How to value a share?

After my last blog, I’ve had a few people ask me how to actually value a share? (when I say a few, I really mean two). However, two caveats before we get started:

1. Thousands of research papers, University seminars and online courses dedicated to valuations and corporate finance indicate just how topical valuation methodologies are. Therefore, I’m just going to cover the absolute basics to give a high-level overview of valuations.
2. There’re plenty of ifs and buts in valuations and there is no right or wrong answer. If there were, that would mean we live in a perfect market…which we don’t. It’s also not rocket science, just keep it simple!

I’ve also included a link at the bottom of this blog to an excel document I’ve put together which illustrates a very basic valuation using everything I discuss below.

With that said, let’s get stuck into it:

Valuation Techniques

There are several techniques you can use to value a stock. One of the most widely used ones (and arguably the most accurate) is known as a discounted cash flow (DCF) which discounts free cash flows to equity investors and that is what the rest of the blog is going to cover.

In doing a DCF, you predict the entity’s free cash flows into the future. Then discount those cash flows back to today by using a rate you would expect to earn on this stock as an investor. This gives you the value of the entity’s equity which you divide by the number of shares and voila, there’s your value per share.

Why free cash flows (FCF’s) you may be asking? FCF’s to equity investors are essentially the core output of the entity’s operations. It’s what’s left over to pay to shareholders. Everything the entity does on a day to day basis results in cash flows.

Here are the 8 things you will need:

1. The entities latest financial statements

How do you get the FCF’s? Financial statements have to comply with certain accounting rules (broadly known as IFRS – International Financial Reporting Standards). To get to the FCF’s of an entity, you first need to remove all the accounting quirks. The simplest way is to start is with a figure called net income which you will find in every entity’s financial statements. You then add back the accounting quirks such as depreciation which are non-cash items.

Now in this net income figure, there are certain numbers which are not included which we must add/deduct to get to the entities FCF’s. These range from movements in working capital (e.g.: when debtors reduce, that means a debtor has paid me, which means I’ve received cash) to capital expenditure (e.g.: when I buy a new computer for my company, that will result in a cash outflow).

In the attached excel workbook at the bottom of the page, I’ve listed a few common ‘quirks’ you need to add/deduct from the net income figure to get to your FCF’s.

2. Growth rate

Now that you have your FCF’s, you need to predict by how much they will grow by in the future. This is where a lot of ifs and buts come into valuations. You will have to use your own judgement to determine this. A good starting point is to look at the entities historical compounded annual growth rate (CAGR) of revenue (once again, there are far more accurate ways of doing this, but a historical growth rate is used for the sake of simplicity).

You can then start adjusting this figure for various scenarios. For example, is the company launching a new drug soon? Is the new CEO the next Steve Jobs? Do you believe the new competitor’s product is far superior? Just on a side note; try not to get too carried away with adjusting your growth rate. Fiddling too much with your rates/cash flows is where things can start to go very wrong!

3. Risk free rate

As I mentioned earlier, you need to discount the future FCF’s at a rate you would expect to earn on this stock as an investor. But what is this rate?

Well a good starting point is by looking at a risk-free rate. What rate of return would you be willing to accept if there were zero risk associated to the investment? The benchmark for a risk-free rate is government bonds (e.g.: in South Africa, one of the common bonds is known as the R186). Why government bonds? Your returns are almost guaranteed, and thus “risk-free”.

Now that you have a risk-free rate, what additional return would you expect for taking the risk of investing in this stock? This is known as an ‘equity risk premium’ (see point 4 below).

(Food for thought, are government bonds really risk free if there’s a chance that a government can default on their debt? Think the Greek government debt crisis in 2008).

4. Equity Risk Premium

One of the core principles of valuations is risk vs return. If you invest in something ‘riskier’, you would expect a higher compensation for taking on this risk, right? The equity risk premium is a measure of ‘how much’ extra return you would expect as a return for a riskier investment, or, the return you expect less the risk-free rate.

To get this rate, you can either look backwards or forward. Looking backwards is probably the easiest (although not the most accurate). If you take historical market returns (i.e.: what has the JSE returned historically), less the risk-free rate, you end up with your equity risk premium.

Please note that there are arguably far more accurate ways to determine an equity risk premium (i.e.: taking mature market risk free rates and adjusting these with country specific risk based on credit default swaps).

5. Beta

Beta is essentially a measure of relative risk. It tells you how risky a stock is relative to an average risk stock. It’s calculated by running a regression on the returns of a stock vs the returns on a market index. A high beta stock (i.e.: greater than 1) means it’s more volatile than the market. A lower beta stock (i.e.: less than 1) means it’s less volatile than the market.

There are alternate ways to determine beta (which take into account the industry, entity debt levels, proportion of fixed costs to variable costs, etc) and I’m fairly adverse to using regression beta’s, but it’s the simplest way to determine beta.

6. Cost of Equity

The cost of equity is the rate that you’re going to use to discount your future cash flows to todays date. The simplest model to determine the cost of equity is known as CAPM – Capital Asset Pricing Model. It’s denoted as:

Cost of equity = risk free rate + beta (market risk premium-risk free rate)

All the inputs into this calculation have been discussed above.

7. Terminal value

If we grow the entity’s FCF’s at the growth rate determined from point 2 above forever, the entity would be come unrealistically big. Think of it this way, if your growth rate is larger than the growth rate of the economy, it will reach a point where the company you’re valuing is larger than the South African economy (highly unrealistic).

Therefore, after we’ve predicted our future FCF’s for a period of 5 years (5 years is a rule of thumb) at the growth rate we determined, we grow the remaining cash flows into perpetuity at a stable growth rate. This figure gives us the ‘terminal value’.

8. Number of entity’s shares

You will be able to find the number of issued ordinary shares in the entity’s financial statements.

Putting everything together

If you’ve reached the end of this post and are still reading, well-done!

To see how to put all the information from 1-8 above into a DCF calculation, see the attached excel document here:

You might also be asking yourself, “Daniel this is all good and well, but where do I find this information?” As I feel like this post is already becoming a bit lengthy, I will cover this in another blog.

And as usual, if you have any questions, comments or critiques, please do let me know!