How to arrive at the Fair Value Estimate of a stock

By Morningstar Analysts |  12-11-18 | 
 

Morningstar analysts’ fair value estimate for stocks helps investors see beyond the present market price and determine what a company is really worth.

Adam Fleck, Morningstar’s director of equity research, says there's an art and a science to valuing stocks. An art in deeply understanding the company, the product, the customers and the competitive landscape, and a science in being able to marry those understandings with the financial statements.

Ultimately, a company's intrinsic worth is linked to the future cash flows it can generate. According to Fleck, cash is king. "Cash is what is actually coming in and out of the company that the management can do things with. And free cash flow is what's used to do things that interest investors such as paying dividends, paying down debt, or buying back stock."

Arriving at the Intrinsic Value

It's early Saturday morning. You roll up to an auction, ready to bid a hot piece of Sydney real estate. The auctioneer stands out front, gavel in hand, and soon a small crowd begins to form – some there the buy, but most just to watch.

He starts the bidding at the price guide, $600,000, but soon other buyers get excited, paddles are flying, tension builds, and suddenly the price is up – $850,000, $860,000, $865,000.

The auctioneer points at you – "sir/madam are you going to make a bid?"

The calculation you have to make takes into consideration a variety of factors. You must rise above the heat of the auction to establish how much you think the property is actually worth, taking into account location, neighbourhood, future value, whether there's space to extend the bathroom...

Buying a stock is a similar process. On a digital exchange, millions of stocks trade every day, and the price of each stock will move depending on current popularity and the market's whims. An investor must determine a stock's fair value, or intrinsic value, before they decide to buy. It's no easy task.

At Morningstar, equity analysts calculate what they think the long-term intrinsic value of a stock is, helping you see beyond the present market price. Analysts believe that over time, the share price will reflect the intrinsic value of the underlying business.

Uncovering the Fair Value Estimate, or FVE 

Forecasting is hard. But a good analyst who has spent years getting to know an industry well, can use informed assumptions and technical analysis to successfully predict a company's future revenue and growth prospects.

Morningstar analysts use a valuation method known as a discounted cash flow, or DCF. The key behind a DCF model is relatively simple: a stock's worth is equal to the present value of all its estimated future cash flows, minus an appropriate discount rate.

Future cash flows refer to how much cash the analyst believes the company is going to generate in the future after spending the money necessary to keep the company growing at its current rate. Many variables go into estimating those cash flows, but among the most important are the company's future sales growth and future profit margins.

Predicting growth 

Predicting a company's future revenue needs detective work. Beyond the company's top line revenue figures, analysts will consider a variety of additional factors including:

  • customer base
  • product quality
  • industry trends,
  • economic data, and
  • a company's competitive advantages

For example, let's look at milk and instant formula Company A:

NOV 12

Looking at that strong revenue growth over the past 5 years, you might be tempted to think: wow, it's accelerating each year, 80% might be next.

But this is unlikely to get you to the correct figure, Fleck says. "The potential pitfalls of only looking at revenue is you don't know exactly what's driving that revenue, and it's hard to make an assumption when you don't know the component parts."

Instead, Fleck breaks up A2's revenue, looking deeply into geography – where A2's product is consumed, where it's sold, the type of products each market consumes, gathers insights into the volume growth of infant formula, the price growth of the infant formula market, and movements in A2's market share. He then uses these estimations to predict how much A2's revenue will grow, on average, for the next 10 years.

Predicting profits margins 

Determining a company's future operating profits also needs creative thought. For Company A, EBIT margins– earnings before interest and tax – look great:

But just like revenue, be cautious about extrapolating the past into the future. "You could be tempted to look at the past couple years and conclude that the company can again lift margins by 5% in 2019. But this would be too optimistic," Fleck warns.

Again – he'll need to dig deeper, looking to Company A's competitors to determine the current margins for infant formula, and estimate how much larger margins can get.

Once an analyst estimates the cash flows the company is expected to generate in the future, they have to discount those future cash flows back to the present to account for the time value of money.

Discounting cash flows

Once analysts estimate the future cash flows they anticipate a company to generate, they have to discount them back to the present day to account for the time value of money.

Why? Because a dollar tomorrow is worth less than a dollar today. "If you have $100 today and you put it in a bank account, and it earned 2% a year, you would have $102 dollars one year from now. In 2 years it will become $104.04; 3 years $106.12, and so on,” he explains. “But if we flip that, $122 dollars 10 years from now, is worth $100 dollars today, at a 2% per annum interest rate."

Determine a discount rate

Morningstar analysts use a weighted average cost of capital, or WACC, to determine the rate at which to discount a company's future cash flows back to the present. A company's WAAC accounts for both the firm's cost of equity and its cost of debt.

The cost of debt is relatively straightforward: It's the interest rate a company must pay to borrow money, based on the current yield on any of the bonds the company has issued. Just as a person with an excellent credit rating can borrow from banks at lower rates than someone who has missed payments in the past, financially strong and stable companies can borrow at lower rates than riskier firms.

The cost of equity is a little more complicated, but Morningstar analysts have adopted a simplified methodology. For companies with a primary business in Australia, they assign a cost of equity of 7.5%, 9%, 11%, or 13.5%, depending on a company's level of systematic risk.

Morningstar analysts view Company A as an average risk company and have estimated a 9% cost of equity. Then, they added 1% due to the company’s exposure to China upping risk. Currently Company A has no debt, meaning there is no need to include a borrowing rate in the WACC calculation.

Discount the projected free cash flows to the present 

So now that we have our discount rate of 10%, we can discount the projected free cash flows to the present.

The basic formula for discounted cash flows, applied to Company A:

nov 1

nov2

Then we calculate the 'discount factor' every year by dividing the free cash flow projected for that year by the discount factor.  For example, in 2018, Morningstar analysts have projected Company A's free cash flow to be $ 2,85,363 in 2019. Discounted:

nov3

Then, analysts add up the resulting numbers to get the present value of those cash flows of $3.7 billion, and divide that figures by the number of shares outstanding for Company A. This results in almost $5 per share.

The cash flow projections of Company A:

Nov - BIG ONE

But wait, that doesn't seem right…Company A is currently trading at almost $10. What are we missing?

Calculate the Terminal Value and discount it to the present 

The last piece of the puzzle is the terminal value – also known as the perpetuity value.

This step is necessary because companies exist much longer than 10 years, and analysts need to account for all the cash earned for all those years. However, Fleck says it's not feasible to project a company's future cash flows out to infinity, year by year.  To solve this problem, Fleck estimates a company's future cash flows for a certain period, and then estimates the value of all cash flows after that in one lump sum.

The equation looks a bit technical, but it’s really quite simple:

Nov A

Nov B

FCFn = Free Cash Flow in the final year of the model / g = Long Term Growth Rate / WACC = Weighted Average Cost of Capital

This equals to $ 16,495,347. This is the Terminal Value at the end of the model. To find out what the value is today, says we must discount back to today.  Therefore, the present value of our TV is: 16,495,347/2.594 = $6,359,038

To reach the final valuation, Fleck and his team take 10 years of free cash flow forecasts, discounted to today plus terminal value, discounted to today minus net debt and other adjustments divided by share count equals FVE.

3,674,833 + 6,359,038 = $10,033,871

As equity holders, any debt the company has would not belong to us, Fleck notes. Therefore, need to remove that from the calculation.

Additionally, the model didn't include any cash or other holdings Company A has today – only that generated in the future. "That’s what the third line is doing – removing debt, adding cash, and adding the firm’s holding in Synlait, another New Zealand stock," Fleck says.

3,40,455 + 2,87,100 / 7,50,817 = $ 14.20 (Divide the equity value by the number of shares outstanding, to get our FVE/share).

The figures are in NZ dollars. The figures used for illustrative purposes are of Company A2 Milk. This post initially appeared on Morningstar Australia

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