Stock Valuation

Introducing Methods for Stock Valuation

• Generally, there are two types of stock valuation models:

  • Income valuation
  • Relative valuation

• The most popular method for income valuation is discounted cash flow analysis (DCF)

  • DCF involves discounting the future profits of a stock

    • These profits can include the following:

      • Dividends
      • Earnings
      • Cash flows

  • The discounted rate normally includes a risk premium

    • This is commonly based on the capital asset pricing model

• Possibly, the most common method for relative valuation is the Price to earnings ratio (P/E ratio)

  • This method is based on historic ratios
  • It measures a stock's value based on measurable attributes
• Income valuation is what financial analysts use to justify stock prices
• Relative valuation is what drives long-term stock prices

Defining Metrics used in Stock Valuation

• The following are useful quantitative metrics for relative valuation:

  • P/E ratio
  • P/B ratio
  • D/E ratio
  • Gross Profit Margins
  • Return on invested capital (ROIC)
  • Return on assets (ROA)
  • Total addressable market (TAM)
  • Liquidity ratio
  • R/D expenses
  • Retained earnings
  • Retained earnings to market value
  • Insider ownership

• The following are useful qualitative metrics for relative valuation:

  • Earnings comparison to other companies in the industry
  • Quality of CEO

Defining a Price to Earnings Ratio

• Intuitively, a P/E ratio represents how a stock's current price compares to its current earnings per share (EPS)
• Note, it doesn’t consider future earnings or growth (or lack of growth)

• The EPS represents how a company's net income compares to the number of available shares of stock

  • Generally, a higher EPS is better

• A lower P/E ratio is better

  • Roughly, a P/E ratio $< 16$ is ideal

$$\text{EPS} = \frac{\text{Net Income}}{\text{Common Stock}}$$ $$\text{P/E Ratio} = \frac{\text{Stock Price}}{\text{EPS}}$$

Defining a Price to Book Value Ratio

• Intuitively, a P/B ratio represents how a stock's current price compares to its current ownership per share
• Note, it doesn't consider future ownership or growth (or lack of growth)
• The book value represents how a company's equity compares to the number of available shares of a stock

• Generally, a lower P/B ratio is better

  • Roughly, a P/B ratio $< 1$ is ideal

$$\text{BPS} = \frac{\text{Equity}}{\text{Common Stock}}$$ $$\text{P/B Ratio} = \frac{\text{Stock Price}}{\text{BPS}}$$

Defining a D/E Ratio

• Intuitively, a D/E ratio represents how a stock's current debt compares to its current ownership
• Note, it doesn't consider future debts or future ownership

• Generally, a lower D/E ratio is better

  • Roughly, a D/E ratio $< 2$ is ideal

$$\text{D/E Ratio} = \frac{\text{Total Debts}}{\text{Total Equity}}$$

Defining Gross Profit Margins

• Intuitively, gross profit margins represent how a company's profits compare to its total revenue
• It's used to find whether the product is practical and worth producing
• Note, it doesn't consider future profits or future revenue
• Generally, higher profit margins are better
• A good margin will vary considerably by industry

$$\text{Gross Profit} = \text{Revenue } - \text{ COGS}$$ $$\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}}$$

Defining Return on Invested Capital

• Intuitively, return on invested capital (ROIC) represents how effective a company reinvests in itself
• Specifically, it represents how a company's income (after major expenses) compares to its invested capital
• EBITDA is a company's income after major expenses
• EBIT is a company's income after major expenses and depreciation
• Invested capital is a company's long-term liabilities and equity

$$\text{EBITDA} = \text{Revenue } - \text{ COGS } - \text{ Operating Expenses}$$ $$\text{EBIT} = \text{EBITDA } - \text{ Depreciation } - \text{ Amortization}$$ $$\text{Invested Capital} = \text{Assets } - \text{ Current Liabilities}$$ $$\text{ROIC} = \frac{\text{EBIT}}{\text{Invested Capital}}$$

Defining Return on Assets

• Intuitively, return on assets (ROA) represents how effective a company generates profits using its existing assets
• Specifically, it represents how a company's income (after major expenses) compares to its total assets
• EBITDA is a company's income after major expenses
• EBIT is a company's income after major expenses and depreciation

$$\text{EBITDA} = \text{Revenue } - \text{ COGS } - \text{ Operating Expenses}$$ $$\text{EBIT} = \text{EBITDA } - \text{ Depreciation } - \text{ Amortization}$$ $$\text{ROA} = \frac{\text{EBIT}}{\text{Assets}}$$

Defining Total Addressable Market

• Intuitively, total addressable market (TAM) represents the market size
• Specifically, it's the total possible demand for the product
• On the other hand, serviceable available market (SAM) is the portion of TAM targeted and served by a company's product

• Lastly, serviceable obtainable market (SOM) is the share of market

  • It's the percentage of SAM which is realistically reached

Defining Liquidity Ratio

• Intuitively, liquidity ratio represents how many resources a company has to meet its short-term obligations
• Roughly, it represents how much of the short-term liabilities are covered by cash

• Generally, higher liquidity ratios are better

  • If the ratio is $> 1$, then the company is fully covered

$$\text{Liquidity Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

Defining Retained Earnings

• Intuitively, retained earnings represent how much a company reinvests in itself
• Generally, retained earnings is just the net income remaining after a company pays its expenses and dividends to its shareholders

• Retained earnings can contribute to the following:

  • Paying down debt
  • Expanding operations
  • Other reasons

• Another relevant measure is retained earnings to market value

  • This represents how successful a company has been in utilizing their retained money
  • This measures how effective a company's retained earnings are contributing to the growth of the company
  • This is calculated over a period of time

$$\text{Retained Earnings to Market Value} = \frac{p_{t} - p_{t-1} - ... - p_{t-k}}{e_{t} + e_{t-1} + ... + e_{t-k}}$$

• Here, $p_{t}$ represents the price for a $t^{th}$ year
• Whereas, $e_{t}$ represents the earnings for a $t^{th}$ year

Describing Insider Ownership

• Intuitively, insider ownership represents how many insiders are selling compared to buying at a company
• Generally, insiders buy shares only because they believe the company is undervalued

• Key executives (i.e. CEO, CFO, or directors) buying their company's stock could indicate growth

  • However, most companies today require newly appointed executives to own shares

  • Thus, the following are a few exceptions to this rule:

    • Newly appointed executives and directors buying shares
    • Insider executives exercising stock options by buying stock
    • Many other specific reasons
• Note, one or two insiders aren’t important, whereas many is better
• Ideally, the buy/sell ratio should be around $1\%$

Bill Ackman's Keys to Successful Investing

• Invest in public companies
• Understand how the company makes money
• Invest at a reasonable price

• Invest in a company that could last forever

  • Product is inelastic
  • Product is unique
  • Product is established
• Find a company with limited debt
• Look for high barriers to entry
• Invest in a company immune to extrinsic factors
• Invest in a company with low reinvestment costs
• Avoid businesses with controlling shareholders

References

• Wiki about Methods of Stock Valuation
• Wiki about Total Addressable Market
• Wiki about Liquidity Ratio
• Article about Retained Earnings