Week 5: Comparative Valuation of Common Stocks

News

Week 5

Comparative Valuation of Common Stocks

THE LAW OF ONE PRICE !

Valuation is at the core of investing and every investor needs to understand the basics of determining whether a stock represents good value, either against its own fundamentals or in comparison to other comparable investments.

First we discuss the ‘Comparables method’ which provides investors a practical tool to compare the investability of comparable stocks and is recognised as being less involved then more fundamental valuation techniques.

One of the most common ways an investor can determine whether a common stock represents good value or not is to the use the ‘comparables method’, which is a catch-all method that can be used in the absence of more involved fundamental valuation techniques. Other widely used techniques include the dividend discount model (DDM) and the more involved discounted cash ow model (DCF).

The comparables method doesn’t attempt to find an intrinsic value for the stock like the other two valuation methods do; it simply compares the stock’s price multiples to a benchmark to determine if the stock is relatively undervalued or overvalued. e rationale for this is based o of the Law of One Price, which states that two similar assets should sell for similar prices. e intuitive nature of this method is one of the reasons it is so popular.

This method can be used in almost all circumstances because of the vast number of multiples that can be applied, such as the price- to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), price-to-cash ow (P/CF) and many others. Of these ratios, the P/E ratio is the most commonly used one because it focuses on the earnings of the company, which is one of the primary drivers of an investment’s value.

When can you use the P/E multiple for a comparison?
You can generally use it if the company is publicly traded because you need the price of the stock, and you need to know the earnings of the company. Secondly, the company should be generating positive earnings because a comparison using a negative P/E multiple would be meaningless. And lastly, the earnings quality should be strong; earnings should not be too volatile and the accounting practices used by management should not drastically distort the reported earnings.

These are just some of the main criteria investors should look at when choosing which ratio or multiples to use. If the P/E multiple cannot be used, simply look at using a different ratio such as the price-to-sales or price-to-book multiple. No one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select the valuation method that best suits the situation. In addition, investors are not limited to just using one method. O en, investors will perform several valuations to create a range of possible values or average all of the valuations into one. e ‘comparables method’, is a relatively simple fundamental technique used to value stocks.

One of the more involved methods in which to value companies is through the use of ‘Absolute valuation models’ which attempt to find the intrinsic or ‘true’ value of an investment based only on that companies’ fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash ow and growth rate for a single company, and you wouldn’t worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash ow model, residual income models and asset-based models.

Let’s take a look at the two most popular and widely used ‘absolute valuation model’ techniques, the Dividend Discount Model (DDM) and the Discounted Cash Flow model (DCF):

Dividend Discount Model (DDM)

The dividend discount model (DDM) is one of the most basic absolute valuation models. e dividend model calculates the “true” value of a rm based on the dividends the company pays its shareholders.

The justification for using dividends to value a company is that dividends represent the actual cashflows going to the shareholder, thus valuing the present value of these cashflows should give you a value for how much the shares should be worth. So, the first thing you should check if you want to use this method is if the company actually pays a dividend.

Secondly, it is not enough for the company to just a pay dividend; the dividend should also be stable and predictable. e companies that pay stable and predictable dividends are typically mature blue-chip companies in mature and well-developed industries. These types of companies are o en best suited for this type of valuation method. For instance, take a look at the dividends and earnings of company XYZ below and see if you think the DDM model would be appropriate for this company:

200520062007200820092010
Dividends Per Share$0.50$0.53$0.55$0.58$0.61$0.64
Earnings Per Share$4.00$4.20$4.41$4.63$4.86$5.11

In this example, the earnings per share are consistently growing at an average rate of 5%, and the dividends are also growing at the same rate. is means the rm’s dividend is consistent with its earnings trend which would make it easy to predict for future periods. In addition, you should check the payout ratio to make sure the ratio is consistent. In this case, the ratio is 0.125 for all six years, which is good, and makes this company an ideal candidate for the dividend model.

Discounted Cash Flow Model (DCF)

What if the company doesn’t pay a dividend or its dividend pattern is irregular? In this case, move on to check if the company ts the criteria to use the discounted cash ow model.
Instead of looking at dividends, the DCF model uses a rm’s discounted future cash flows to value the business. e big advantage of this approach is that it can be used with a wide variety of forms that don’t pay dividends, and even for companies that do pay dividends, such as company XYZ in the previous example.

The DCF model has several variations, but the most commonly used form is the Two-Stage DCF model. In this variation, the free cash flows are generally forecasted for five to ten years, and then a terminal value is calculated to account for all of the cash flows beyond the forecast period.

So, the first requirement for using this model is for the company to have predictable free cash flows, and for the free cash flows to be positive. Based on this requirement alone, you will quickly find that many small high-growth forms and non-mature forms will be excluded due to the large capital expenditures these companies generally face.For example, take a look at the simplified cash flows of the following form:

200520062007200820092010
Operating Cash Flow43878914628902565510
Capital Expenditures7859951132125622351546
Free Cash Flow-347-206330-3663301036

In this snapshot, the rm has produced increasingly positive operating cash ow, which is good.

But you can see by the high level of capital expenditures that the company is still investing a lot of its cash back into the business in order to grow.

This results in negative free cash flows for four of the six years, making it extremely difficult (nearly impossible) to predict the cash flows for the next five to ten years.

So, in order to use the DCF model most effectively, the target company should generally have stable, positive and predictable free cash flows. Companies that have the ideal cash flows suited for the DCF model are typically the mature forms that are past the growth stages