How to quickly value any stock
A simple formula to find undervalued stocks
Value investing, when stripped down to its core, is relatively straightforward. You buy a company for less than it is worth, and you let it compound your capital for the years to come.
However, this simple statement raises two fundamental questions:
- How do you find out how much a company is worth?
- How much should you pay for it?
Let me try to answer.
When you start a business, you back up your fantastic idea with some capital with the expectation that it will grow. If your business is successful, it will compound the initial cash into a substantial pile of riches.
Investing is exactly like starting a business, only that you don’t have to create it. You instead have the opportunity to pick and choose between countless existing companies. You have to select a company that will successfully grow your initial investment. This is not a trivial quest.
Many factors can impact the success of a business, but you could argue that it all boils down to profitability.
It is all about cash and how much $ a company can generate. You should pay particular attention to free cash flow, which is the cash left after accounting for capital expenditures.
The correct price to pay today for a stock is the present value of all future cash flows.
Your job as an investor is to figure out how much to pay today by discounting future profit expectations.
Let’s assume that stock XXX will generate $10 in free cash flow each year over the next three years. You might think that discounted present value is $30 ($10 x 3), but you would be wrong.
You need to factor in inflation as future money has less purchasing power. Considering current inflation levels at around 8%(today's rate), the present value should be $27.6, not $30. If you buy stock XXX today at $27.6, assuming your yearly profit expectations of $10 are correct and inflation stays at 8%, you’ll preserve your purchasing power in 3 years.
The higher the expected inflation is, the higher the discount rate you should be using.
However, this approach will not produce any growth in principal. To further improve your profit odds, you should add an expected return and a margin of safety (to limit the risk of error). The margin of safety is somehow subjective, but it should be higher for risky companies. I generally use a discount rate between 9% and 20%.
If you add a desired 12% yearly rate of return(including a margin of safety) on top of 8% inflation, you’ll get a discount rate of around 20% per year with a present value for stock XXX of approximately $23.7.
All you have to do now is wait for the price of stock XXX to get under $23.7 and buy it. If all your future assumptions are correct, you’ll compound your capital. Easy peasy!
However, the keyword here is FUTURE. This process works well only if you can assume correctly how much cash flow the company will produce in the future ($10 per year in our example).
Sadly the future is hard to predict, so creating cash flow projections is time-consuming, complicated and not necessarily accurate.
When looking at a stock, I like to start with the past and use a little formula to find “potential” undervalued stocks worth looking at more in-depth.
As a start, I forget about predicting the future and focus instead on past cash flows to evaluate current price valuation.
First, I calculate the simple discount rate:
- Discount rate= (1+my desired year return %) x (1+inflation rate %)
Optionally, I consider growth in the formula and subtract from the discount rate a growth rate equal to the growth rate of the global economy. Let’s say 3%.
- Discount rate= [(1+my desired year return %) x (1+inflation rate %)] - (growth rate %)
Once I have an appropriate discount rate, I calculate the last five years' average free cash flow.
- 5Y Avg. FCF = (FCF_Y1 + FCF_Y2 + FCF_y3 + FCF_y4 + FCF_y5)/5
I then divide it by the number of shares outstanding to obtain a 5y average free cash flow per share.
- 5y Avg. FCF/Share = 5y Avg. free cash flow / Shares Outstanding
I finally divide the 5y Avg. FCF/Share by the discount rate. That gives me a present value price of $.
- Present value of cash flow= (5y Avg. free cash flow / Share) / (Discount rate)
If the market price is currently lower than my calculated present cash flow value, the stock is potentially undervalued, and it is worth looking at more closely.
The formula is excellent, but it is just the start of an in-depth valuation.
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Disclaimer: The author might or might not hold ownership in the company mentioned when writing this article. I do not provide personal investment advice, and I am not a qualified licensed investment advisor. I am an amateur, independent investor. All the information is for entertainment or educational purposes only and should not be construed as personal investment advice. While the information provided is believed to be accurate, it may include errors or inaccuracies.
