Stock Valuations: Simple and Practical Approach

From Theory to Practice: Insights into Valuations

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Disclaimer: The information contained within this website and article is not financial advice and reflects my opinion in a strictly personal capacity. I am an engineer by training and profession; I do not possess formal qualifications in finance or investment. I may hold positions in stocks mentioned and hence probably biased. This website and article isn’t writtent to give you advise. I am just using as my online journal to share knowledge and insights and to get feedback - I can’t guarantee the complete accuracy of all content so don’t relie on it. Please conduct your own research or consult a prefessinal financial advisor - I am not the one.

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Business Valuation

Business Value = Total cash it will produce over lifetime in today’s value

Let’s understand that and dig bit deeper.

Imagine you come across someone selling a magical tree that produces money instead of leaves. This tree will continue to generate money for many years, though not indefinitely. How would you determine its worth? To decide what you should pay for this tree to ensure it's a profitable investment, you first need to calculate the total amount of money it will generate.

Here are two crucial factors to consider:

1. Any money you spend on purchasing the tree could alternatively be deposited in a bank, earning interest with no risk tied to the tree's performance. This interest rate from the bank represents your risk-free rate. To justify buying the tree instead of keeping your money in the bank, you'd want a return slightly higher than this risk-free rate to compensate for the risks you're taking. Lets call it as your required return rate.

2. Money received today is more valuable than money received in the future. Why? Because money in hand today can be used to purchase goods or invested to earn more money.

So, how do you figure out how much to pay for the tree? Follow these steps:

• Estimate how much money the tree will generate each year until it ceases to produce money.

• Adjust the value of this future money to its equivalent in today's dollars. This adjustment process, known as 'discounting by your required return,' considers the higher value of today's money compared to future money.

• Sum up all this adjusted money from each year to determine the total value of the tree. If this total value (or intrinsic value) exceeds the price you would pay to own the tree, then purchasing it is a wise decision.

Now replace “The Tree” with “The Business” and exact process we followed is called Discounted Cash Flow (DCF). Now its easy to explain what DCF actually is but as you noticed earlier, you have to come up with “How much cash a Business will generate each year until it ceases to exist” . In order to come up with that we need to answer following questions -

• How long this business will exist?

• What would be the terminal value when it ceases to exist?

• How much cash it will generate each year from now to that day?

To answer above question, we need to go through SIMPLE and SOLID framework to understand the business dynamics and then only we can even attempt to put some calculated guess or assumption about answering those three questions. Hence it is important to go through those two frameworks first before valuing the business.

If you want to go deep into Discounted Cash Flow, Then download this guide from Aswath Damodaran.

It is very important to understand the concept of DCF and actually build excel spreadsheet - just to understand where does business gets it value. However, once you understand the concept and have grasp of it - you don’t really need to go through complex excel spreadsheet with nth degree of accuracy to get the valuation of 2 decimal point precision.

I prefer simple approach, hence although i believe only way to actually value a business is through DCF but down side is complexity as well as false precision. I use following two simple methods first instead of crunching numbers in DCF spreadsheet.

Method 1: Quick and Simple Calculations

Start by taking a look at a business's current Revenue, Gross Margin, and either Earnings or Free Cash Flow. Using your understanding and historical data, apply frameworks like SIMPLE and SOLID to forecast the growth in Revenue, Gross Margin, Earnings, and Cash Flow over the next three years. This involves assessing the current reported numbers and then making growth assumptions for the next three years, along with estimating the probable numbers after this period.

Once you've projected the Earnings or Cash Flow for three years ahead, consider what multiple the market might be willing to assign to these earnings at that time. Predicting market dynamics three years in the future can be challenging, so it's wise to be conservative with your market multiple estimates. Being too conservative, however, might mean missing out on potential investment opportunities; aim for a 'Goldilocks' approach—neither too high nor too low.

After determining the future valuation (i.e., the valuation after three years), you need to discount this figure back to its present value using your required rate of return. If the present value you calculate is higher than the current share price, it suggests that, according to your analysis, the stock is undervalued and presents a potential upside.

For example, Let’s take Megaport

• Current Shares Issued: 160 million

• Cash on Hand: $63 million

• FY2024 Revenue Forecast: $190 - $195 million

• FY2024 EBITDA Forecast: $51m - $57m

Future Projections for FY2027:

• Revenue: $380 million

• Gross Profit: $266 million

• Net Profit: $135 million

• CAGR for Revenue (2024-2027): 26.0%

Valuation Calculation:

• Price-to-Earnings Ratio: 30 times net earnings

• Projected Market Capitalization: 30 x $135 million = $4.05 billion

• Projected Number of Shares: 170 million

• Future Share Price: $4.05 billion / 170 million shares = $23.82 per share

The discounted present value of the future share price of $23.82 in FY27, using a 10% required rate of return until FY24, is approximately $17.90 per share. This value represents what the share price in FY27 is worth in today's dollars.

If you're comfortable with the assumptions, including the 26% CAGR in revenue growth, the projected net profit for FY27, the PE multiple for that year, and the expected dilution, then the calculated share price value comes out to approximately $17.90.

Now this is just Quick and Simple way to come up with valuation based on few assumptions.

(Note: I didn’t come up with this method myself. I picked it up from internet/podcast/Strawman post etc. I have seen it used this quite often at Strawman)

Method 2: Flip it (Reverse DCF)

Instead of wrestling with the task of calculating a company's value through a web of assumptions, why not start with what's already reflected in the stock price? This approach lets you evaluate whether those assumptions are grounded in reality.

To get started, please download this Excel spreadsheet:

Once you open the spreadsheet, here’s what you’ll see:

I’ve intentionally hidden the Reverse DCF calculations between rows 11 and 23—feel free to dive in. (For the terminal value, I've used a 3.5% perpetual growth rate.)

Essentially, you'll need to input the following parameters:

• Current Share Price

• Shares on Issue

• Required Rate of Return

• Free Cash Flow in Year 1

Then, adjust the growth rate until your valuation aligns closely with the current share price.

This method reveals, for example, that the market has factored in a 30% growth for 10 years. In other words, if the company increases its cash flow by 30% annually for the next decade, you would expect a 10% return.

If you believe a 30% growth in cash flow is reasonable, then you might consider the share price fairly valued. If you think a 30% growth expectation is too optimistic, you might view the share as overvalued. Conversely, if you believe the company can grow its cash flow by more than 50% for the first ten years, then the share might be undervalued.

(Note: This isn’t my method either. I picked up the concept from various sources and put it in simple format in excel)

Final Thought

• A quick and simple calculation (Method 1) is often the easy way to achieve a roughly-right valuation.

• The Flip It or Reverse DCF method highlights the growth expectations already priced into a stock. You can then compare this growth rate with your own judgment to determine if the stock is overvalued, undervalued, or fairly valued.