Valuation: Intrinsic Value
1. Main drawback of the ratios based on price provide relative value - however, they dont tell about value, which is waht a stock is actually worth
2. Having intrinsic value keeps us focused on the value of the business, rather than the price of the stock
3. Second, having an intrinsic value gives you a stronger basis for making investment decisions.
Cash Flow, Present Value and Discount Rates
1. The value of a stock is equal to the present value of its future cash flows.
2. Companies create economic value by investing captial and generating a return. Some of that return pays operating expenses, some gets reinvested in the business, and the rest is free cash flow.
3. A firm can use free cash flow to benefit shareholders in a number of ways - pay a dividend, buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and reinvest it in the business.
4. Free cash flows are what give the firm its investment value. A present value calculation simply adjusts those cashflows to present date.
5. There's a chance we may never receive those future cash flows, and we need to be compensated for the risk, called the "risk premium".
6. Not many cashflows are as certain as those from the feds, we need to tack on an additional premium to compensate
7. So, stocks with stable, predictable earnings often have sunch high valuations - investors discount their future cash flows at a lower rate. A business with a extremely uncertain future should logically have a lower valuation because there's a substantial risk that the potential future cash flows will never materialize.
8. Value is determined by by the amount, timing and riskiness of a firm's future cash flows.
Fun with Discount Rates
1. As interest rates increases, so will discount rates.
2. We can use long-term average treasury rates as a reasonable proxy.
3. Here are some factors that should be taken into account when estimating discount rates
- Size - Smaller firms are generally riskier than larger firsm because they're more vulnerable to adverse events. They also have less diversified product lines and customer bases.
- Financial Leverage - Firms with more debt are generally riskier than firms because they have a higher proportion of fixed expenses (debt payments) relative to other expenses. Earnings will be better in good times, but worse in bad times, with an increased risk of financial distress.
- Cyclicality - Because the cash flows of cyclical firms are tougher to forecast than stable firms, their level of risk increases
- Management/Corporate Goveranance
- Economic Moat
- Complexity
Investor's Checklist: valuation - Intrinsic Value
1. Estimating an intrinsic value keeps you focused on the value of a business, rather than on the priced of the stock
2. Stock are worth the present value of their future cashflows, and that value is determined by the amount, timing, and riskiness of the cash flows.
3. A discount rate is equal to the time value of money plus a risk premium
4. The risk premium is tied to factors like the size, financial health, cyclicality, and competitive position of the firm you're evaluating.
5. To calculate an intrinsic value, follow these five steps: Estimate cash flows for the next year, forecast a growth rate, estimate a discount rate, estimate a long-run growth rate and the discounted cash flows to the perpetuity value.