An introduction to stock valuation
Mar 11, 2021
Do you see yourself as a value investor? Or perhaps a growth investor? Are you trying to find stocks that sell well below what they are worth? Do you think that price is what you pay, while value is what you get? How do you really start to figure out the value of a stock?
How to estimate the value of a stock - intrinsic value - as Warren Buffett calls it?
Intrinsic value is the number or range you can calculate if you were an all knowing businessman who could see far into the future. The value you are calculating is then the present value of the net cash flows your investment will generate to you from now on until judgement day, which are being discounted back to present with an appropriate discount rate.
Why should you be a value investor?
The whole point about investing is to lay out a sum of money now in order to receive a greater amount or many amounts in the future. Whether you call yourself a value investor or growth investor, the same principle stands. As Charlie Munger has said: "All intelligent investing is value investing!"
Estimate the future cash flows
The problem with stocks is that the cash flows they produce in the future is not determined. It is not printed on the certificate, as you have with bonds. A bond investor has the idea of a coupon in mind, which was the amount the instrument paid out on predetermined intervals. The instruments used to have the coupon attached to them, and the bond holder could bring the coupon to the bank and cash it out. As a bond investor you would know what the cash flows would be in the future, that is to say, as long as the underlying company didn't go bankrupt. Then other rules would follow.
Stocks on the other hand do not have a predetermined cash flow printed on the instrument. But as a shareholder you own a piece of the equity of the underlying business. You own a part of the company, and therefore you are entitled to a corresponding proportion of the company's equity and it's future cash flows.
That's the reason why people say investing in stocks is risky. It is! Because you don't know for sure what the company will produce of value, or what it might destroy. But you will know however how large part of the company you own, based on how many shares you are owning.
This is where the job as a stock analyst comes in; you have to try to estimate the future cash flow on your own. Both cash flows into the company as well as out of the company. That's what we call the net cash flows. You need to have an idea of the which cash flows will be going into the company (from shareholders), and cash flows going out of the company (to the shareholders).
The job is in a way to try to estimate the net cash flow, print it on the instrument, and change that stock into a bond.
Warren Buffett says that's the way they think themselves when they invest in new machinery and equipment in the subsidiaries of Berkshire Hathaway.
An example - investing in The Coca-Cola Company
If you were to buy The Coca-Cola Company today you'd have to lay out about $220 bn for the whole company. Would it be a good investment to pay $220 bn today in return for what the company will be able to create of value to the owner for the next 200-300 years? The discount rate doesn't make much difference when you get that far out.
The answer to that question depends on how much cash flow the company would distribute to you, and when those cash flows would occur. What won't give you the answer is how many analysts who recommend the stock, how much volume there is in the stock, or how the stock chart looks like. It's simply just a matter of how much cash the business can generate for it's owners over time.
What is a good investment?
The example above illustrates the idea that applies to all types of investments. Whether you're going to invest in a farm, a rental apartment, or any other financial asset. Even if you were to own oil in the ground. The point is you pay something now in order to get a future cash flow in return.
Ask yourself: How much do you get, when will you get it, and how sure are you?
What are the best investments?
The best investments you do in the stock market is in companies that you buy cheaply, for much less than what they are worth, and in those companies that also will be able to reinvest their cash flows at a high rate of return. If you have bought a company that is very profitable, which manages to reinvest its earnings back into the company and use those earnings to buy very profitable machines or other assets; then you have a compounding machine! The best investments come from buying cheap companies that have a high return on it's own capital, and that have a great ability to reinvest efficiently.
What are the worst investments?
Doing the exact opposite is the worst you could have. You invest in a company, you pay to much for it, much more than what it is worth. And to make things worse, the company requires a ton of capital for even the slightest sum of profit. And perhaps it is even forces to reinvest its earnings in low-earning assets just to stay competitive. Then it will hardly generate any cash. If it does, it's likely from borrowed money!
How Warren thinks about it
Even though Warren only buys a part of the shares in a company the thought process is the same. He looks at the investment as if he's buying the whole company. He tries to estimate what the whole company produces compared to what the company costs. Then he can translate that into what one share is worth.
Warren Buffett is the chairman and CEO of Berkshire Hathaway, a company that doesn't pay a dividend to its owners. How can such a stock have value you ask? You see, the ability to distribute future cash flows to the owners increase over time.
If you are offered to buy the whole company for $620 bn today, you should ask yourself the following question:
Will Berkshire Hathaway be able to distribute enough cash to you early enough, taking into consideration what the current interest rates are, which affect the discount rate? If you can't answer that question, you shouldn't invest in the stock.
Watch the investor legend Warren Buffett explain the idea of valuation himself in the video below. The part we covered in this post starts at 19:55 in the video.
