Have you always wondered how to value stocks? How many times have you found a great company, but don’t know how much to pay for it? Or, have you been too overwhelmed by DCF where you need to “project” future cash flows?

 

If you answered “YES” to any of the above, continue reading to learn simple methods to value stocks.

 

Valuation

 

When performing a DCF, you go through 17 different sheets and have to come up with a precise value upto two decimal places. You know how much effort this takes. But, what you get as an outcome is just a number of “intrinsic value.” Now that you have this number with you, you will buy if the stock is below that number.

 

But, what do you do when the stock reaches this number? Do you sell and exit? What happens when the price becomes 2x of your calculated intrinsic value? Do you sell now? You see, DCF cannot answer these questions. All the effort that you put in to build models on 17 different sheets goes out for a toss.

 

Expected Returns

 

When you hear Peter Lynch Valuation technique, what comes to your mind? Is it the “PEG Ratio”? Well, I won’t blame you for that. Because Lynch had coined this metric. PEG, or Price-Earnings to Growth ratio, in a nutshell, is the ratio of a company’s PE to the expected growth of that company. If the ratio is well below 1, then the company is undervalued.

 

But again, this method faces the same drawback as that of DCF. You don’t know what to do once the stock crosses this number.

 

I’ll be going through another metric which isn’t that widely discussed, but is a simple technique to determine what you should pay for a company. The process is simple. First, you analyse a company as you would normally do. Once you’ve found this company to be worth buying, you’ll then proceed to this method of valuation.

 

Here’s what you’ll do. You’ll determine what is a decent enough return for you. Consider this as your opportunity cost. Let’s say you want a 10x return in 10 years. You’ll look at the company, and make a conservative estimate what its PE ratio might be in 10 years time. Based on that PE ratio, you’ll get a number of EPS. Based on the current EPS, you’ll determine how realistically achievable is the future EPS. If it is highly likely, then you go and buy the stock.

 

Putting It In Practice

 

Let’s take an example so that you understand this better. I’ll be taking Nestle India in this case. As of writing Nestle India is trading at a price of ~₹19,000 per share. We have the H1FY22 numbers, and Nestle India had generated an EPS of ₹120. To be conservative, let’s assume that Nestle India generate a similar EPS in H2FY22, giving us an annual EPS of ₹240 for FY22.

 

You want at least 20% CAGR from your investments, and Nestle India should be no different. Now you have to estimate a conservative PE ratio which Nestle India will trade at in FY32. Nestle’s PE has ranged from mid 20s to as high as 90. Overall, its median PE has been 46. Let’s also look at the last 5 years. In this case, the median PE has been 70. We’ll be taking an average of these two as we should also be capturing the effect of low interest rates which has bumped up the PE in the last 5 years.

 

The average of these two periods is 58. Let’s take 50 as our exit PE in FY32 to be more conservative. You want 20% CAGR over this period, this would include both share price growth and dividend yield. Deducting the current 1% dividend yield, you want the stock to grow at 19% CAGR.

 

This means if Nestle India should be a worthwhile investment for you, it should trade at ₹1,08,000 per share (₹19,000 x 1.19^10) in FY32. With our exit PE as 50, the EPS in FY32 would be ₹2160. This means Nestle India should grow it’s EPS at 24% CAGR over the next decade. How likely is this? You’ll be able to answer this question only if the stock is within your circle of competence.

 

You can look at past growth rates, but don’t base your decisions on that alone. Past performance is no guarantee of future returns. Understand the opportunity size of the company, and how quickly can the company capture that opportunity.

 

In Nestle India’s case if you think it is highly likely that Nestle India will grow its EPS at 24% CAGR, then go ahead and buy the stock. But, if you think 24% CAGR is highly unlikely, then you should probably give it a pass.

 

Closing Thoughts

 

A simple valuation technique that helps you focus more on understanding and analysing the business, than on valuation alone. When you are doing DCF, you’ll spend more time on your valuation model than analysing the business. Using this simple method will help you free up a lot of your time that goes in valuation.

 

You’ll also understand whether or not to invest in a company based on what return you want. In the end, a stock being overvalued or undervalued shouldn’t matter to you. What should matter to you is, if I buy the stock today, will it give me my required returns? And that should be an easier question to answer as compared to projecting the income statement for the next 5 or 10 years.

 

Till next time.