash flow methodology
  • Benjamin Graham's valuation method
  • Brian McNiven's approach
  • net present value calculation

Discounted Cash Flow (DCF) Analysis

As indicated above, a number of valuation methodologies have been used as a stock value calculator.

The most common 'commercial' method in use is the discounted cash flow (DCF) analysis for calculating net present value. It is based on future likely cash flows for the life of the company.

Because money in the future is worth less than it is today, this estimate is 'discounted' to determine the company's worth today.

The 'discount' or discount rate applied (as a percentage) is the return the investor wished to make from investment in the stock.

The greater the return required, the lower will the calculated fair value of the stock be .. and the less likely that the current share price will approach (from above) the calculated fair value of the stock - or be below it.

The investor should require a greater 'discount' (higher return) based on the perceived risk of the investment. Realistic discounts might vary from 12 to 16 per cent.

Dividing the calculated 'worth' of the company by the number of shares on issue provides a dollar valuation of the stock.

This dollar valuation can be compared to the current market price to determine whether the current market price is 'fair value'.

The best calculators I have found to carry out different types of DCF calculations are at ...

Dividend Discount Methodology

This methodology attempts to simplify the discounted cash flow approach by substituting stock dividends for the cash flows and applying a constant growth model to the company's dividends.

The assumption is that investors will ultimately obtain the future cash generation of the company as dividends ... and it is these dividends that provide value.

Check out this link for a discussion of the dividend discount methodology, and for a dividend discount calculator.

Benjamin Graham's Valuation method

In his book, The Intelligent Investor, Ben Graham provides an alternative straight-forward formula for calculating fair value of 'growth' stocks.

This formula is intended to produce results similar to those from more refined mathematical calculations such as discounted cash flow (DCF) calculations.

His formula is:

Intrinsic Value = Current (Normal) Earnings x (8.5 + twice the expected annual growth rate)

He discounts the intrinsic value to provide a margin of safety. He suggests that the growth rate should be that expected over the next seven to ten years.

A variation of Ben Graham's approach adapted from The Intelligent Investor is claimed to be more accurate.

Brian McNiven's Approach

Brian McNiven, the author of Market Wise also had difficulty with some of the assumptions of the discounted cash flow (DCF) model. He provides an alternative 'absolute' approach to DCF analysis based mainly on historical company performance over the previous five years - or four years and one projected year.

Any future concerns about the company performance are reflected in the required return (equivalent to the discount rate) - which is increased if the perceived company risk increases.

His approach is based on determining a multiplier to the equity per share using an Adopted Performance Criteria (APC) which in some cases might be the 'normalized' (adjusted) return on equity, or alternatively, the internal rate of return of the cash flows over the period in question.

I am more comfortable with the McNiven approach to calculating stock fair value outlined in the link above as its determination is completely (absolutely) independent of the stock price - as any estimate of stock intrinsic value ought to be.

Why? With this approach, the value of a stock is determined by the economics of the company, whereas the latest stock price is what one buyer agreed to pay to a seller - which may be completely divorced from value considerations.

Net Present Value Calculation

The net present value (NPV) calculation allows the estimation of stock fair value that can then be compared to the current share price.

This enables the value investor to decide whether the current share price represents fair value or whether the stock is undervalued or overvalued.

A financial calculator or a spreadsheet can be used as an NPV calculator. To see the required steps in the calculation, look here.

To Conclude

Irrespective of the valuation approach taken, I try not to be blinded by numbers when considering stock values. Qualitative concerns also need to be taken into account before deciding whether a particular stock is a worthy candidate for my portfolio.

An assessment of the quality of the company management and the potential for future strong growth are two such considerations.

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