As mine is a Accountancy degree, the Valuation module is more specific and involves accounting adjustments. More specifically, you will learn about these:
- Methodology
- Economic analysis
- Industry analysis
- Company analysis
- Accounting analysis
- Performance analysis
- Prospective analysis
Methodology
The first step of valuation is to understand how the valuation works. Using this approach, we will first need to do qualitative and quantitative research to understand the past economic circumstances that surrounded the company and how did they perform in those circumstances.
With this information, we will forecast the future economic circumstances, and then predict the financial performance of the company. This will then give you the fair value per share of the company.
Economic analysis
Economic analysis is the first step in understanding the company's past and present economic circumstances. You can look at these macroeconomic factors on the countries that the company is in:
- Gross domestic product (GDP)
- Unemployment rates
- Inflation
- Interest rates
- Budget deficit
- Consumer sentiment
In addition, you can figure out the economic attractiveness and risk of the country:
- Infrastructure factors: natural resources, physical infrastructure, human infrastructure, and banking and legal system
- Sovereign risk: political risk, fiscal and monetary policy, and foreign exchange control
If the country the company is investing in and selling to has many natural resources, extensive physical infrastructure, strong human infrastructure, and a developed banking and legal system, then it is easier for the company to have strong financial performance there.
If these factors become more favourable in future, it is more likely that the company will become better, on a macro-level. Similarly, you would want to see that the country has a more stable political system, and an expansionary fiscal and monetary policy in future.
Expansionary fiscal policies involve a lowering of corporate and personal tax rates and a higher government spending. Expansionary monetary policies include the reduction in the prime interest rates and increase in money supply.
The reason for doing economic analysis is so that you understand the risk that the company has faced on a macroeconomic level and to forecast whether such economic circumstances will persist in the future, deteriorate, or improve. This will in turn affect the forecasting of the company's future performance.
Industry analysis
Industry analysis is a more in-depth study of the circumstances that the company has faced and will face in the future. Even though the entire country that the company is vested in might have very good economic indicators, certain industries might not perform well.
For instance, during an economic recovery, the banking and financial sector is likely to lead the recovery and companies in these industries will perform even better. A particularly important concept is that of sector rotation and industry life cycle.
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| Source: http://www.wallstreetcourier.com/images/content/da-sector-rotation-strategy-investing.gif |
Depending on which part the economy is at, different industries will outperform the market.
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| Source: http://knowledgegrab.com/wp-content/uploads/2013/06/Product-life-cycle.jpg |
Similarly, depending on which stage along the industry life cycle the company is in, the company will have different financial performance. For instance, technology firms performed very well during the growth stage just prior to the dot-com bubble.
Another tool that can be used to analyse whether a firm is in an industry that is profitable would be using the value chain analysis. The value chain analysis determines which stage the company is in in the production and sale of a certain good.
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| Source:http://www.pennside.com/hs-fs/hub/197151/file-29049166-jpg/images/pharma-competitive-intelligence-needs-business-value-chain-550.jpg?t=1481217323364 |
The diagram above shows the value-chain in the sale of pharmaceutical and drugs. With the value-chain, we need to identify which process is the most value-adding one. In this case, it is the research and development, and a company that focuses on doing research and development will do better than one which simply manufactures the drug.
The last and probably most important tool in industry analysis is the Porter's Five Forces. According to Michael Porter, there are 5 forces that determine how profitable an industry will be.
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| Source: http://www.cgma.org/Resources/Tools/essential-tools/PublishingImages/porters-five-forces.jpg |
To determine whether the company is in a profitable industry, you must assess the amount of power the company has over the other stakeholders.
- Rivalry increases with:
- Industry growth rate
- Concentration and balance of competitors
- Excess capacity and exit barriers
- Degree of differentiation and switching costs
- Economies of learning and operating leverage
- Threat of new entrants decreases with:
- Economies of scale
- Whether incumbents can take actions to deter entry (network effort)
- Access to channels of distributorship and relationships
- Legal barriers
- Threat of substitutes increases when:
- Lack of differentiation with competitor's products
- Low switching costs
- Bargaining power of buyers increases when:
- Buyers are more concentrated or more informed
- They are price sensitive
- Bargaining power of suppliers increases when:
- Suppliers can siphon value from producers
- Suppliers have supplier concentration and information
The perpetual analysis for the Porter's Five Forces is the comparison between the airline industry and the pharmaceutical industry. Do the Porter's Five Forces yourself and you will understand why pharmaceutical companies are so much more profitable than airline companies.
Company analysis
The last stage of qualitative analysis is company analysis. Even if the country and industry is doing well, a company might still perform poorly due to the company itself being inherently poor. The reverse is also true. For instance, JetBlue being in the airline industry, has turned in profit year after year.
To do a company analysis, you can utilise a SWOT analysis. Doing a SWOT analysis will enable you to identify the key strengths and weaknesses of the company and understand whether they are well poised in the industry.
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| Source: http://www.conceptdraw.com/How-To-Guide/picture/SWOT-Analysis-Blocks.png |
You can refer to this for some of the common strengths, weaknesses, opportunities, and threats.
- Strengths:
- Strong market position
- Strong brand name
- Low cost
- Technological leadership
- Weaknesses:
- Weak market position
- Weak brand
- High cost
- High staff turnover
- Opportunities:
- Demographics
- Deregulation
- Lifestyle changes
- Competitors in distress
- Threats:
- Competition
- Deregulation
- Political/ Social unrest
- Rising factor prices
Thereafter, you will need to analyse the company's strategies and whether they work and also management and how effective is management.
- Nature of product or services
- Product differentiation or cost leadership
- Degree of integration within the value chain
- Vertical integration or horizontal integration
- Degree of geographical diversification
- Domestic or international markets
- Degree of industry diversification
- Single or multi-firm industries
To study management and it's effectiveness, you can consider these factors.
- Disclosure culture: integrity, transparency when it comes to financial reporting
- Attitudes towards risk: risk management and controls and whether management takes excessive risks
- Compensation policies: are the managers overpaid or rewarded for taking excessive risks
- Management depth: the breadth of management expertise
- Level of focus and discipline and succession plans
With a complete economic, industry and company analysis, we can understand why and how the company has performed in the past and how it will perform in future. You will now halfway there in determining the valuation of the company, but the next step is accounting analysis.
Accounting analysis
Because different companies have different accounting policies, income and expenses are recognised on a different basis. As a result , the net income for one company might be different from that of another company.
There is thus a need to undo such accounting distortions, so that the company's net income and net asset values are accounted for with policies similar to those of other companies in the same industry.
There are a total of 14 accounting distortions that you will learn how to undo, with 8 of them affecting the assets, 4 affecting the liabilities, and 2 affecting the equity portion of the company.
- Assets:
- Depreciation and amortisation of non-current assets
- Taking off-balance sheet leased assets onto the balance sheet
- Expensing instead of capitalising off intangible assets
- Reversing revenue improperly recognised
- Impairment of non-current assets and current assets
- Increase in allowances for doubtful debts
- Tax loss no longer being able to be carried forward
- Borrowing cost capitalised
- Liabilities:
- Unearned revenue understated
- Provision understated
- Taking off-balance sheet joint ventures onto the balance sheet
- Taking securitised arrangements onto the balance sheet
- Equity:
- Recycling of OCI to net income
- Increase in contingent claims from employee stock compensation
This is an accounting-heavy segment and many analysts simply ignore this segment. If you want to know the accounting entry for any of them, you can simply drop me an email and I will add in the explanation.
Performance analysis
There are two primary tools in performance analysis, ratio analysis and cash flow analysis. Before you start on analysing the performance of the company, you will need to condense the financial statements of the company.
In other words, the income statement and balance sheet will be reorganised to become condensed and simplified. For the balance sheet, it will be arranged into these segments.
- Net working capital: operating cash, trade receivables, inventories, other current assets less trade payables and other current liabilities
- Net non-current working capital: non-current tangible assets, derivatives less deferred tax liabilities and other non-current non-interest bearing liabilities
- Investment assets: excess cash (cash minus operating cash), minority equity investments, and other non-operating investments
- Debt: current debt, non-current debt, and preference shares
- Group equity: ordinary shareholder's equity, non-controlling interest in equity less assets held for sale
For the income statement, they will be condensed into these segments:
- Net operating profit after tax = net profit - investment profit after tax + interest expense after tax
- Net investment profit after tax = investment and interest income x (1 - tax rate)
- Less interest expenses after tax = interest expense x (1 - tax rate)
After preparing the condensed financial statements, you can use it to do a performance analysis using ratio analysis and cash flow analysis. Minimally, you should perform these analyses against competitors.
- Profitability analysis:
- Return on assets
- Gross profit margin (gross profit / sales)
- Net profit margin
- EBITDA margin (EBITDA / sales)
- Liquidity analysis:
- Current ratio
- Quick ratio
- Operating cash ratio (cash flow from operations / current liabilities)
- Efficiency analysis:
- Days receivables outstanding
- Days inventories held
- Days payables outstanding
- Cash conversion cycle
- Asset turnover
- Solvency analysis
- Liabilities to equity ratio
- Debt to equity
This analysis will allow you to identify the segments where the company does not perform so well and which areas they perform better.
Prospective analysis
This is the final part of the valuation framework. Once you have understood how the company performed in the past (performance analysis) while in the economic circumstances (economic, industry and company analysis), you will have a better idea of how the company will do in the future.
If you have done the previous parts currently, this should be rather easy. Look for the chairman's statement in the company's annual reports, and also press releases and news about the company for their plans going forward. This will give you a better inkling of their likely performance.
The most important thing is to identify the revenue drivers of the company. You can run a regression against any metric for revenue and a R-squared of anything above 0.3 is considered good. Thereafter, try to predict the future performance of this metric.
Suppose the CAGR for number of retail stores in the past 5 years is 20% on the back of the Brexit, lowering of interest rates and so on. In the future, the economy is expected to be similar, so you assign a growth of 10% due to conservatism.
With the regression analysis, you can extrapolate the retail stores growth to revenue growth. Thereafter, you can forecast the income statement, balance sheet, and cash flow statement. Do take note that the explicit forecast period is usually 10 years, and growth rates taper to 2% after 5 years.
To forecast the income statement and balance sheet, use this.
- Sales (according to forecast)
- Less cost of sales (percentage of sales, use historical average)
- Less SG&A (use regression against past sales, then extrapolate to future)
- Less depreciation (percentage of net non-current working capital)
- Less other operating expense (percentage of sales, use historical average)
- Add other operating income (percentage of sales, use historical average)
- Add interest income (percentage of investment assets, use historical average)
- Add other income (percentage of sales, use historical average)
- Less interest expense (percentage of debt, use historical average)
- Equals net income
For the balance sheet, use this.
- Net working capital (percentage of sales, use historical average)
- Net non-current working capital (percentage of sales, use historical average)
- Investment assets: excess cash (percentage of sales, use historical average)
- Debt (percentage of total assets, use historical average)
- Group equity (residual of asset minus liabilities)
For the cash flow statement, use this.
- Net profit before tax
- Less change in operating working capital (calculate from the forecasted balance sheet)
- Less tax payments (percentage of sales, use historical average)
- Equals cash flow from operations;
- Change in net non-current working capital
- Add change in net investment assets (calculate from the forecasted balance sheet)
- Equals cash flow from investing (calculate from the forecasted balance sheet)
- Change in ending debt (calculate from the forecasted balance sheet)
- Add change in group equity (assume zero)
- Equals cash flow from financing
With the cash flows forecasted, you can proceed to do the valuation for the company. The most common way is to do a discounted cash flow analysis using free cash flow to the firm (FCFF). To do so, you will need to calculate the weighted cost of capital (WACC).
WACC = debt/ total assets x (1 - tax rate) x cost of debt + equity/ total assets x cost of equity
To get the cost of debt, you can go to the financial statements which should be stated. If not, you can use an implicit interest rate given by interest expenses dividend by total debt. To get the cost of equity, you can use the capital asset pricing model (CAPM).
Cost of equity = risk free rate + Beta (market rate of return - risk free rate)
The risk free rate is taken to be the country's yield on the 10-year government bonds. The market rate of return is the compounded average rate of return of the country's index. You can get the Beta from Yahoo Finance or Google Finance or you can calculate it yourself by this formula.
Beta = (rate of return of stock - risk free rate) / (rate of return of market - risk free rate)
Do the monthly rate of return for at least 5 years so that you have a sample size of at least 50. With this all in place, you will have the WACC which you can discount back the cash flows to the firm.
Discounted cash flow analysis (DCF)
Divide the first year cash flow by (1+WACC), then the second year cash flow by (!+WACC)^2 and so on till the end of the explicit forecast period.
For the terminal value, take the cash flow for the 11th year, and divide it by (risk free rate - perpetual growth rate) and then dividing it by (1+WACC)^10 again. Add up all the discounted cash flows to get the present value of the firm.
After calculating the present value of the firm, you should subtract away the present value of debt to arrive at the present value of equity. You can treat debt as a bond, and discount the interest expenses back to present value. Divide the present value of equity by the number outstanding shares to get the fair value per share.
Peer analysis
After getting a fair value per share through a discounted cash flow analysis, you will need to double up your calculations by performing a peer analysis. It works like a sense check to your workings. Usually, these are the multiples used.
- Price-earnings ratio
- Price-to-book ratio
- EV/EBITDA
Get a bunch of similar companies, and find out the average ratio. For instance, the average price-earnings ratio is 20. Take 20 and multiply it with your calculated earnings per share to arrive at the fair value per share. You can do so similarly for the other ratios.
Sensitivity analysis
This is a very important part of your valuation. While doing the DCF and peer multiple valuation, you should always have a optimistic case and a pessimistic case. Do the revenue forecast for an optimistic case by increasing the growth rate and lower it for the pessimistic case.
For the peer multiple valuation, take the highest ratio and the lowest ratio to be the optimistic and pessimistic fair values per share. With this range, put them onto a football field valuation chart.
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| Source: https://www.amttraining.com/wp-content/uploads/2013/07/enterprise-value.png |
Based on this, you can come up with a range of fair value per share for the target company. Buy the stock when it is trading below the the range, and give it a margin of safety of around 30%. For instance, the lowest range might be $1, and a 30% margin would mean that you purchase the stock when the price drops below $0.70.
Conclusion
Valuation of a company's stock is more of an art than a science. There is a lot of prediction to be done. However, practice makes perfect and do not give up trying.
Hope that this has been a good summary of how to value a company's stock, and if you want a stock analysis, feel free to write it in the comments below.
If you found this post useful, please do share it, and spread the word. Thank you.
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