Valuation of Stocks

METS INSTITUTE OF MANAGEMENT
PART-TIME MASTERS DEGREE IN MANAGEMENT
MMM/ MFM/ MHRDM/ MIM THIRD YEAR SEMESTER FIRST [2010-2013]
CERTIFICATE FROM GUIDE

This is to certify that the project entitled Valuation of Stocks. has been successfully completed by MR.Tarun Ruparelia under my guidance during the Third year i.e. 2009-2010 in partial fulfillment of his/her course, Master Degree in Finance under the University of Mumbai through the METs Institute of Management, General Arun Kumar Vaidya Chowk, Bandra Reclamation, Bandra (W.), Mumbai 400 050.
Name of Project Guide:
Prof Nitin Kulkarni.
Address of Guide: MET Complex, Bandra Reclamation, Bandra (W), Mumbai 400-050 Tel. No.: 26440446 Date:
Signature of Project Guide:
___________________________
Valuation of Stocks 201 2

UNIVERSITY PROJECT Valuation of Stocks.
Project Guide PROF. NITIN KULKARNI
Project prepared by Tarun Ruparelia (Master in Financial Management) MFM- III Year, Semister I Roll No- 99
METS Institute of Management Bandra (W) - Mumbai Academic Year: 2009-2010
2|Page

Table of Contents
METS INSTITUTE OF MANAGEMENT...................................................................................1 CERTIFICATE FROM GUIDE.................................................................................................1
TABLE OF CONTENTS..........................................................................................3 INTRODUCTION TO VALUATION......................................................................4 THE ROLE OF VALUATION ................................................................................7 READING A BALANCE SHEET:.........................................................................12
CURRENT ASSETS....................................................................................................................13 CURRENT LIABILITIES................................................................................................................15 DEBT & EQUITY.....................................................................................................................16 CURRENT & QUICK RATIO..........................................................................................................17 WORKING CAPITAL...................................................................................................................19 PRICE/BOOK, DSO & TURNS.....................................................................................................21
METHODS OF VALUATION...............................................................................23
EARNINGS-BASED VALUATIONS.....................................................................................................23 Is the P/E the Holy Grail?................................................................................................24 REVENUES-BASED VALUATIONS....................................................................................................27 CASH FLOW-BASED VALUATIONS..................................................................................................29 EQUITY-BASED VALUATIONS........................................................................................................31 YIELD-BASED VALUATIONS..........................................................................................................35 MEMBER-BASED VALUATIONS......................................................................................................35 DISCOUNTED CASH FLOW ANALYSIS...............................................................................................36
ANALYSING EQUITY VALUE USING DCF ANALYSIS.................................39 VALUE DRIVERS.................................................................................................41 CONCLUSION ......................................................................................................45 BIBLIOGRAPHY...................................................................................................47
3|Page
Introduction to Valuation
Valuation is the first step toward intelligent investing. When an investor attempts to determine the worth of her shares based on the fundamentals, she can make informed decisions about what stocks to buy or sell. Without fundamental value, one is set adrift in a sea of random short-term price movements and gut feelings. For years, the financial establishment has promoted the specious notion that valuation should be reserved for experts. Supposedly, only sell-side brokerage analysts have the requisite experience and intestinal fortitude to go out into the churning, swirling market and predict future prices. Valuation, however, is no abstruse science that can only be practiced by MBAs and CFAs. Requiring only basic math skills and diligence, any person can determine values with the best of them. Before you can value a share of stock, you have to have some notion of what a share of stock is. A share of stock is not some magical creation that ebbs and flows like the tide; rather, it is the concrete representation of ownership in a publicly traded company. If XYZ Corp. has one million shares of stock outstanding and you hold a single, solitary share that means you own a millionth of the company. Why would someone want to pay you for your millionth? There are quite a few reasons, actually. There is always going to be someone else who wants that millionth of the ownership because they want a millionth of the votes at a shareholder meeting. Although small by itself, if you amass that millionth and about five hundred thousand of its friends, you suddenly have a controlling interest in the company and can make it do all sorts of things, like pay fat dividends or merge with your company. Companies buy shares in other companies for all sorts of reason. Whether it is an outright takeover, in which a company buys all the shares, or a joint venture, in which the company typically buys enough of another company to earn a seat on the board of directors, the stock is
4|Page

always on sale. The price of a stock translates into the price of the company, on sale for seven and a half hours a day, five days a week. It is this information that allows other companies, public or private, to make intelligent business decisions with clear and concise information about what another company's shares might cost them. The share of stock is a stand-in for a share in the company's revenues, earnings, cash flow, shareholder's equity -- you name it, the whole enchilada. For the individual investor, however, this normally means just worrying about what portion of all of those numbers you can get in dividends. The share of ownership entitles you to a share of all dividends in perpetuity. Even if the company's stock does not currently have a dividend yield, there always remains the possibility that at some point in the future there could be some sort of dividend. Finally, a company can simply repurchase its own shares using its excess cash, rather than paying out dividends to shareholders. This effectively drives up the stock price by providing a buyer as well as improving earnings per share (EPS) comparisons by decreasing the number of shares outstanding. Mature, cash-flow positive companies tend to be much more liberal in this day and age with share repurchases as opposed to dividends, simply because dividends to shareholders get taxed twice. The main categories of valuation I will elucidate are valuations based on earnings, revenues, cash flow, equity, dividends and subscribers. Finally, I will sum this all up in a conclusion that positions these valuations in the broader context of fundamental analysis and gives us a sense of how to apply these in our own investment efforts. Knowing what an asset is worth and what determines that value is a pre-requisite for intelligent decision making -- in choosing investments for a portfolio, in deciding on the appropriate price to pay or receive in a takeover and in making investment, financing and dividend choices when running a business. The premise of valuation is that we can make reasonable estimates of value for most assets, and that the same fundamental principles determine the values of all types of assets, real as well as financial. Some assets are easier to value than others, the details of valuation vary from asset to asset, and the uncertainty associated with value estimates is different for different assets, but the core principles remain the same. This introduction lays out some
5|Page

general insights about the valuation process and outlines the role that valuation plays in portfolio management, acquisition analysis and in corporate finance. It also examines the three basic approaches that can be used to value an asset. A philosophical basis for valuation A postulate of sound investing is that an investor does not pay more for an asset than it is worth. This statement may seem logical and obvious, but it is forgotten and rediscovered at some time in every generation and in every market. There are those who are disingenuous enough to argue that value is in the eyes of the beholder, and that any price can be justified if there are other investors willing to pay that price. That is patently absurd. Perceptions may be all that matter when the asset is a painting or a sculpture, but we do not and should not buy most assets for aesthetic or emotional reasons; we buy financial assets for the cashflows we expect to receive from them. Consequently, perceptions of value have to be backed up by reality, which implies that the price we pay for any asset should reflect the cashflows it is expected to generate. Valuation models attempt to relate value to the level of, uncertainty about and expected growth in these cashflows. There are many aspects of valuation where we can agree to disagree, including estimates of true value and how long it will take for prices to adjust to that true value. But there is one point on which there can be no disagreement. Asset prices cannot be justified by merely using the argument that there will be other investors around who will pay a higher price in the future. That is the equivalent of playing a very expensive game of musical chairs, where every investor has to answer the question, "Where will I be when the music stops? before playing. The problem with investing with the expectation that there will be another person around to sell an asset to, when the time comes, is that you might end up being the looser of all. So just how do you value the shares of a company? Based on earnings, revenues, cash-flow. . . or something else entirely? Or do you simply apply multiple valuations in order to discern what the fair price for a share of stock might be?
6|Page
The Role of Valuation

Valuation is useful in a wide range of tasks. The role it plays, however, is different in different arenas. The following section lays out the relevance of valuation in portfolio management, in acquisition analysis and in corporate finance. 1. Portfolio Management The role that valuation plays in portfolio management is determined in large part by the investment philosophy of the investor. Valuation plays a minimal role in portfolio management for a passive investor, whereas it plays a larger role for an active investor. Even among active investors, the nature and the role of valuation is different for different types of active investment. Market timers use valuation much less than investors who pick stocks, and the focus is on market valuation rather than on firm-specific valuation. Among security selectors, valuation plays a central role in portfolio management for fundamental analysts, and a peripheral role for technical analysts. The following sub-section describes, in broad terms, different investment philosophies and the roles played by valuation in each one. 1. Fundamental Analysts: The underlying theme in fundamental analysis is that the true value of the firm can be related to its financial characteristics -- its growth prospects, risk profile and cashflows. Any deviation from this true value is a sign that a stock is under or overvalued. It is a long-term investment strategy, and the assumptions underlying it are that: (a) The relationship between value and the underlying financial factors can be measured. (b) The relationship is stable over time. (c) Deviations from the relationship are corrected in a reasonable time period.
7|Page

Fundamental analysts include both value and growth investors. The key difference between the two is in where the valuation focus lies. Reverting back to our break down of assets in figure 1.1, value investors are primarily interested in assets in place and acquiring them at less than their true value. Growth investors, on the other hand, are far more focused on valuing growth assets and buying those assets at a discount. While valuation is the central focus in fundamental analysis, some analysts use discounted cashflow models to value firms, while others use multiples and comparable firms. Since investors using this approach hold a large number of 'undervalued' stocks in their portfolios, their hope is that, on average, these portfolios will do better than the market. 2. Activist Investors: Activist investors take positions in firms that have a reputation for poor management and then use their equity holdings to push for change in the way the company is run. Their focus is not so much on what the company is worth today but what its value would be if it were managed well. Investors like Carl Icahn, Michael Price and Kirk Kerkorian have prided themselves on their capacity to not only pinpoint badly managed firms but to also create enough pressure to get management to change its ways. How can valuation skills help in this pursuit? To begin with, these investors have to ensure that there is additional value that can be generated by changing management. In other words, they have to separate how much of a firms poor stock price performance has to do with bad management and how much of it is a function of external factors; the former are fixable but the latter are not. They then have to consider the effects of changing management on value; this will require an understanding of how value will change as a firm changes its investment, financing and dividend policies. As a consequence, they have to not only know the businesses that the firm operates in but also have an understanding of the interplay between corporate finance decisions and value. Activist investors generally concentrate on a few businesses they understand well, and attempt to acquire undervalued firms. Often, they wield influence on the management of these firms and can change financial and investment policy. 3. Chartists: Chartists believe that prices are driven as much by investor psychology as by any underlying financial variables. The information available from trading measures -- price movements, trading volume and short sales -- gives an indication of investor psychology and future price movements. The assumptions here are that prices move in predictable patterns, that
8|Page

there are not enough marginal investors taking advantage of these patterns to eliminate them, and that the average investor in the market is driven more by emotion than by rational analysis. While valuation does not play much of a role in charting, there are ways in which an enterprising chartist can incorporate it into analysis. For instance, valuation can be used to determine support and resistance lines[5] on price charts. 4. Information Traders: Prices move on information about the firm. Information traders attempt to trade in advance of new information or shortly after it is revealed to financial markets. The underlying assumption is that these traders can anticipate information announcements and gauge the market reaction to them better than the average investor in the market. For an information trader, the focus is on the relationship between information and changes in value, rather than on value, per se. Thus an information trader may buy an 'overvalued' firm if he believes that the next information announcement is going to cause the price to go up, because it contains better than expected news. If there is a relationship between how undervalued or overvalued a company is, and how its stock price reacts to new information, then valuation could play a role in investing for an information trader. 5. Market Timers: Market timers note, with some legitimacy, that the payoff to calling turns in markets is much greater than the returns from stock picking. They argue that it is easier to predict market movements than to select stocks and that these predictions can be based upon factors that are observable. While valuation of individual stocks may not be of much direct use to a market timer, market timing strategies can use valuation in one of at least two ways: (a) The overall market itself can be valued and compared to the current level. (b) Valuation models can be used to value a large number of stocks, and the results from the cross-section can be used to determine whether the market is over or under valued. For example, as the number of stocks that are overvalued, using the valuation model, increases relative to the number that are undervalued, there may be reason to believe that the market is overvalued. 6. Efficient Marketers: Efficient marketers believe that the market price at any point in time represents the best estimate of the true value of the firm, and that any attempt to exploit
9|Page

perceived market efficiencies will cost more than it will make in excess profits. They assume that markets aggregate information quickly and accurately, that marginal investors promptly exploit any inefficiencies and that any inefficiencies in the market are caused by friction, such as transactions costs, and cannot exploited. For efficient marketers, valuation is a useful exercise to determine why a stock sells for the price that it does. Since the underlying assumption is that the market price is the best estimate of the true value of the company, the objective becomes determining what assumptions about growth and risk are implied in this market price, rather than on finding under or overvalued firms. 7. Valuation in Acquisition Analysis: Valuation should play a central part of acquisition analysis. The bidding firm or individual has to decide on a fair value for the target firm before making a bid, and the target firm has to determine a reasonable value for itself before deciding to accept or reject the offer. There are special factors to consider in takeover valuation. First, there is synergy, the increase in value that many managers foresee as occurring after mergers because the combined firm is able to accomplish things that the individual firms could not. The effects of synergy on the combined value of the two firms (target plus bidding firm) have to be considered before a decision is made on the bid. Second, the value of control, which measures the effects on value of changing management and restructuring the target firm, will have to be taken into account in deciding on a fair price. This is of particular concern in hostile takeovers. As we noted earlier, there is a significant problem with bias in takeover valuations. Target firms may be over-optimistic in estimating value, especially when the takeover is hostile, and they are trying to convince their stockholders that the offer price is too low. Similarly, if the bidding firm has decided, for strategic reasons, to do an acquisition, there may be strong pressure on the analyst to come up with an estimate of value that backs up the acquisition. 8. Valuation in Corporate Finance: There is a role for valuation at every stage of a firms life cycle. For small private businesses thinking about expanding, valuation plays a key role when they approach venture capital and private equity investors for more capital. The share of a firm that a venture capitalist will demand in exchange for a capital infusion will depend upon the
10 | P a g e

value she estimates for the firm. As the companies get larger and decide to go public, valuations determine the prices at which they are offered to the market in the public offering. Once established, decisions on where to invest, how much to borrow and how much to return to the owners will be all decisions that are affected by valuation. If the objective in corporate finance is to maximize firm value[6] , the relationship between financial decisions, corporate strategy and firm value has to be delineated. As a final note, value enhancement has become the mantra of management consultants and CEOs who want to keep stockholders happy, and doing it right requires an understanding of the levers of value. In fact, many consulting firms have come up with their own measures of value (EVA and CFROI, for instance) that they contend facilitate value enhancement. 9. Valuation for Legal and Tax Purposes: Mundane though it may seem, most valuations, especially of private companies, are done for legal or tax reasons. A partnership has to be valued, whenever a new partner is taken on or an old one retires, and businesses that are jointly owned have to be valued when the owners decide to break up. Businesses have to be valued for estate tax purposes when the owner dies, and for divorce proceedings when couples break up. While the principles of valuation may not be different when valuing a business for legal proceedings, the objective often becomes providing a valuation that the court will accept rather than the right valuation.
11 | P a g e
Reading a Balance Sheet:

"Cash Is King?" Sure, you have heard the cliche. You will be talking to another investor about the latest addition to your portfolio and the conversation will turn to how each of you picks stocks. The other investor will smile at you and wink, cryptically saying, "Cash is king." Although somewhat perplexed, you don't dare ask for clarification for fear of looking like a fool. But what the heck does that really mean? Publicly traded companies are designed to make money. The conventional way of scoring this pursuit is by looking at the company's ability to grow various flavors of earnings -- operating earnings, pretax earnings, net income and earnings per share are all common measures. However, this is not the only way to determine if there is real value in a company's stock. A company's real earnings are the earnings that make it from the Consolidated Statement of Earnings to the Balance Sheet as a liquid asset. Shareholder value ultimately derives from liquid assets, the assets that can easily be converted into cash. A company's value is determined by how much in the way of liquid assets it can amass. There are two ways to think about this. The first is to look at terminal value, which assumes for the sake of calculating potential return that at some future point a company will close down its operations and turn everything into cash, giving the money to shareholders. The second is to look at where tangible shareholder value comes from -- returns on invested capital generated by the company's operations. If a company has excess liquid assets that it does not need, it can deploy those assets in two ways to benefit shareholders -- dividends and stock buybacks.
12 | P a g e

Knowing what is on the balance sheet is crucial to understanding whether or not the company you are investing in is capable of generating real value for shareholders. Most investors who look at annual reports, 10-Ks and 10-Qs spend far too much time worrying about earnings and far too little time worrying about the balance sheet and its cousin, the Statement of Cash Flows. It is the balance sheet that can tell you if a company has enough money to continue to fund its own growth or whether it is going to have to take on debt, issue debt, or issue more stock in order to keep on keeping on. Does a company have too much inventory? Is a company collecting money from its customers in a reasonable amount of time? It is the balance sheet -- the listing of all of the assets and liabilities of a company -- that can tell you all of this. Where do you find all this information about the balance sheet? Would you believe that you can get it for free? The documents that the Securities and Exchange Commission (SEC) makes available to you online at the Edgar website give you all sorts of balance sheet information in the 10-Ks and 10-Qs. The 10-K is a toned-down version of the annual report with more text and fewer pretty pictures that comes out once a year, containing the company's annual balance sheet. The 10-Q is a quarterly filing that a company makes with the SEC three times a year (with the fourth filing being the 10-K in the fourth quarter) that also tracks the balance sheet through the course of the year. The advantage of the annual balance sheet over the quarterlies is that the annual balance sheet has been double-checked by accountants before it was filed with the SEC. Armed with this information, you are ready to begin your journey through the balance sheet.
Current Assets
The first major component of the balance sheet is Current Assets, which are assets that a company has at its disposal that can be easily converted into cash within one operating cycle. An operating cycle is the time that it takes to sell a product and collect cash from the sale. It can last anywhere from 60 to 180 days. Current assets are important because it is from current assets that a company funds its ongoing, day-to-day operations. If there is a shortfall in current assets, then the company is going to have to dig around to find some other form of short-term funding, which normally results in interest payments or dilution of shareholder value through the issuance of
13 | P a g e

more shares of stock. There are five main kinds of current assets -- Cash & Equivalents, Shortand Long-Term Investments, Accounts Receivable, Inventories and Prepaid Expenses. Cash & Equivalents are assets that are money in the bank, literally cold, hard cash or something equivalent, like bearer bonds, money market funds, or vintage comic books. All right, it does not include vintage comic books. Cash and equivalents are completely liquid assets, and thus should get special respect from shareholders. This is the money that a company could immediately mail to you in the form of a fat dividend if it had nothing better to do with it. This is the money that the company could use to buy back stock, and thus enhance the value of the shares that you own. Short-Term Investments are a step above cash and equivalents. These normally come into play when a company has so much cash on hand that it can afford to tie some of it up in bonds with durations of less than one year. This money cannot be immediately liquefied without some effort, but it does earn a higher return than cash by itself. It is cash and investments that give shares immediate value and could be distributed to shareholders with minimal effort. Accounts Receivable, normally abbreviated as A/R, is the money that is currently owed to a company by its customers. The reason why the customers owe money is that the product has been delivered but has not been paid for yet. Companies routinely buy goods and services from other companies using credit. Although typically A/R is almost always turned into cash within a short amount of time, there are instances where a company will be forced to take a write-off for bad accounts receivable if it has given credit to someone who cannot or will not pay. This is why you will see something called allowance for bad debt in parentheses beside the accounts receivable number. The allowance for bad debt is the money set aside to cover the potential for bad customers, based on the kind of receivables problems the company may or may not have had in the past. However, even given this allowance, sometimes a company will be forced to take a write-down for accounts receivable or convert a portion of it into a loan if a big customer gets in real trouble. Looking at the growth in accounts receivable relative to the growth in revenues is important -- if receivables are up more than revenues, you know that a lot of the sales for that particular quarter
14 | P a g e

have not been paid for yet. We will look at accounts receivable turnover and days sales outstanding later in this series as another way to measure accounts receivable. Inventories are the components and finished products that a company has currently stockpiled to sell to customers. Not all companies have inventories, particularly if they are involved in advertising, consulting, services or information industries. For those that do, however, inventories are extremely important. Inventories should be viewed somewhat skeptically by investors as an asset. First, because of various accounting systems like FIFO (first in, first out) and LIFO (last in, first out) as well as real liquidation compared to accounting value, the value of inventories is often overstated on the balance sheet. Second, inventories tie up capital. Money that it is sitting in inventories cannot be used to sell it. Companies that have inventories growing faster than revenues or that are unable to move their inventories fast enough are sometimes disasters waiting to happen. We will look at inventory turnover later as another way to measure inventory. Finally, Prepaid Expenses are expenditures that the company has already paid to its suppliers. This can be a lump sum given to an advertising agency or a credit for some bad merchandise issued by a supplier. Although this is not liquid in the sense that the company does not have it in the bank, having bills already paid is a definite plus. It means that these bills will not have to be paid in the future, and more of the revenues for that particular quarter will flow to the bottom line and become liquid assets.
Current Liabilities
Current Liabilities are what a company currently owes to its suppliers and creditors. These are short-term debts that normally require that the company convert some of its current assets into cash in order to pay them off. These are all bills that are due in less than a year. As well as simply being a bill that needs to be paid, liabilities are also a source of assets. Any money that a company pulls out of its line of credit or gains the use of because it pushes out its accounts payable is an asset that can be used to grow the business. There are five main categories of
15 | P a g e

current liabilities: Accounts Payable, Accrued Expenses, Income Tax Payable, Short-Term Notes Payable and Portion of Long-Term Debt Payable. Accounts Payable is the money that the company currently owes to its suppliers, its partners and its employees. Basically, these are the basic costs of doing business that a company, for whatever reason, has not paid off yet. One company's accounts payable is another company's accounts receivable, which is why both terms are similarly structured. A company has the power to push out some of its accounts payable, which often produces a short-term increase in earnings and current assets. Accrued Expenses are bills that the company has racked up that it has not yet paid. These are normally marketing and distribution expenses that are billed on a set schedule and have not yet come due. A specific type of accrued expense is Income Tax Payable. This is the income tax a company accrues over the year that it does not have to pay yet according to various federal, state and local tax schedules. Although subject to withholding, there are some taxes that simply are not accrued by the government over the course of the quarter or the year and instead are paid in lump sums whenever the bill is due. Short-Term Notes Payable is the amount that a company has drawn off from its line of credit from a bank or other financial institution that needs to be repaid within the next 12 months. The company also might have a portion of its Long-Term Debt come due with the year, which is why this gets counted as a current liability even though it is called long-term debt -- one of those little accounting quirks.
Debt & Equity

The remainder of the balance sheet is taken up by a hodge-podge of items that are not current, meaning that they are either asset that cannot be easily turned into cash or liabilities that will not come due for more than a year. Specifically, there are five main categories -- Total Assets, LongTerm Notes Payable, Stockholder's/Shareholder's Equity, Capital Stock and Retained Earnings.
16 | P a g e

Total Assets are assets that are not liquid, but that are kept on a company's books for accounting purposes. The main component is plants, property and equipment and encompasses any land, buildings, vehicles and equipment that a company has bought in order to operate its business. Much of this is actually subject to an accounting convention called depreciation for tax purposes, meaning that the stated value of the total assets and the actual value or price paid might be very different. Long-Term Notes Payable or Long-Term Liabilities are loans that are not due for more than a year. These are normally loans from banks or other financial institutions that are secured by various assets on the balance sheet, such as inventories. Most companies will tell you in a footnote to this item when this debt is due and what interest rate the company is paying. The last main component, Stockholder's or Shareholder's Equity, is composed of Capital Stock and Retained Earnings. Frankly, this is more than a little bit confusing and does not always add all that much value to the analysis. Capital stock is the par value of the stock issued that is recorded purely for accounting purposes and has no real relevance to the actual value of the company's stock. Capital in Excess of Stock is another weird accounting convention that is pretty difficult to explain. Essentially, it is any additional cash that a company gets from issuing stock in excess of par value under certain financial conventions. Retained earnings is another accounting convention that basically takes the money that a company has earned, less any earnings that are paid out to shareholders in the form of dividends and stock buybacks, and records this on the company's books. Retained earnings simply measures the amount of capital a company has generated and is best used to determine what sorts of returns on capital a company has produced. If you add together capital stock and retained earnings, you get shareholder's equity -- the amount of equity that shareholders currently have in the company.
Current & Quick Ratio

So, you have managed to read through my abbreviated definitions of various items on the balance sheet -- congratulations. Now we get to have some fun with numbers and start playing
17 | P a g e

around with these various pieces of information. We do this to derive some rather compelling information about how well the company manages its assets and whether or not the company represents a bargain based on the assets it has at its disposal. The first tool you can use is called the Current Ratio. A measure of how much liquidity a company has, this is simply the current assets divided by the current liabilities. For instance, if JOE'S BAR AND GRILL has $10 million in current assets and $5 million in current liabilities, you get: Current Ratio = = 2.0
As a general rule, a current ratio of 1.5 or greater is normally sufficient to meet near-term operating needs. A current ratio that is too high can suggest that a company is hoarding assets instead of using them to grow the business -- not the worst thing in the world, but potentially something that could impact long-term returns. You should always check a company's current ratio (as well as any other ratio) against its main competitors in a given industry. Certain industries have their own norms as far as which current ratios make sense and which do not. For instance, in the auto industry a high current ratio makes a lot of sense if a company does not want to go bankrupt during the next recession. If you recall the discussion on inventories, I mentioned that sometimes inventories are not necessarily worth what they are on the books for. This is particularly true in retail, where you routinely see close-out sales with 60% to 80% markdowns. It is even worse when a company going out of business is forced to liquidate its inventory, sometimes for pennies on the dollar. Also, if a company has a lot of its liquid assets tied up in inventory, it is very dependent on the sale of that inventory to finance operations. If the company is not growing sales very quickly, this can turn into an albatross that forces the company to issue stock or take on debt. Because of all of this, it pays to check the Quick Ratio. The quick ratio is simply current assets minus inventories divided by current liabilities. By taking inventories out of the equation, you can check and see if a company has sufficient liquid assets to meet short-term operating needs. Say you look at the balance sheet of Joe's Bar and Grill and find out that they have $2.5 million
18 | P a g e

of their current assets in hamburger buns that are sitting in inventory. You now can figure out the company's quick ratio: Quick Ratio = = = 1.5
Looks like Joe's makes the grade again. Most people look for a quick ratio in excess of 1.0 to ensure that there is enough cash on hand to pay the bills and keep on going. The quick ratio can also vary by industry. As with the current ratio, it always pays to compare this ratio to that of peers in the same industry in order to understand what it means in context. Finally, some investors will use something called the Cash Ratio, which is the amount of cash that a company has divided by its current liabilities. This is not a common ratio, however, so I know of no general guideline to use when you want to check it. It is just another method to compare various companies in the same industry with each other in order to figure out which one is better funded.
Working Capital
The best way to look at current assets and current liabilities is by combining them into something called Working Capital. Working capital is simply current assets minus current liabilities and can be positive or negative. Working capital is basically an expression of how much in liquid assets the company currently has to build its business, fund its growth, and produce shareholder value. If a company has ample positive working capital, then it is in good shape, with plenty of cash on hand to pay for everything it might need to buy. If a company has negative working capital, then its current liabilities are actually greater than their current assets, so the company lacks the ability to spend with the same aggressive nature as a working capital positive peer. All other things being equal, a company with positive working capital will always outperform a company with negative working capital. I cannot emphasize enough how important working capital is. Working capital is the absolute lifeblood of a company. About 99% of the reason that the company probably came public in the first place had to do with getting working capital for whatever reasons -- building the business,
19 | P a g e

funding acquisitions or developing new products. Anything good that comes from a company springs out of working capital. If a company runs out of working capital and still has bills to pay and products to develop, it has big problems. A valuation that I am coming to like more and more is comparing working capital to the company's current Market Capitalization. Market capitalization is the value of all the shares of stock currently outstanding plus any long-term debt or preferred shares that the company has issued. The reason you add long-term debt and preferred shares (which are a special form of debt) to the market capitalization is because if you were to buy the company, not only would you have to pay the current market price but you would also have to incur the responsibility for the debt as well. If you take a company's working capital and measure it against a company's market capitalization, you can find some pretty cool stuff. You can compare working capital to market capitalization by dividing working capital by that market capitalization. For instance, if we use Joe's Bar and Grill again, we know that it has $10 million in current assets and $5 million in current liabilities. If you know that Joe's Bar and Grill has no debt, one million shares outstanding and each share is $10 a pop, you can figure out the working capital to market capitalization ratio. Working Capital = = = 50%
What all of that math tells you is that 50% of the market's valuation of Joe's Bar and Grill is backed up by working capital. Theoretically, if you were to liquidate Joe's tomorrow, you would get 50 cents on the dollar just from working capital alone. This is a tremendous amount of money to have at your disposal and really very nice for Joe's. Basically, if you see working capital to market capitalizations of 50% or higher, things are pretty good. Even though working capital is nifty, just looking at the amount of cash a company has relative to its market capitalization is also pretty enlightening. Simply take the cash and equivalents and divide it by the market capitalization to see what the percentage is. If you are dealing with a company where 10% or more of the capitalization is backed up with cold, hard cash, you have a
20 | P a g e

company that has ample funds to get itself going. Also, you might want to net out the inventories from working capital and check that percentage just to make sure that the number is not all that different, especially for retailers and clothing manufacturers. You do this by simply subtracting inventories from working capital.
Price/Book, DSO & Turns

The last three ratios that you can derive from the balance sheet are the Price-to-Book Ratio, Days Sales Outstanding (DSO), and Inventory Turnover. I saved these for last because they are the most complicated. The one of these that I think is absolutely useless is the venerable Price-to-Book Ratio. Conceived in a time when America was made up mainly of industrial companies that had actual hard assets like factories to back up their stock, its utility has waned in the past few decades as more and more companies that are not very capital intensive have grown and become commercial giants. The fact that Microsoft (Nasdaq: MSFT) doesn't have very much in the way of book value doesn't mean the company is overvalued -- it just means that the company does not need a lot of land and factories to make a very high-margin product. Traditional book value is simply the shareholder's equity divided by the number of shares of stock outstanding. Since I think that it is more informative to look at the company as a whole, however, I do my price-to-book ratios using the aggregate market capitalization of the company divided by the current shareholder's equity. I also use something called Enterprise Value, which is market capitalization minus cash and equivalents plus debt. The reason you subtract cash and equivalents from market capitalization is because if someone were to actually buy the company, they would get all the cash the company currently has, meaning it would effectively be deducted from the cost after the transaction was closed. The enterprise value (EV) to shareholder's equity (SE) looks like this, then: EV/SE =
21 | P a g e

This number will get you a simple multiple, much like the price/earnings ratio or the price/sales ratio. If it is below 1.0, then it means that the company is selling below book value and theoretically below its liquidation value. Some value investors will shun any companies that trade above 2.0 times book value or more. Days Sales Outstanding is a measure of how many days worth of sales the current accounts receivable (A/R) represents. It is a way of transforming the accounts receivable number into a handy metric that can be compared with other companies in the same industry to determine which player is managing its receivables collection better. A company with a lower amount of days worth of sales outstanding is getting its cash back quicker and hopefully putting it immediately to use, getting an edge on the competition. To figure out DSO, you first have to figure out Accounts Receivables Turnover. This is: A/R Turnover = Sometimes you will only be able to get the accounts receivable from the last fiscal year, and therefore will have to use the revenues from the last fiscal year. However, the fresher the information, the better. What this ratio tells you is how many times in a year a company turns its accounts receivable. By "turn," I mean the number of times it completely clears all of the outstanding credit. For this number, higher is better. To turn this number into days sales outstanding, you do the following: DSO = This tells you roughly how many days worth of sales are outstanding and not paid for at any given time. As you might have expected, the lower this number is, the better it is for the company. By comparing DSOs for various companies in the same industry, you can get a picture of which companies are managing their credit better and getting money in faster on their sales. This is a crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business.
22 | P a g e

The same is true of Inventory Turnover. The less money you have tied up in inventory in order to fill your distribution channels, the more money you will have to do all the other things a company needs done -- marketing, advertising, research and development, acquisitions, expansions, and so on. You want a company to turn its inventories as often as possible during the year in order to free up that working capital to do other things. To figure out how much a company is turning its inventory, you need to find out the Cost of Goods Sold (COGS) for the past 12 months. COGS is the second entry in the Consolidated Statement of Earnings right below the revenue line. Just add up the last four quarters worth of COGS and then find out the current inventory level. If you have problems finding these numbers, a call to the company's investor relations department will usually get you the information you need. Inventory Turnover = If two companies are the same in every way but one is turning over its inventories more often, the one with better inventory management is the one that is going to be able to grow faster. Inventory management actually is a bottleneck for growth if it is not efficient enough, tying up a lot of working capital that could be better used elsewhere. If you can find out a company's DSO and inventory turns relative to its peers, you will have an incredible view into how well the company can fund its own growth going forward, allowing you to make better investments.
Methods of Valuation
Earnings-Based Valuations
Earnings Per Share and the P/E Ratio The most common way to value a company is to use its earnings. Earnings, also called net income or net profit, is the money that is left over after a company pays all of its bills. To allow for apples-to-apples comparisons, most people who look at earnings measure them according to earnings per share (EPS).
23 | P a g e

You arrive at the earnings per share by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if XYZ Corp. has one million shares outstanding and has earned one million dollars in the past 12 months, it has a trailing EPS of $1.00. (The reason it is called a trailing EPS is because it looks at the last four quarters reported -- the quarters that trail behind the most recent quarter reported.
The earnings per share alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. For instance, if, in our example above, XYZ Corp. was currently trading at $15 a share, it would have a P/E of 15.
Is the P/E the Holy Grail?
There is a large population of individual investors who stop their entire analysis of a company after they figure out the trailing P/E ratio. With no regard to any other form of valuation, this group of intelligent investors blindly plunge ahead armed with this one ratio, purposefully ignoring the vagaries of equity analysis. Popularized by Ben Graham (who used a number of other techniques as well as low P/E to isolate value), the P/E has been oversimplified by those who only look at this number. Such investors look for "low P/E" stocks. These are companies that have a very low price relative to their trailing earnings. Also called a "multiple", the P/E is most often used in comparison with the current rate of growth in earnings per share. The assumption is that for a growth company, in a fairly valued situation the price/earnings ratio is about equal to the rate of EPS growth. In our example of XYZ Corp., for instance, we find out that XYZ Corp. grew its earnings per share at a 13% over the past year, suggesting that at a P/E of 15 the company is pretty fairly valued. People believe that P/E only makes sense for growth companies relative to the earnings
24 | P a g e

growth. If a company has lost money in the past year or has suffered a decrease in earnings per share over the past twelve months, the P/E becomes less useful than other valuation methods we will talk about later in this series. In the end, P/E has to be viewed in the context of growth and cannot be simply isolated without taking on some significant potential for error. Are Low P/E Stocks Really a Bargain? With the advent of computerized screening of stock databases, low P/E stocks that have been mispriced have become more and more rare. When Ben Graham formulated many of his principles for investing, one had to search manually through pages of stock tables in order to ferret out companies that had extremely low P/Es. Today, all you have to do is punch a few buttons on an online database and you have a list as long as your arm. This screening has added efficiency to the market. When you see a low P/E stock these days, more often than not it deserves to have a low P/E because of its questionable future prospects. As intelligent investors value companies based on future prospects and not past performance, stocks with low P/Es often have dark clouds looming in the months ahead. This is not to say that you cannot still find some great low P/E stocks that for some reason the market has simple overlooked -- you still can and it happens all the time. Rather, you need to confirm the value in these companies by applying some other valuation techniques.
The PEG and YPEG : The most common applications of the P/E are the P/E and growth ratio (PEG) and the year-ahead P/E and growth ratio (YPEG). The PEG simply takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. Since it is future growth that makes a company valuable to both an acquirer and a shareholder, seeking either dividends or free cash flow,. to fund stock
25 | P a g e

buybacks. This makes some degree of intuitive sense. Only looking at the trailing P/E is kind of like driving while looking out the rearview mirror. If a company is expected to grow at 10% a year over the next two years and has a P/E of 10, it will have a PEG of 1.0.
A PEG of 1.0 suggests that a company is fairly valued. If the company in the above example only had a P/E of five but was expected to grow at 10% a year, it would have a PEG of 0.5 -implying that it is selling for one half (50%) of its fair value. If the company had a P/E of 20 and expected growth of 10% a year, it would have a PEG of 2.0, worth double what it should be according to the assumption that the P/E should equal the EPS rate of growth. While the PEG is most often used for growth companies, the YPEG is best suited for valuing larger, more-established ones. The YPEG uses the same assumptions as the PEG but looks at different numbers. As most earnings estimate services provide estimated 5-year growth rates, these are simply taken as an indication of the fair multiple for a company's stock going forward. Thus, if the current P/E is 10 but analysts expect the company to grow at 20% over the next five years, the YPEG is equal to 0.5 and the stock looks cheap according to this metric. As always, one must view the PEG and YPEG in the context of other measures of value and not consider them as magic money machines. Although the PEG and YPEG are helpful, they both operate on the assumption that the P/E should equal the EPS rate of growth. Unfortunately, in the real world, this is not always the case. Thus, many simply look at estimated earnings and estimate what fair multiple someone might pay for the stock. For example, if XYZ Corp. has historically traded at about 10 times earnings and is currently down to 7 times earnings because it missed estimates one quarter, it would be reasonable to buy the stock with the expectation that it will return to its historic 10 times multiple if the missed quarter was only a short-term anomaly.
26 | P a g e

When you project fair multiples for a company based on forward earnings estimates, you start to make a heck of a lot of assumptions about what is going to happen in the future. Although one can do enough research to make the risk of being wrong as marginal as possible, it will always still exist. Should one of your assumptions turn out to be incorrect, the stock will probably not go where you expect it to go. That said, most of the other investors and companies out there are using this same approach, making their own assumptions as well, so, in the worst-case scenario, at least you won't be alone. A modification to the multiple approaches is to determine the relationship between the company's P/E and the average P/E of the S&P 500. If XYZ Corp. has historically traded at 150% of the S&P 500 and the S&P is currently at 10, many investors believe that XYZ Corp. should eventually hit a fair P/E of 15, assuming that nothing changes. This historical relationship requires some sophisticated databases and spreadsheets to figure out and is not widely used by individual investors, although many professional money managers often use this approach.
Revenues-Based Valuations
Valuation: The Price/Sales Ratio Every time a company sells a customer something, it is generating revenues. Revenues are the sales generated by a company for peddling goods or services. Whether or not a company has made money in the last year, there are always revenues. Even companies that may be temporarily losing money, have earnings depressed due to short-term circumstances (like product development or higher taxes), or are relatively new in a high-growth industry are often valued off of their revenues and not their earnings. Revenue-based valuations are achieved using the price/sales ratio, often simply abbreviated PSR. The price/sales ratio takes the current market capitalization of a company and divides it by the last 12 months trailing revenues. The market capitalization is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example
27 | P a g e

company XYZ Corp. has ten million shares outstanding, priced at $10 a share, then the market capitalization is $100 million. Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. The logic here is that if you were to acquire the company, you would acquire its debt as well, effectively paying that much more. This avoids comparing PSRs between two companies where one has taken out enormous debt that it has used to boast sales and one that has lower sales but has not added any nasty debt either. Market Capitalization = (Shares Outstanding * Current Share Price) + Current Long-term Debt The next step in calculating the PSR is to add up the revenues from the last four quarters and divide this number into the market capitalization. Say XYZ Corp. had $200 million in sales over the last four quarters and currently has no long-term debt. The PSR would be: PSR = The PSR is a measurement that companies often consider when making an acquisition. If you have ever heard of a deal being done based on a certain "multiple of sales," you have seen the PSR in use. As this is a perfectly legitimate way for a company to value an acquisition, many simply expropriate it for the stock market and use it to value a company as an ongoing concern. Uses of the PSR As with the PEG and the YPEG, the lower the PSR, the better. Ken Fisher, who is most famous for using the PSR to value stocks, looks for companies with PSRs below 1.0 in order to find value stocks that the market might currently be overlooking. This is the most common application of the PSR and is actually a pretty good indicator of value, according to the work that James O'Shaughnessey has done with S&P's CompuStat database. The PSR is also a valuable tool to use when a company has not made money in the last year. Unless the corporation is going out of business, the PSR can tell you whether or not the concern's
28 | P a g e

sales are being valued at a discount to its peers. If XYZ Corp. lost money in the past year, but has a PSR of 0.50 when many companies in the same industry have PSRs of 2.0 or higher, you can assume that, if it can turn itself around and start making money again, it will have a substantial upside as it increases that PSR to be more in line with its peers. There are some years during recessions, for example, when none of the auto companies make money. Does this mean they are all worthless and there is no way to compare them? Nope, not at all. You just need to use the PSR instead of the P/E to measure how much you are paying for a dollar of sales instead of a dollar of earnings. Another common use of the PSR is to compare companies in the same line of business with each other, using the PSR in conjunction with the P/E in order to confirm value. If a company has a low P/E but a high PSR, it can warn an investor that there are potentially some one-time gains in the last four quarters that are pumping up earnings per share. Finally, new companies in hot industries are often priced based on multiples of revenues and not multiples of earnings.
Cash Flow-Based Valuations

Cash-Flow (EBITDA) & Non-Cash Charges Despite the fact that most individual investors are completely ignorant of cash flow, it is probably the most common measurement for valuing public and private companies used by investment bankers. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA). Why look at earnings before interest, taxes, depreciation and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. For instance, CYBEROPTICS (Nasdaq: CYBE) enjoyed a 15% tax rate in 1996, but in 1997 that rate will more than double. This situation overstates CyberOptics' current earnings and understates its forward earnings, masking the company's real operating situation. Thus, a canny analyst would
29 | P a g e

use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits. As for depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. Amortization normally comes in when a company acquires another company at a premium to its shareholder's equity -- a number that it account for on its balance sheet as goodwill and is forced to amortize over a set period of time, according to generally accepted accounting principles (GAAP). When looking at a company's operating cash flow, it makes sense to toss aside accounting conventions that might mask cash strength. When and How to Use Cash Flow Cash flow is most commonly used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. Cable TV companies like TIME-WARNER (NYSE: TWX) and TELECOMMUNICATIONS INC. (Nasdaq: TCOMA) have reported negative earnings for years due to the huge capital expense of building their cable networks, even though their cash flow has actually grown. This is because huge depreciation and amortization charges have masked their ability to generate cash. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition, thus it makes sense for investors to use it as well. The most common valuation application of EBITDA, the discounted cash flow, is a rather complicated spreadsheet exercise that defies simple explanation. Economic Value Added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just eat it up. The most straightforward way for an individual investor to use cash flow is to understand how cash flow multiples work. In a private or public market acquisition, the price-to-cash flow multiple is normally in the 6.0 to 7.0 range. When this multiple reaches the 8.0 to 9.0 range, the acquisition is normally considered
30 | P a g e

to be expensive. Some counsel selling companies when their cash flow multiple extends beyond 10.0. In a leveraged buyout (LBO), the buyer normally tries not to pay more than 5.0 times cash flow because so much of the acquisition is funded by debt. A LBO also looks to pay back all the cash used for the buyout within six years, have an EBITDA of 2.0 or more times the interest payments, and have total debt of only 4.5 to 5.0 times the EBITDA. Investors interested in going to the next level with EBITDA and looking at discounted cash flow or EVA are encouraged to check out the bookstore or the library. Since companies making acquisitions use these methods, it makes sense for investors to familiarize themselves with the logic behind them as this might enable an investor to spot a bargain before someone else.
Equity-Based Valuations
What is Equity? Equity is a fancy way of referring to what is actually there. Whether it's tangible things like cash, current assets, working capital and shareholder's equity, or intangible qualities like management or brand name, equity is everything that a company has if it were to suddenly stop selling products and stop making money tomorrow. Traditionally, investors who rely on buying companies with a substantial amount of equity to back up their value are a paranoid lot who are looking to be able to collect something in liquidation. However, as the TV-dominated mass-consumer age has helped intangibles like brand names create powerful moats around a core business, contemporary investors have begun to push the boundaries of equity by emphasizing qualities that have no tangible or concrete value, but are absolutely vital to the company as an ongoing concern.
The Balance Sheet: Cash & Working Capital Like to buy a dollar of assets for a dollar in market value? Ben Graham did. He developed one of the premier screens for ferreting out companies with more cash on hand than their current market
31 | P a g e

value. First, Graham would look at a company's cash and equivalents and short-term investments. Dividing this number by the number of shares outstanding gives a quick measure that tells you how much of the current share price consists of just the cash that the company has on hand. Buying a company with a lot of cash can yield a lot of benefits -- cash can fund product development and strategic acquisitions and can pay high-caliber executives. Even a company that might seem to have limited future prospects can offer tremendous promise if it has enough cash on hand. Another measure of value is a company's current working capital relative to its market capitalization. Working capital is what is left after you subtract a company's current liabilities from its current assets. Working capital represents the funds that a company has ready access to for use in conducting its everyday business. If you buy a company for close to its working capital, you have essentially bought a dollar of assets for a dollar of stock price -- not a bad deal, either. Just as cash funds all sorts of good things, so does working capital.
Shareholder's Equity & Book Value Shareholder's equity is an accounting convention that includes a company's liquid assets like cash, hard assets like real estate, as well as retained earnings. This is an overall measure of how much liquidation value a company has if all of its assets were sold off -- whether those assets are office buildings, desks, old T-shirts in inventory or replacement vacuum tubes for ENIAC systems. Shareholder equity helps you value a company when you use it to figure out book value. Book value is literally the value of a company that can be found on the accounting ledger. To calculate book value per share, take a company's shareholder's equity and divide it by the current number of shares outstanding. If you then take the stock's current price and divide by the current book value, you have the price-to-book ratio. Book value is a relatively straightforward concept. The closer to book value you can buy something at, the better it is. Book value is actually somewhat skeptically viewed in this day and
32 | P a g e

age, since most companies have latitude in valuing their inventory, as well as inflation or deflation of real estate depending on what tax consequences the company is trying to avoid. However, with financial companies like banks, consumer loan concerns, brokerages and credit card companies, the book value is extremely relevant. For instance, in the banking industry, takeovers are often priced based on book value, with banks or savings & loans being taken over at multiples of between 1.7 to 2.0 times book value. Another use of shareholder's equity is to determine return on equity, or ROE. Return on equity is a measure of how much in earnings a company generates in four quarters compared to its shareholder's equity. It is measured as a percentage. For instance, if XYZ Corp. made a million dollars in the past year and has a shareholder's equity of ten million, then the ROE is 10%. Some use ROE as a screen to find companies that can generate large profits with little in the way of capital investment. COCA-COLA (NYSE: KO), for instance, does not require constant spending to upgrade equipment -- the syrup-making process does not regularly move ahead by technological leaps and bounds. In fact, high ROE companies are so attractive to some investors that they will take the ROE and average it with the expected earnings growth in order to figure out a fair multiple. This is why a pharmaceutical company like MERCK (NYSE: MRK) can grow at 10% or so every year but consistently trade at 20 times earnings or more.
Intangibles Brand is the most intangible element to a company, but quite possibly the one most important to a company's ability as an ongoing concern. If every single MCDONALD'S (NYSE:MCD) restaurant were to suddenly disappear tomorrow, the company could simply go out and get a few loans and be built back up into a world power within a few months. What is it about McDonald's that would allow it to do this? It is McDonald's presence in our collective minds -- the fact that nine out of ten people forced to name a fast food restaurant would name McDonald's without hesitating. The company has a well-known brand and this adds tremendous economic value despite the fact that it cannot be quantified.
33 | P a g e

Some investors are preoccupied by brands, particularly brands emerging in industries that have traditionally been without them. The genius of INTEL (Nasdaq: INTC) and MICROSOFT (Nasdaq: MSFT) is that they have built their company names into brands that give them an incredible edge over their competition. A brand is also transferable to other products -- the reason Microsoft can contemplate becoming a power in online banking, for instance, is because it already has incredible brand equity in applications and operating systems. It is as simple as Reese's Peanut Butter cups transferring their brand onto Reese's Pieces, creating a new product that requires minimum advertising to build up. The real trick with brands, though, is that it takes at least competent management to unlock the value. If a brand is forced to suffer through incompetence, such as AMERICAN EXPRESS (NYSE: AXP) in the early 1990s or Coca-Cola in the early 1980s, then many can become skeptical about the value of the brand, leading them to doubt whether or not the brand value remains intact. The major buying opportunities for brands ironically comes when people stop believing in them for a few moments, forgetting that brands normally survive even the most difficult of short-term traumas. Intangibles can also sometimes mean that a company's shares can trade at a premium to its growth rate. Thus a company with fat profit margins, a dominant market share, consistent estimate-beating performance or a debt-free balance sheet can trade at a slightly higher multiple than its growth rate would otherwise suggest. Although intangibles are difficult to quantify, it does not mean that they do not have a tremendous power over a company's share price. The only problem with a company that has a lot of intangible assets is that one danger sign can make the premium completely disappear. The Piecemeal Company Finally, a company can sometimes be worth more divided up rather than all in one piece. This can happen because there is a hidden asset that most people are not aware of, like land purchased in the 1980s that has been kept on the books at cost despite dramatic appreciation of the land around it, or simply because a diversified company does not produce any synergies. SEARS
34 | P a g e

(NYSE: S), DEAN WITTER DISCOVER (NYSE: DWD) and ALLSTATE (NYSE: ALL) are all worth a heck of a lot more broken apart as separate companies than they ever were when they were all together. Keeping an eye out for a company that can be broken into parts worth more than the whole makes sense, especially in this day and age when so many 1970s conglomerates are crumbling into their component parts.
Yield-Based Valuations
A dividend yield is the percentage of a company's stock price that it pays out as dividends over the course of a year. For example, if a company pays $1.00 in dividends per quarter and it is trading at $100, it has a dividend yield of 4%. Four quarters of $1 is $4, and this divided by $100 is 4%. Yield has a curious effect on a company. Many income-oriented investors start to pour into a company's stock when the yield hits a magical level. The historical performance of the Dow Dividend Approach supports the general conclusion buttressed by Jim O'Shaugnessey's work that shows that a portfolio made up of large capitalization, above-average yielding stocks outperforms the market over time. Some, like Geraldine Weiss, actually invest in stocks based on what yield they should have. Weiss measures the average historical yield and counsels investing in a company's shares when the yield hits the edge of the undervalued band. For instance, if a company has historically yielded 2.5% and is currently paying $4 in dividends, the stock should trade in the $160 range. Anyone interested in learning more about Weiss's yield-oriented valuation approach should check out Dividends Don't Lie. The simplest way to take advantage of stocks that are undervalued based on their yield is to use the Dow Dividend Approach.
Member-Based Valuations
Sometimes a company can be valued based on its subscribers or its customer accounts. Subscriber-based valuations are most common in media and communication companies that
35 | P a g e

generate regular, monthly income -- like cellular, cable TV and online companies. Often, in a subscriber-based valuation, analysts will calculate the average revenues per subscriber over their lifetime and then figure the value for the entire company based on this approach. If AMERICA ONLINE (NYSE: AOL) has six million members and each sticks around, on average, for 30 months, spending an average of $20 a month, the company is worth 6 million times $20 times 30 or $3.6 billion. This sort of valuation is also used for cable TV companies and cellular phone companies. For instance, Continental Cablevision was bought out for $2000 a subscriber. Another way a company can be valued on members is based on accounts. In the healthcare informatics industry, companies are routinely acquired based on the value of their existing accounts. These acquisitions often completely ignore the past earnings or revenues of the company, instead focusing on what additional revenue could be conceivably generated from these new accounts. Although member-based valuations seem rather confusing, their exact mechanics are unique to each industry. Studying the history of the last few major acquisitions can tell an inquisitive investor how the member model has worked in past mergers and can suggest how it might work in the future.
Discounted Cash Flow Analysis

In the DCF methodology, there are two steps in the valuation process: Step 1: Forecast the Free Cash Flow to the Firm (FCFF) This is the cash flow excluding financing effects, but after capital expenditures, working capital usage and taxes. Symbolically, Free Cash Flow to the Firm is calculated as: Earnings Before Interest and Taxes * (1-tax rate) + Non-cash charges (after Tax)
- (Capital Expenditures Depreciation)
- Change in non-cash working capital = Free Cash Flow to the Firm

36 | P a g e

Forecasting free cash flow to the firm through some horizon date involves using financial modeling techniques. Step 2: Calculate the Weighted Average Cost of Capital (WACC) This is used to discount the firms free cash flows back to the present date. Symbolically, the Weighted Average Cost of capital is calculated as: Weighted after-tax cost of debt + Weighted cost of equity = Weighted Average Cost of Capital WACC can be derived from the Capital Asset Pricing Model (CAPM), What is WACC? The Weighted Average Cost of Capital (WACC) is: A measure of a companys cost of funds, considering both debt and equity. A hurdle rate for all of the firms investments. Only those projects that generate returns in excess of the WACC should be undertaken. A discount rate that can be applied to a firms free cash flow to determine its present value. It is this last use that is important in equity valuation. Measuring the WACC involves calculating the cost of a firms debt, calculating the cost of the firms equity, and combining the two. Well start first by calculating the cost of debt,. Calculating the Cost of Debt: Calculating the cost of a firms debt is by far the easier of the two components of WACC to determine. It is simply the after-tax cost of borrowing at current market rates.
37 | P a g e

For bank loans, it is the rate a bank would charge when lending to the company under current conditions. Example Five years ago, Company X used $100 million in ten-year notes at par with a coupon of 8% p.a., paid semi-annually. Today, these bonds have five years to maturity and are trading in the market at a price of 102.05 to yield 7.50%. For WACC purposes, the cost of debt is therefore 7.5% pretax, on a market value of $102.05m. Compared with calculating the cost of debt, calculating a firms cost of equity is more involved, as we shall now see., Calculating the Cost of Equity - CAPM One way of determining a firms cost of equity is to equate it to the rate of return required by investors. This can be determined by using the Capital Asset Pricing Model (CAPM), whose main features are: Investors demand a higher rate of return to compensate for higher levels of risk.
-
For bonds, it is the current market yield on the companys outstanding debt.
The risk of a stock is measured as the stocks beta ( ), a risk measure relative to the market.
The market portfolio a portfolio consisting of all the equities available in the market is used as a benchmark. This market portfolio has a return of Rm and a beta of 1.
38 | P a g e

An individual stock will have a beta greater than 1 if it is more risky (volatile) that the market, and a beta less than 1 if it is less risky. The risk-return trade-off can then be shown on a chart plotting against risk. Specifically, the trade-off is defined by the straight line drawn between the risk-return of the risk free security, and that of the market portfolio.
Determining a Stocks Beta The CAPM provides a way of determining investors return, and hence a firms cost of capital, once the firms beta is known but how is a value for beta obtained? In practice, there are numerous sources of published betas including the major brokerage houses and financial information providers such as Bloomberg, Standard and Poors, Barra and Ibbotson Associates. A commonly used method used by these firms to calculate beta is to perform a regression and analysis between the rates of return on a broad market index and the returns on a specific stock. Beta is the slope of the resulting regression line. Unfortunately, betas calculated for the same company will vary depending on the period during which the data was gathered. In general, there is a trade-off between using data over: -
A long period (five years or more) - the calculated beta will be more stable, but less reflective of current market conditions. A short period (five years or less) the calculated beta will reflect current market conditions more closely, but will be less stable over time.
Analysing Equity Value Using DCF Analysis

While there are many calculations involved in performing a DCF analysis, the basic steps are as follows: Calculate the firms WACC
39 | P a g e

Forecast the firms Free Cash Flow until the horizon period Calculate the firms value at the horizon period using the perpetual growth assumption Using the WACC, discount the above two amounts to obtain the firms Enterprise Value the total market capitalization of the firm including both debt and equity Deduct the market value of a firms debt from the Enterprise Value to obtain the Market Value of Equity Some relationships Involving Enterprise Value Enterprise Value = Market Value + Market Value of Debt Market Value of Equity = Enterprise Value Market Value of Debt Market Value per Share = Market Value of Equity + Number of shares issued
DCF Worked Example: The spreadsheet below shows a detailed calculation of the market value of equity, and the market value per share.
40 | P a g e
Value Drivers
In most businesses, there are a relatively small number of factors which determine the Discounted Cash Flow valuation for the company. They are: Sales Growth Rate (during growth period) Perpetuity Growth Rate (after horizon date)
41 | P a g e

Operating Profit Margin Tax Rate on Operating Profit Incremental Capital Expenditures Incremental Working Capital Investment Cost of Capital
Changes in any of the above parameters can result in substantial variations in the calculated value of a firm. This is particularly true when the forecast period is fairly long, e.g., 10 years.
Sensitivity Analysis of Value Drivers
42 | P a g e

The table below shows a simple company model. Initial sales of 100 grow at 15% p.a. Using the remaining base case assumptions, we can obtain and Enterprise Value of $396.87.
43 | P a g e

Sensitivity Analysis of Value Drivers Chart The chart below shows how a one percentage point increase in each of the value drivers affects the Enterprise Value of the company (in percentage terms) analysed on the previous page.
Sni i i y f . %o t hnen a e rvr e s v o1 Pi Cag i Vl D es t t 0 n u i
1 5 1 0 5 0 5
Cp x ae Sle a s Go t r wh P r eu y ep t it G wh r t o Poit rf Mr in ag W C WC AC
u l V s p r t E i e g n a h c %
-
-0 1 -5 1
DCF Analysis Summary To summarise, the key points of Discounted Cash Flow (DCF) analysis are: A companys Free Cash Flow to the Firm (FCFF) consists of funds generated by the firm after allowing for taxes, changes in working capital, depreciation, and capital expenditures. FCFF is available to repay debt and to make distributions to shareholders FCFF is protected over two periods: o A limited period of above-average growth, which is forecast year by year. o An infinite period of normal growth, during which the firm typically earns a return equal to its WACC.
-
WACC is used to discount all free cash flows back to their present value. The sum of thee present values is the firms Enterprise Value (debt plus equity)
Relationships involving Enterprise Value:

44 | P a g e

o Enterprise Value = Market Value of Equity + Market Value of Debt o Market Value of Equity = Enterprise Value Market Value of Debt
o -
Market Value per Share = Market Value of Equity
Number of shares issued
Key Value Drivers are valuation parameters such as: sales growth rates, gross profit margins, capital expenditures, working capital requirements, and WACC. All of these have a major influence on the determination of Enterprise Value and therefore share price.
Conclusion
Valuation plays a key role in many areas of finance -- in corporate finance, in mergers and acquisitions and in portfolio management. The models presented will provide a range of tools that analysts in each of these areas will find of use, but the cautionary note sounded in this introduction bears repeating. Valuation is not an objective exercise, and any preconceptions and biases that an analyst brings to the process will find their way into the value. The analyst faced with the task of valuing a firm/asset or its equity has to choose among three different approaches -- discounted cashflow valuation, relative valuation and option pricing models; and within each approach, they must also choose among different models. These choices will be driven largely by the characteristics of the firm/asset being valued - the level of its earnings, its growth potential, the sources of earnings growth, the stability of its leverage and its dividend policy. Matching the valuation model to the asset or firm being valued is as important a part of valuation as understanding the models and having the right inputs. Once you decide to go with one or another of these approaches, you have further choices to make whether to use equity or firm valuation in the context of discounted cashflow valuation, which multiple you should use to value firms or equity and what type of option is embedded in a firm. The DCF methodology provides the best approach to valuation for the following reasons :
45 | P a g e

It is not dependent upon accounting measures of earnings or assets. It includes only cash earnings, net of the investment required to generate those earnings. It provides for an objective method for recognizing the cost of capital It recognizes the time value of money.
Principles of Valuation
The present value of any future cash flow is influenced by four variables: Quantity What is the size of the cash flow? Probability What is the probability that the cash flow will actually occur? Timing When will the cash flow occur? Discount Rate What discount rate (interest rate) should be used to calculate the present value of the cash flow? Unlike a bond, the cash flows from equities are uncertain, which is why the probability of the cash flow occurring is one of the four variables that we must consider. Dealing with Uncertainty Uncertainty with respect to the probability of a cash flow occurring can be addressing either by: Adjusting the discount rate the greater the uncertainty, the bigger the discount rate.
Adjusting the size of the anticipated cash flow the greater the uncertainty, the smaller
the cash flow.

46 | P a g e
Bibliography
http://acumennet.com
Investment Valuation : Second Addition by Aswath Damodaran

The Dark Side of Valuation by Aswath Damodaran
47 | P a g e

Valuation of Stocks

Diunggah oleh

Informasi Dokumen

Deskripsi Asli:

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

Valuation of Stocks

Diunggah oleh

Hak Cipta:

Format Tersedia

METS INSTITUTE OF MANAGEMENT

PART-TIME MASTERS DEGREE IN MANAGEMENT

MMM/ MFM/ MHRDM/ MIM THIRD YEAR SEMESTER FIRST [2010-2013]

CERTIFICATE FROM GUIDE

Name of Project Guide:

Prof Nitin Kulkarni.

Signature of Project Guide:

Valuation of Stocks 201 2

Project Guide PROF. NITIN KULKARNI

METS Institute of Management Bandra (W) - Mumbai Academic Year: 2009-2010

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

The Role of Valuation

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Reading a Balance Sheet:

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Debt & Equity

Valuation of Stocks 201 2

Current & Quick Ratio

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Price/Book, DSO & Turns

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Is the P/E the Holy Grail?

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Cash Flow-Based Valuations

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Discounted Cash Flow Analysis

- Change in non-cash working capital = Free Cash Flow to the Firm

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Analysing Equity Value Using DCF Analysis

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Valuation of Stocks 201 2

Sensitivity Analysis of Value Drivers

Valuation of Stocks 201 2

Valuation of Stocks 201 2