Stock Valuation Methods Part 1 – Cash Flow
Stock Valuation Methods Part 1:
In the next 3 articles we are going to go over 3 Stock valuation methods that are commonly used:
- Cash Flow
- Comparable Companies
Figure 8. Fundamental Valuation Methods
We will look at Cash Flow stock valuation methods first
Cash flow based valuations can take the form of a discounted cash flow where we project cash flows in to the future and discount them all back to the present using the WACC we calculated above or capitalized cash flows where we assume an average cash flow for the company and capitalize it using the WACC. We will go over a discounted cash flow approach here as it is more complex.
First – What is Cash Flow? It is the cash available to the company after taxes and capital expenses (buildings, equipment) have been paid. We refer to this as Free Cash Flow or cash flow that is freed up and available to the company.
To do a discounted cash flow we need
- Cash Flows
To calculate value per share we also need
- Interest Bearing Debt
- Number of Shares
We also need to understand how long we are projecting the cash flows for at which point we create a value we refer to as the terminal value where were assume a steady state cash flow. For companies that go through economic cycles like commodity based companies (oil, gold, forest products for ex) we need to project cash flows though the cycle whereas companies that have steady (flat, rising constantly, declining constantly) cash flows we only need a few years of cash flows prior to creating the terminal value.
So if we look at the example below for the Widgets Company we see how to set up a discounted cash flow. We have (an assumed) cash flow of 70, 80, 90 and 100 million (MM $) in years 2016, 2017, 2018 and 2019. Starting in the year 2020 we assume the cash flow will be steady at 105 (or 5% above the 2019 value)
We stated at the first of this e-book we need to make assumptions. For a DCF we need assumptions about these cash flows and when and how much the terminal value will be. These values are based on analysis of the company, the industry it is in and any other factors that may affect it.
You see the next line in Figure 10 is the Discount rate. If the cash flow is before interest payments we will use WACC, if after we use just the Cost of Equity. This is tied to the Enterprise value versus Equity value discussion from above. Are we valuing just the equity or are we valuing the Enterprise and removing the debt after to get the equity.
The present value factor line is calculated as follow:
1 / (1 + discount Rate) ^ year
Example for Year 3: 1/(1 + .1) ^ 3 = 0.75
The present value factor discounts the cash flow back to today, i.e. what is that future cash flow worth in todays terms. We then multiple the Cash flow value by the present value factor to get the Present Value of Cash Flows line values
Next step is to determine the Terminal Value – For that we need a Terminal growth rate which is the very long term growth rate for the company under the assumption the company will survive forever. For that reason, and the fact most companies do not survive forever, the terminal growth rates tend to be a small number like 2 or 3 %. (There is a lot of literature on this of you are interested.)
The terminal value is calculated as 100 / (WACC – Terminal Growth Rate)
In this example therefore 100/ (10-2) = 12.5
We then add up all the Present Values from year 1 to 4 plus the terminal value to give us the Enterprise Value (1081 in our example)
To Calculate the Equity value therefore we need to subtract the interest bearing debt which we have assumed to be 300 million in this example leaving $781 million in Equity. If there is Preferred Equity (preferred stock) those preferred shareholder get paid before common shareholders if the company was being liquidated so we removed the value of the preferred stock prior to dividing by the number of common shares outstanding to get a value per share. In our example we are (assuming) using book values (from the balance sheet) for both debt and preferred stock. In reality we would use market values for both which would require calculations as well. A minority of companies (10% or so) have preferred stock.
That is the process for a discounted cash flow. You see there are some numbers we can easily get from the financial statements and there are assumptions and research required to get the cash flows, growth rates and discount rates.
In the next stock valuation methods article we will discuss Asset Based Valuation.