How To Value a Stock In Under 5 Minutes

There are many ways to value a stock. But is it possible to do it in under 5 minutes? In my previous posts I have outlined how to value a company’s stock with the discounted cash flow model (DCF).

In my opinion DCF’s are a more comprehensive and technical tool you should be doing to value a business. As most investors are aware, a businesses intrinsic value is the total value of its future free cash flow, discounted back to its present value.

If you have ever done a DCF before, you will know that it is a lot of work. Also using a DCF to value a stock that is pre-profit leaves a lot of room for error during forecasting. The slightest variation can throw off valuations very quickly.

Recently I have been using a rather simple and effective valuation method to pre-screen potential investments. If you, like me find enjoyment in analysing businesses to invest in, you want to quickly sift through the good from the bad.

This simple valuation method I will be explaining uses a metric that even a novice investor will have heard of. The P/E ratio.

Some people reading this may argue that P/E ratios ignore capital structures and the finer details of a business. While this is true in every sense, this valuation method is mainly for screening and ball-parking a rough “fair value”.

The biggest advantage to this method is that it is simple and very quick.

If you are interested in this template you can find it in my store in the link below.

Why Value a Stock using the PE Valuation Model

Discounted Cash Flows take a while to perform and the mathematics behind them are complex. I also usually only perform a DCF after I have analysed a company’s financial statement and read their reports.

So, there is a lot of work put in even before we get to the valuation part. This may be fine if you really interested in the company you are looking to invest in.

However, with nearly 2000 stocks on the ASX, you will also want to quickly short-list these to investment grade stocks.

We know that not all investments are created equal, and no business is worth an infinite amount of money.

This is where the PE Valuation Model can come in handy.

You can think of it as shortcut to a DCF. While a DCF might be more complicated and what most professionals use, you cannot discount the simple things in life.

DCF’s are more technical, but your calculations are only as good as your assumptions. If a business’s performance deters away from your assumptions, your valuation goes out the window. It’s ‘garbage in, garbage out’.

An investor can sometimes over think too much. Which is why I personally think that this PE Valuation method can be very useful.

In investing you do not have too be 100% right to do well. You can be half right and still make decent returns.

Don’t over complicate the small things. We have to work smarter and not harder.

How to Value a Stock with the PE Valuation Model

The logic behind the PE Valuation Model is that it uses 3 input variables. That is:

1. Expected revenue growth rate
2. Expected future net margin
3. Suitable/Reasonable PE multiple

Especially for smaller capitalisation stocks, they are mostly non-profitable. So usual valuation metrics cannot be used on them.

When you invest in these companies, you have to be optimistic. Heck, every large cap stock used to be a small cap stock at one stage. Think CSL, Telstra, Amazon, Google, Apple etc.

Even if the business is not yet profitable, you have to think that they will be profitable 5 years or 10 years from now.

To value a stock using the PE method you have to first project a suitable revenue growth rate for the next 5 – 10 years.

You then have to apply an appropriate net margin, assuming that the company will be profitable in year 5 or later. You can roughly apply a margin that is the industry average, or a margin you expect.

Once you have forecasted a net profit , you divide that value by the shares outstanding to get the earnings per share (EPS).

Using the P/E formula, you can calculate the price of the share bring multiplying the EPS by a suitable PE multiple. This can be a multiple that is the industry average or the stock market average.

It can also be a multiple that you think is suitable for a company that is growing at the scale you think it will grow at.

To finish it off you will have to discount the calculated price with your required rate of return. This rate will have to be discounted back the same amount of years that you based your forecast on.

PE Valuation Model Example

If I lost you above, let us run through an example using a template I modeled using an Excel spreadsheet. This is an example using a real company on the ASX called Accent Group (AX1). For full disclosure, I do own shares in this company.

In the first step, we will need to forecast revenue growth and net margins of the company. I tend to lean towards calculating an average to get a sense of what we can expect.

It is worth mentioning that your forecasts is what you are expecting the company to achieve.

This could mean that you think the business can grow much better than their historical averages. Or become more economically efficient resulting in a higher net margin.

Like I mentioned above, be careful with your assumptions. Your valuation is only as good as your assumptions. ‘Garbage In, Garbage Out’!!!

Next step we can play around with numbers and where your inputs will matter.

Having too optimistic or conservative assumptions will have significant impacts on the fair value. The same goes with your required rate of return and the assumed P/E.

The historic PE of the ASX200 has been roughly 16. If you choose a PE higher than the ASX you are likely thinking that the business will be growing better than the market average.

Once you have decided on your assumptions, take the earnings for year 5 or 10 and divide that by the shares outstanding. This is your EPS, which you multiply with your assumed PE multiple.

The final result is the share price that you will need to discount back with your required rate of return over the appropriate years.

Key Takeaways

• Valuations do not need to be complicated
• The PE Valuation Model can be used to pre-screen your next investment ideas
• You don’t need to be 100% right in investing to have a decent return. You just have to be roughly right

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