How to Value a Business on the Stock Market
“Whenever you invest in a company, you’re looking for its market cap to rise.”
-Peter Lynch-
How do you value a business on the stock market? Investing in the stock market is tricky, especially if you are trying to buy individual stocks. Warren Buffett is an advocate for investing in low cost index funds for most investors.
This is because a know nothing investor can achieve greater returns than most managed funds by periodically investing in the broader market over a long period of time.
Choosing individual stocks becomes risky if you are not willing to put in the work. This risk is multiplied if you do not know what you are doing.
However, investing in individual stocks have the potential of generating greater returns than you would otherwise get from an index fund. Which is why in this post I will outline the steps I go through to value a business.
Before we get started you should understand that not all businesses are created equal. Investing in the wrong company can lead to substantial losses than may not be recoverable.
This is the importance of doing your due diligence and making sure you do not slack on the research.
Valuing a business is not just a number on a screen, but a collective of information that needs to be assessed. In my process of analysing a business I follow these 4 steps:
- Analysing the company spanning the last 10 years
- Reading the annual reports of the company over the past 10 years
- Projecting future prospects of the business
- Calculating the present value of the business
Below I will breakdown the steps outlined in more detail by using a business that I have recently researched as an example.
1. Analysing the Business Financials
Before I start with anything, my analysis begins with evaluating the past financial performance of a business over the past decade.
You may choose to extend this by more, but 10 years is sufficient for me. Reason being that past performance may not be an indicator for a business’s future performance.
It does however give an indication on how well the business is managed. This will usually translate to future years, assuming that business economics will not change dramatically.
Below is my excel spreadsheet that I use to analyse the financial performance of a company-
Using this spreadsheet I am able to compare the past performance of the business. If you have not already read my previous posts on how to interpret financial reports or you would like a refresher here are the links to the post (income statement, balance sheet and cash flow statement).
The spreadsheet lists all the metrics that I require and shows the growth rates over the years. Using this method I am able to see if there are any dramatic changes in specific years. And if necessary spend more time to research what happened during the year that caused it.
2. Reading the annual reports
This part is the most time consuming, but also one of the most important part. You can think of the annual report as a business’s diary of sorts. It gives the outline of the company’s activities over the course of the reporting period, and reports any challenges or highlights the business experienced. It is ideal to read annual reports in succession like a story book, as it allows you to see if the business has managed to uphold their promises for the following years.
Further breaking down the financial statements, footnotes and supplementary notes give detailed explanations of the performance of the business. More often than not, listed companies own subsidiaries that contribute to the collective revenue and expenses of the parent company. Reading the annual report in its entirety will provide detailed insight into how the business subsidiaries performs individually.
3. Forecasting future performance
This step is fairly subjective as you are trying to look into the future. There is also a limit on how accurately you are able to forecast a business performance. You often see a disclaimer provided by financial services that “past performance is not an indicator of future performance”.
This already tells you that even “professionals” get it wrong sometimes and do not want to be liable for any losses that you may sustain. Predicting what is going to happen tomorrow is anybody’s guess, trying to predict what will happen over period of years is near impossible.
Consumer behaviour changes, trends come in and out of fashion quickly, economic variables beyond your control and so on. Despite the difficult nature of forecasting business performance, it needs to be done. Which is why stock market investing is partly regarded as speculative.
It is entirely your choice if you decide to approach it aggressively or conservatively. As a personal preference I forecast growth prospects of a business conservatively.
This is because there is more upside potential if the company reports better than expected results. If I were to forecast aggressively and the company results do not meet my prediction, my margin of safety is a lot less.
You may also research on what analysts predict might happen which can be found using yahoo finance.
4. Valuing the company using Discounted Cash Flow (DCF)
The discounted cash flow model is not the only method to value a stock, but it is the model that I usually use. Valuing a business is also subjective to an investor. Two investors with the same set of numbers can come up with two different values.
DCF is the process of estimating the expected future cash flow of the business and discounting the total value with an appropriate discount factor. Thus deriving a present value also known as the intrinsic value of the business.
In simple terms, DCF attempts to calculate the present value of the business based on how much money it will generate in the future.
In my DCF analysis I project for the next 4 years as any longer and it just becomes nonsense. The longer you try to estimate into the future it is like trying to hit a bullseye in pitch black darkness.
Limitations to DCF
The limitations of DCF is that it relies on estimates, and the calculation of the company’s worth is based on how accurate your guess is. Also certain types of businesses are not suitable to value using this methods.
This are businesses that have unpredictable cash flows or when debt and working capital serve different purposes (ie. I would not use this method to value a bank). Below is the excel spreadsheet that I wrote to calculate the value of the stocks I analyse.
The required rate of return is the discount rate. The higher the discount rate the lower the fair value of equity will be and vice versa. One method of determining the discount rate is to calculate the Weighted average cost of capital (WACC), which I have not shown here.
Warren Buffett uses the risk free rate (government bond) as the discount rate, but in these low interest environment the risk free rate is not suitable. You can also think of the discount rate as your return you require for owning that stock.
Play around with the numbers when you do your calculation and also make sure the projected values seem plausible. Devoting your time in researching a company will minimise your risk when investing. It forces you to know how the company operates and generates its revenue.
By assigning a fair value on the stock it will ensure you do not overpay for a company, giving you a margin of safety if the business underperforms. If you would like to use this DCF template go to my etsy store to find out more.
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