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Valuation is, of course, fundamental to investing. Knowing what an asset is worth and the drivers of value is a pre-requisite for intelligent investing (as opposed to speculation). In general, there are two basic methods for valuing stocks. One approach is relative valuation. which compares a stock’s valuation level based on multiples like the Price Earnings ratio  with those of other stocks (known as ‘comparable companies’) or versus the company’s own historical valuation levels.

The alternative approach is absolute, or intrinsic, valuatio n. This is based on the economics of the company itself, and not on its current price. It is usually calculated by calculating the present value of the company’s future free-cash flows (cash flow minus capital spending). This approach is much more aligned with the perspective of value investors. As Benjamin Graham wrote, quot;Price is what you pay, value is what you getquot;. His point was that, when you buy a stock, you are buying ownership of a business with real assets. Should that really change just because the market is moody or plagued by worries about liquidity? On this view, as long as the fundamentals are sound, the daily ups and downs in the markets should not alter the value of what you own.

Valuations are mainly relative.

In practice, though, most valuations are relative valuations. This is most likely because multiple-based methods are are simple and easy to relate to.According to Damodaran, a finance professor at NYU, almost 85% of equity research reports are based upon a multiple and comparables, and more than 50% of all acquisition valuations are based upon multiples. He notes that, even discounted cashflow valuations used in consulting are often relative valuations masquerading as discounted cash flow valuations (the objective being to back into a number that has been obtained by using a multiple). As subscribers toStockopedia Pro  will know, we have a Relative Value calculator for each stock in the market that allows you to derive an indicative valuation versus the sector based on a range of different multiples.

Despite its ubiquity, it’s important to recognise that relative valuation is plagued with issues. Firstly, it relies on accurate comparisons but no two firms are ever exactly similar in terms of their risk and growth profile. Secondly, when the companies you’re using as a benchmark are themselves mispriced (e.g. because of a bubble), relative valuation can lead you badly adrift. If the market, for example, is trading at a P/E ratio that is very high by historical standards, then a stock can appear cheap in relative terms but still be priced unsustainably. For the reason, the best approach is likely to combine relative valuation with a healthy dose of intrinsic valuation.

How can we calculate the intrinsic value of a stock?

As mentioned above, the idea behind intrinsic valuation is to derive an absolute value for an asset, based upon its fundamentals: cash flows, expected growth and risk. Assets with high and predictable cash flows should have higher intrinsic values than assets with low and volatile cash flows. In theory, we should be able to estimate intrinsic in a vacuum for a specific asset, without any information about the market although, in practice, this can be difficult and the results may differ widely between different investors.  In broad terms,  there are four main methods of intrinsic valuation:

1. Discounted Cash Flow (DCF) or NPV Analysis

The most common intrinsic valuation method is the discounted cash flow (DCF) analysis for calculating net present value. In simple terms, discounted cash flow tries to work out the value today, based on projections of all of the cash that it could make available to investors in the future. It is described as quot;discountedquot; cash flow because of the principle of quot;time value of moneyquot; (i.e. cash in the future is worth less than cash today). As part of Stockopedia PRO. we provide pre-baked DCF valuation models for all stocks, which you can then modify with your own assumptions. This is not always easy — as discussed elsewhere, it can be tough to forecast how fast a company’s free cash flows will grow, how long they’ll grow, and at what rate they should be discounted back to the present .

The advantage of DCF analysis is that it is based on free cash flow (FCF), which is less subject to manipulation than some other figures and ratios calculated out of the income statement or balance sheet. It is also forward-looking and depends more on future expectations than historical results. But it does have its weaknesses. It is subject to the principle of quot;garbage in, garbage outquot;, i.e. small changes in inputs can result in large changes in the value of a company, given the need to project cash-flow to infinity.  James Montier argues that, quot;while the algebra of DCF is simple, neat and compelling, the implementation becomes a  minefield of problemsquot; (he cites, in particular, problems with  estimating cash flows and estimating discount rates).

A somewhat disused variant of the DCF is the dividend discount methodology. This substitutes stock dividends for the cash flows and applying a constant growth model to the company’s dividends (known as the Gordon Growth Model). The assumption is that value should be based on the ultimate cash generation of the company for investors, i.e. their dividend stream, but this ignores the potential benefits of owning a share other than dividends, such as capital appreciation (for example, Warren Buffett’s investment vehicle, Berkshire Hathaway, has undoubtedly seen a growth in intrinsic value over the years but does not pay a dividend).

2. Benjamin Graham’s Growth Formula

For those struggling with the complexity of the DCF approach, Benjamin Graham articulated in quot;The Intelligent Investorquot; a simplified formula for the valuation of growth stocks which provides similar results. In his words:

“Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the evaluation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.” 

His formula was: Intrinsic Value = Normal Earnings x (8.5 + twice the expected annual growth rate). 8.5x P/E was therefore Graham’s effective base P/E for a no-growth company. He suggests that the growth rate should be that expected over the next seven to ten years.  Again, this formula can be tweaked and modified as part of PRO.

3. Earnings Power Value  

Earnings Power Value is a valuation technique popularised by Bruce Greenwald, an authority on value investing at Columbia University. EPV uses a very basic equation:

Adjusted Earnings divided by the company’s Cost of Capital.

As it assumes no growth, this is arguably a better way to analyze stocks than Discounted Cash Flow analysis that relies on speculative growth assumptions many years into the future. However, it does rely on an assumption about the cost of capital  as well as the fact that current earnings are sustainable (with several adjustments to clean up the underlying earnings figures). Those interested can read more about EPV here .

4. Asset-Based Methods

A final sub-set of intrinsic valuation methods are those based on an analysis of the balance sheet. The most conservative such method is the liquidation value method, which looks at the values  at which its fixed assets, properties, and other assets can be sold off, less any outstanding liabilities. There are various ways to derive this number, ranging from just straight NAV (assets minus liabilities), to Benjamin Graham’s more conservative NCAV and NNWC calculations. This method assumes that the ongoing value of the company as a business entity is eliminated. As the value usually bears little relation to the market price, it is typically most relevant for true bargain investors (a la Graham) and/or when considering distressed companies. You can read more about NCAV investing here .

A slightly less gloomy asset-based method is replacement cost valuation. Using this approach, the investor calculates what it would cost to replicate the key infrastructure/assets of the business.  Outside of the property sector, this is not however widely used. In practice, it can be complicated, because even if replacement costs could be calculated accurately (not easy),it doesn’t necessarily mean that this is an appropriate market value. For example, it might be that the asset is simply not worth replacing.

Conclusion 

The wisest way to approach stock valuation is likely to be by using many different methods and then comparing the results. This is similar to the approach you might use if you were valuing, say, a house, i.e. you might check out what similar houses in a neighbourhood have sold (a relative approach) while also assessing the quality of materials via a survey (akin to intrinsic valuation).

For anyone interested in reading more about stock valuation, it’s well worth checking out the Little Book of Valuation by Damodoran, available on Amazon  (there’s a useful extract here ). You can also read more about some of the different methodologies via the following links: