How to value stocks – an introduction to valuation concepts

By September 21, 2021 Share investing
Share value

Two years ago I wrote a popular blog that explained some simple share market concepts and jargon (see here). Building on this introductory information, I thought it was timely to discuss basic share market valuation principles to help investors assess whether a stock is over or under valued.  

To be clear, I’m not advocating investing in direct stocks. In fact, there is an overwhelming amount of evidence that demonstrates direct share investing (i.e. picking stocks) fails to produce above market returns over the long run. However, it is still useful to understand basic share market valuation principles.

The ‘Efficient-Market Hypothesis’

The Efficient-Market Hypothesis (EMH) was popularised by Nobel laureate, Professor Eugene Fama. The hypothesis suggests that share prices always accurately reflect all available information. The idea is that the market is made up of thousands (and in some cases, perhaps millions of people) that analyse all available information in relation to a particular company. Many of them are professional investment managers with a lot of education and experience working 40-80 hours per week.  This information informs their trades i.e. at what price they are happy to buy and sell. And it is this process of “price discovery” that determines the value of a stock.  

My personal view is that the EMH might be true over long periods of time. However, in the short run, it is possible (in fact, likely) that markets can be inefficient. Behavioural economics explains that sometimes investors can act irrationally, driven by overconfidence, overreaction, overexuberance, greed, fear and so on. The “meme stock” behaviour earlier this year is a perfect example of how markets can be inefficient and stock prices can be wrong.

This is why it’s useful to understand basic valuation principals.

The value of a business is equal to the present value of its future cash flows

The value of any business is equal to the present value of its future cash flows. To calculate that, you need to forecast the business’ free cash flows and then apply a discount rate to express the value in today’s dollars. The discount rate must reflect the risk associated with the cash flows e.g. the higher the risk, the higher the discount rate. This is called Discounted Cash Flows analysis.  

The table below provides a simple example. This business has a 5-year government contract and is expected to generate $100 per year of free cash flow (i.e. income less all expenses including taxation). After 5 years, the business is not expected to continue. Because the business’ revenue is contractually guaranteed and therefore low risk, a lower discount rate of 8% has been used. The discount rate reflects the return an investor would require to be compensated for the risk. Each year is discounted in today’s dollars using the discount rate. For example, refer to year three. The present value of $100 is $79.38. That means if I have $79.38 today and earn 8% p.a., I’ll have $100 in 3 years from now.

The aggregate value of the present value of future free cash flows is the business’ value, which is $399.

DCF valuation

Shortcut method: valuation multiples

Completing a DCF analysis is time consuming and there’s probably not enough publicly available information. A shortcut valuation method is to use a valuation multiple. I have listed the common valuation multiples below.

  • Price/Earnings – the PE ratio is probably the most common valuation ratio. It measures the value of a company compared to its earnings per share (EPS). The higher the PE, the higher the valuation and the riskier it is. The average PE ratio over the past 20 years is circa 26 for the US market (S&P500) and 18 for the Australian market. The US market’s PE is currently trading at around 34 times and the Australian at 29 times, which is probably due to two factors. Firstly, temporarily lower earnings due to Covid. Secondly, elevated valuation multiples.  
  • Price/Sales – the price/sales multiple is used as a check/secondary measure or for businesses that are not yet profitable (and are expected to benefit from huge scale, such as tech companies, and be profitable in the future). The shortcoming of the price/sales multiple is that it doesn’t consider a company’s profitability which is ultimately a very important factor.
  • Price/Book Value – the price/book ratio compares the value of a company to its net asset value on its balance sheet. Price/book multiples typically range between 1 and 3 times. This valuation metric is less meaningful in some industries, particularly ones that have valuable intangible assets, as these are rarely included on balance sheets.

Two factors that impact valuation multiples

Generally, there are two factors that will influence valuation multiples:

  • Risk – how likely is it that the business will deliver its expected results? Does it have a well-established business? Does it have a strong track record of profitability and paying dividends? Does it have a strong financial position with little debt? These are some examples of things you must consider in order to ascertain a business’s risk. Riskier businesses attract lower multiples/valuations.
  • Growth – does the company have profitable growth prospects? All things being equal, higher growth businesses attract higher valuation multiples. By comparison, businesses that are mature and have limited growth prospects attract lower multiples.

The relationship between risk and growth are illustrated below.

Market multiples

Factors I consider when assessing a stock’s relative value

Below is a list of factors that I consider when assessing the relative value of a stock.

  • PE multiple – relative to its historical levels, peer companies and the market in general.
  • Profitability and dividends – I review historic cash flow, revenue, profitability and dividends to consider volatility and growth.
  • Financial strength including cash holdings and debt exposure.

These three measures usually provide a good, high-level indication of a stocks relative value.

Using Woolworths as an example

Let’s apply these considerations to Woolworths (WOW) as an example:

  • Its PE is trading at 32 times which is very high for a relative mature, low growth, low risk business. Its peer company, Coles is trading on a PE of 22.5 and Metcash (which operated IGA supermarkets) on a PE of 16 times.
  • Woolworths’ sales, cash flow, earnings and dividends have been quite stable over the past 4 years.
  • It has a very strong balance sheet with low and reducing external debt levels.  

Overall, I assess Woolworths as a low risk, low growth business and would expect a PE ratio of 18-24 times to be fair value. Based on forward earnings, it suggests its shares are probably valued towards high $20’s. Since its currently trading at over $39, it appears to be overvalued in my opinion.

Examples of irrationalism

Applying this fundamental analysis to some other stocks results in mindboggling outcomes. Here are a few irrational examples from Australia and overseas:

  • Accounting software provider Xero is trading on a PE ratio of over 1,000 times!
  • REA Group (operates realestate.com.au) is trading on a PE of over 60 times
  • Afterpay is valued at $37 billion and lost almost $160 million last year (and has never made a profit).
  • Uber is worth over $100 billion and lost over $9 billion last year!
  • Tesla is worth over $1 trillion and is trading on a PE of around 400 times.   

High growth companies can be rewarding to invest in. However, there’s no point in paying  too high of a price for the stock, as all you are doing is pre-paying for whatever growth might occur in the future. And if the growth doesn’t occur, it will be your loss.

Clearly some stocks are trading at unsustainable levels and should be avoided.  

Stock valuations are inherently uncertain

Stock analysts spend their whole working life analysing companies to identify investment opportunities. But most of them fail to beat the market. A superior share investment strategy is to adopt a rules-based approach, as these tend to offer a lot of diversification and very low fees. You can incorporate factor-based methodologies that allow you to avoid investing in overvalued sectors and companies.