Fair Value Of A Stock

We all like
bargains but few investors estimate a company’s worth before buying a
stock. Investing requires the same discipline adopted when purchasing a
house, a car or even groceries, literally. The problem arises when
investors don’t anticipate the amount of risk they are taking when
purchasing stocks that trade at high premiums to the intrinsic value of
the business. Buying securities at over inflated levels can lead to
serious loss of capital.

Fair value of a stock is a price below
which, you would buy a stock, and above which you would sell it. The
ground situation is not as simple, however, as you are dealing with a
dynamic investing world.

A
simple method is to use the price-to-earning multiple, where the price
of a company’s stock is divided by the earnings per share of a company.
This method is sensible because earnings is a proxy for how well a
company is performing within a given market opportunity. However, as
long-term investors we are interested in absolute value, irrespective
of how the stock market is currently pricing the company. Here, the P/E
loses relevance since it is will be continuously influenced by the
demand or supply for a company’s stock on the numerator side.

Earnings
per share, which represents the denominator side of the P/E, also may
not help. All earnings do not equal free cash flows. Most of it is
ploughed back into the company for capital expenditure. And as
investors we are interested in the surplus cash (though this term has
many variations, it is loosely defined as the cash after providing for
recurring capital expenditures plus depreciation and taxes, the later
being a non-cash charge), which can be returned to equity shareholders.

This is embodied in the discounted cash flow model. This model
says that the value of a stock is equal only to the future expected
free cash flows, discounted back to the present. When you discount
future income, you essentially adjust for the fact that a rupee in hand
today is more valuable than a rupee to be received in the future
because today’s rupee can be invested elsewhere to generate a return.
The DCF allows you to discount incoming cash flows by a rate, which you
believe equates the level of risk you are assuming. This risk-adjusted
value then is compared with the prevailing stock price to check a
company’s investment worthiness. If a stock is said to be trading at
fair value, it simply means that the market is pricing it according to
the value it represents. Otherwise, it could either be bought or sold
short. With minor modifications, the DCF can be used to value a range
of companies, from those growing faster than the economy to those
growing slower, or matching the pace of the economy.

However, like all
other valuation models, the DCF too has its limitations. For decades it
served analysts and investors well until faced with the prospect of
valuing companies in the so-called new economy businesses and also in a
fast changing economic environment.

Not that the basic premises
of the DCF are under question, but how does one account for companies
where revenues are growing at a rate, which have a high element of
surprise. And small changes in the amount of information available can
bring about large changes in stock prices. How does one come up with an
appropriate discount rate, which reflects the high level of
technological risk for many such companies?

How does the DCF
model build in for a boost in valuation that comes when a company is
taken over by another? The inability to predict the fair value for
these companies also causes their stock prices to fluctuate beyond
wildest imaginations. Limited free float also creates price
distortions. To stretch it a bit, using the words of John Burr
Williams, who pioneered the concept of DCF: “They (the stock market)
had high hopes for the business, but no logical evaluation of these
hopes in terms of stock prices. The very fact that the company was one
of the hardest of all stocks to appraise was the reason it sold at
extravagant prices, for speculation ever feeds on mystery, as we have
seen before.”

In
the end, instead of grasping on the appropriate valuation for these
companies, investors can caution themselves by thinking more carefully
in terms of ‘price’ versus ‘value’.

Price is not value. Price
is what you pay. Value is what you get in return for owning a piece of
a company. When you shop for a consumer durable, you don’t pay the list
price without being sure of the quality of the product and consistency
of its expected performance.

Similar issues should matter more
while investing–the quality of management, nature of the company’s
business, the ability of the management to sustain growth and so on.
Alternatively, think about the return that you will need to compensate
for the investment risk given the quality of the management and the
nature of business. If you cannot see a company providing such a return
over a longer term, do not invest.

When it comes to investing
choosing a great company is only the starting point. In order to make a
good profit, investors must buy stocks of great companies at sensible Prices