How do you value stocks? Chances are that you already do that using Discounted Cash Flow (DCF). For those who don’t know about DCF, let me give you a brief introduction.

 

Warning: Long post ahead. Please go through all the suggested material so that you understand all the concepts better.

 

What is DCF?

Let’s first see what the legend himself has to say about valuing stocks:

Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

— Warren Buffett

 

Whatever cash flow that a business is going to generate over its remaining life, is estimated and discounted back to the present value. All these ‘discounted cash flows’ are added, and this in essence is how DCF valuation works.

If want to understand about DCF in more detail, do read 10-K Diver’s Twitter thread. It won’t take more than 5 minutes.

 

Understanding WACC

Okay, now I can say that you have read the above thread, and you have a fair idea of DCF. This is a valuation technique that is taught in most of the B-schools.

There’s also a discount rate that we assign during DCF. This is Weighted Average Cost of Capital (or WACC). This calculates cost of debt and cost of equity and assigns weights to it.

To calculate cost of equity, a funny thing known as Capital Asset Pricing Model (CAPM) is used. This is how the CAPM formula looks like:

 

What CAPM tries to do, in essence, is estimate the expected returns of that particular stock. Let’s look at the components to see how flawed this is. First you take the risk-free rate, then you take the expected market return over the risk-free rate and multiply that by a Greek letter (β), which signifies the fluctuations of that particular stock. What this means is that you higher the β, higher will be expected returns of that stock.

 

We must understand that β is just a measure of volatility. And tying volatility to expected returns means assuming that the market is efficient (another funny thing taught to business school graduates). Let me ask you a question: If a great company is down 50%, does that make the business more risky?

 

Look at what Warren & Charlie have to say about this:

Please take out 8 minutes to watch the video. You’ll get a lot of clarity about volatility and risk.

 

Projections

People keep on projecting future income statements and balance sheets to get an “estimate” of what the cash flows might look like in the future. All these projections are done down to the second decimal place. And everything is based on assumptions.

 

Even the promoters of the company might not be knowing what will happen to their own company in future. That is how much of fantasy is being written while doing DCF. And if you’re off by even a small percentage points, your intrinsic value changes drastically.

 

The best fantasy writing tool is not word, but excel.

 

The ‘Terminal Value’ Problem

You see that every DCF assumes that a company will grow forever, at a “conservative” rate , which is a little less than the GDP growth rate. This is assumed as the terminal growth rate, which is used in calculating the terminal value. Determining the future GDP growth in itself is a whole new challenge, let alone the company’s terminal growth rate.

 

Let’s see how much terminal value fluctuates the “intrinsic value”. Let’s say you calculated the WACC as 10% and estimated that the terminal growth rate will be 6%. Just see what happens when you vary the terminal growth rate by 1% on either side. You get deviations upto 33% of the total terminal value.

 

Normally, this terminal value forms a bulk of everyone’s DCF valuation, going anywhere from 50% to 80% of the total valuation. Now you can see how much these small changes affect the overall value.

 

The ‘Intrinsic Value’ Conundrum

“You buy a stock when its price is below it’s intrinsic value.” I’ve heard this arguement a lot. But what do you do when the stock price reaches it’s intrinsic value? Do you sell? What happens when the price becomes 2x of your calculated intrinsic value? Do you sell now?

 

You see intrinsic value shouldn’t matter to you. What should matter is how much returns could you possiblly get if you buy the stock at the current price? What could be the potential downside at the current price (not in terms of stock price movement, but business)? If you start asking these questions, you won’t even feel the need to number crunch through 17 excel sheets to determine the value.

 

What Should You Do?

You might be wondering how you should value a company? Apart from DCF, there are many different techniques to value a company. And you don’t need to be right to the second decimal point. Just a rough estimate whether a company is cheap or not should be fine.

 

You can use Peter Lynch’s method. Let’s say you want a 10 bagger return in a decade, and the stock that you are analysing is Asian Paints (not a recommendation, just an example). At the time of writing, Asian Paints is trading at a PE of 90, which is at the high end of its history. Being conservative, you say that the PE might taper down to it’s long term average of 50 over the next 10 years.

 

Now to to get a 10x return, the market cap of Asian Paints has to be over ₹30 lakh crore. And with the PE of 50 that we had expected, Asian Paints must generate a profit of ₹60,000 crore in 2031. Ask yourself how likely is that? To give a perspective, Asian Paints had generated a revenue of ₹25,000 crore in FY21. REVENUE. And their profit was ₹3139 crore.

 

To generate a ₹60,000 crore profit, Asian Paints needs to grow its profit 19 fold — a massive 34% CAGR, which it has never achieved in its history. In fact, it’s profit CAGR is just 14% over the last decade. If you think it is highly likely that Asian Paints will change it forture, then go ahead. But, if you think 34% CAGR is highly unlikely, then you should probably give it a pass.

 

You see all this didn’t even take a couple of minutes to decide. But, to do all this you must have studied everything about the business. BUSINESS, NOT STOCK PRICE. Only after you’ve found that this business is something that you’d like to own (again ignoring the stock price), then you’ll determine whether the quoted price is the right price to pay for the business.

 

Another technique that I’d suggest is Prof. Bruce Greenwald’s Earnings Power Method (EPV). A simple technique that won’t take much of your time, but will surely give you a rough idea whether the company is cheap or not.

 

This method normalizes the earnings over a business cycle, adds back whatever a company could have spent on future growth (to estimate this, the company must be in your circle of competence). The core premise of EPV is to assume that future growth will be zero. Since we can’t predict the future, we’ll value the company by keeping growth as zero.

 

After all these adjustments, we get adjusted earnings. Now, we discount this using an appropriate cost of capital (not WACC 😉). This cost of capital differs from business to business, and even from person to person. I suggest you to read Dinesh Sairam’s article on cost of capital. He has beautifully explained the concept.

 

Bruce Greenwald’s book is highly underrated. I would recommend you to give it a read for the sheer amount of simplicity it provides when it comes to valuation.

 

Conclusion

You see, valuation is more of an art than science. If you can’t determine whether a company is cheap or expensive by doing back of the envelope calculations, then that stock is probably outside of your circle of competence. Valuation is simple. You don’t need to complicate it.

 

And valuation is just a part of the overall process. In fact, valuation comes after you’ve done all analysis about the business. You first need to understand the ins and outs of the business, valuations comes only after you’ve decided you want to buy the business.

Don't give valuation more attention than it deserves. At the same time, don't ignore it completely. Click To Tweet

 

If you’ve reached this far, I hope you’ve learned something from this article. If you did, do share it.

 

Till next time.