Understanding the Valuation section in the company report

Contents of this article:

• Overview: The Valuation Section
• Intrinsic Valuation: Method, Data & Analysis
  • Share Price VS Fair Value
  • Which DCF Method is used to calculate Fair Value?
    • 2-Stage Discounted Cash Flow Model (DCF)
    • Dividend Discount Model (DDM)
    • Excess Return Model
    • Adjusted-Funds-From-Operation (AFFO) 2-Stage DCF Model
• Relative Valuation: Metrics, Data & Analysis
  • How do we select the preferred multiple?
  • How do we know which companies should we compare to?
  • What is Fair Ratio?
• Analyst Price Target
• Video Guide: How to use the Simply Wall St Valuation Section

 

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Understanding the Valuation Section

There are two main methods for valuing companies; relative and intrinsic valuation. Each approach has its advantages and limitations and gives a different view of the company’s value. Simply Wall St uses both methods, incorporating them into the checks that form the valuation arm of our snowflake.

There are six (6) key metrics that we check and analyze in the Valuation section as shown in the screenshot below. The first two checks are based on Intrinsic Valuation while the other 4 on Relative Valuation and Analyst Price Target forecast.

 

 

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Intrinsic Valuation: Method, Data & Analysis

Intrinsic valuation focuses on the company itself, and compares the current price to an estimate of fair value.

We use 3 metrics to assess the company's intrinsic valuation. First, we check whether the company's share price falls below our fair value estimate, which we derive using the Discounted Cash Flow Model. Second, we check whether the company's share price is at least 20% lower than our fair value estimate. Lastly, We check whether the company's share price is at least 20% lower compared to the analysts' price target (Learn more about Price Targets)

Theoretically, the value of a company is the present value of all the future cash flows it can provide to shareholders. To get this value, the Discounted Cash Flow (DCF) method is used. This method uses inputs and assumptions about the underlying business to project the cash flows generated each year in the future, and then discounts each year back to today’s present value and adds them together. Depending on the company we use a slightly different DCF method.

 

Share Price vs Fair Value

This section compares the current market price of the company with fair value estimate.

We use the Discounted Cash Flow model to estimate the fair value of the company. This model focuses on determining the value of the company at present based on the future free cash flow that the company can generate.

Simply Wall St uses 4 variations of DCF depending on the characteristics of a particular stock, such as its industry and data availability for the company.

 

Which DCF method is used to calculate fair value?

Simply Wall St uses 4 variations of DCF depending on the characteristics of a particular stock, such as its industry and data availability for the company.

1. 1. 2-Stage Discounted Cash Flow Model
      Suitable for companies that are not expected to grow at a constant rate over time. These companies tend to be high-growth initially and become stable after a couple of years.

   2. Dividend Discount Model (DDM)
      We use this as an alternative when the 2-stage DCF is not available. This is more suitable for companies that consistently pay out a meaningful portion of their earnings as dividends.

   3. Excess Returns Model
      Used for financial companies such as banks and insurance firms. These companies generally do not have a significant proportion of physical assets and face different regulatory requirements for cash holdings to other businesses.

   4. Adjusted-Funds-From-Operations (AFFO) 2-Stage Discounted Cash Flow Model
      Used for Real Estate Investment Trusts (REITs) as these companies incur capital gains and other real estate-specific factors which impacts their free cash flows.

 

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The 2-Stage Discounted Cash Flow Model

Suitable for companies that are not expected to grow at a constant rate over time. These companies tend to be high-growth initially and become stable after a couple of years.

Calculating Fair Value using the 2-Stage Discounted Cash Flow Model

Two calculations are performed: high-growth stage and stable-growth stage. In high-growth , estimates over the next ten years of levered free cash flow to equity are used, which are sourced from market analyst consensus estimates. If no estimates are available, then the last estimate or reported value is extrapolated using the historical average annual growth rate. The following years are then forecast to grow, but with the growth rate reducing each year, until it reaches the long-run stable growth rate.

In stable-growth, a terminal value is calculated using the Gordon Growth formula, with an assumption that the company will continue to grow its earnings at the 5-year average of long-term government bond rate, forever. The sum of the cash flow arising from the forecasts are then discounted to today's value using a discount rate, then divided by shares on issue, giving a value per share.

Example Calculation: Microsoft (NasdaqGS:MSFT)

Sample 10 years of future free cash flow forecast

The present value of the next 10 years' cash flows amounts to $858,402.87.

Terminal Value

Total Equity Value

Fair Value per Share

NasdaqGS:MSFT’s current share price of US$312.79 (as of September 28, 2023) is 13.5% below our fair value estimate of US$361.8. Therefore, it passed the first check but did not meet the criteria for the second check.

 

 

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Dividend Discount Model (DDM)

Since dividends are a form of cash flow that is directly returned to shareholders, it can be used to determine how much a share value is worth to a shareholder who will reap the benefit of these future dividend payments. The Gordon Growth model is used to discount a company's dividend payments over time, with the assumption that dividends will continue to grow at a certain rate forever.

 

Calculating Fair Value Using Dividend Discount Model

To determine the value of a stock using the Dividend Discount Model, we use the following formula:

Let's use BSE:530365 as an example which uses DDM at the time of this publication.

Example Calculation:

Value = Expected Dividends Per Share of ₹1 / (17.80% Discount Rate - 6.76% Perpetual Growth Rate)

The result yields a fair value of ₹9.05.

 

 

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Excess Returns Model

This model is better suited to calculate the intrinsic value of financial companies than the traditional discounted cash flows model. The key assumption for this model is that equity value is how much the firm can earn, over and above its cost of equity, given the level of equity it has in the company at the moment. The returns above the cost of equity is known as excess returns:

Calculating Fair Value using Excess Returns Model

1. Derive Excess Returns

The formula to calculate excess returns is as follows:
Excess Return = (Stable Return on Equity – Cost Of Equity) × (Stable Book Value Of Equity)

2. Terminal Value of Excess Returns

The calculated excess return is subsequently used to derive the terminal value of the company, which represents the expected earnings the company can generate perpetually. This terminal value is a fundamental component in discounted cash flow models. The formula for determining the terminal value of excess returns is as follows:

Terminal Value of Excess Returns = Excess Return / (Cost of Equity – Perpetual Growth Rate)

3. Determine the Company's Fair Value

Putting this all together, we get the value of the company:

Fair Value per share = Stable Book Value of Equity + Terminal Value of Excess Returns

Let's use NYSE:BAC as an example:

Fair Value Calculation:

(9.8% Stable Return on Equity - 7.61% Cost of Equity) × $35.38 Stable Book Value Of Equity = $0.78 Excess Returns

$0.78 Excess Returns / (7.61% Cost of Equity - 2.15% Perpetual Growth Rate) = $14.26 Terminal Value of Excess Returns

USD35.38 Stable Book Value Per Share + $14.26 Terminal Value of Excess Returns = $49.64 Fair Value per share

 

 

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Adjusted Funds From Operation (AFFO) DCF Model

This model is the same as the 2-Stage Discounted Cash Flows Model, except for one key difference – instead of discounting the company's free cash flows, we use its Adjusted Funds from Operations (AFFO) instead. AFFO better reflects the operational cash flows of REITs as opposed to the commonly used free cash flows.

Funds from Operations (FFO) is the company's earnings, with depreciation and amortization added back on, and removal of capital gains from property sales. AFFO has other adjustments to the FFO number to make it even more accurate, by subtracting off capital expenditure and maintenance costs of the property, and adding rental increases. These factors are very specific to property and REITs, making it a far superior measure of value for these types of stocks.

In instances where forecasted AFFO data is not available, we resort to using forecasted FFO. However, in cases where both AFFO and FFO forecasts are unavailable, we fall back to using free cash flow.

Let’s use NYSE:AMT as an example. There are forecasted AFFO data available from our data provider, hence we use AFFO.

Sample 10 years of future AFFO forecast

The present value of the next 10 years AFFO amounts to $48,025.6

Terminal Value

The terminal value is calculated using the formula:

Terminal Value = AFFO2033 × (1 + g) ÷ (Discount Rate – g)

For NYSE:AMT, the terminal value is:

Terminal Value = $8,334.814 x (1 + 2.15%) ÷ (6.55% - 2.15% ) = $193,381.65

The present value of the terminal value is then computed as:

Present value of terminal value = Terminal Value ÷ (1 + r)^10
Present value of terminal value = $193,382 ÷ (1 + 6.55%)^10 = $102,511.06

Total Equity Value

The total equity value is determined by summing the present value of the next 10 years' AFFO and the present value of the terminal value:

Total Equity Value = Present value of next 10 years AFFO + Present value of terminal value
Total Equity Value = $48,026 + $102,511 = $150,536.66

Fair Value per Share

Finally, the fair value per share is calculated by dividing the total equity value by the total number of shares outstanding:

Fair value per Share = Total value / Shares Outstanding
Fair value per Share = $150,537 / 466 = $322.93

 

 

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Relative Valuation: Metrics, Data & Analysis

Relative Valuation is where we compare the company in question to other companies. We assess a company's relative valuation using three metrics:

• Price-to-Earnings, Book, or Sales Ratio compared to its peers,

• Price-to-Earnings, Book, or Sales Ratio compared to the industry; and,

• Price-to-Earnings, Book, or Sales Ratio vs the Fair Ratio.

Key Valuation Metric

In order to conduct Relative Valuation, we need first to decide on an appropriate valuation ratio for a company (P/E, P/S, or P/BV), to then compare it to other companies. This is because not every valuation ratio is relevant to every business.

 

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Selection of Preferred Multiple

The most common multiples used in relative valuation are Price to Earnings (P/E), Price to Sales (P/S) and Price to Book (P/B). The question is which of them is the best one to use? For some companies, all of them can be useful, while for others only some of them make sense, or even provide any information at all.

Price to Earnings ratios are useful for companies that are profitable, and have meaningful earnings compared to their valuations. Mathematically, the P/E ratio provides no information if a company is loss making (unprofitable). If a company has very small earnings then the PE ratio could be quite high, and will change rapidly with very small changes in earnings from quarter to quarter. Therefore, we use Price to Earnings for companies that are profitable, and have a PE ratio below 150.

Note: You can toggle on "Forward PE" if you want to view data for Forward PE Ratio based on forecasted earnings. You can also view the data that was used in the P/E calculation by selecting "Data" under the graph.

Price to Sales is generally the next best option. Companies will more consistently have revenue, with only very few early stage companies having no revenue at all. This means that for most companies, we can calculate a P/S ratio by dividing the market capitalisation by revenue. Generally, very high growth companies and those in the earlier stages are best valued using Price to Sales.

Note: You can toggle on "Forward PS" if you want to view data for Forward PS Ratio based on forecasted sales. You can also view the data that was used in the P/S calculation by selecting "Data" under the graph.

Price to Book is useful in particular for banks or other financial institutions for whom the value of their assets are particularly important, typically because they generate their generate income from their asset base. It is calculated by dividing the market capitalisation by the book value of the company. The book value of a company is the value of its assets minus the value of liabilities.

How do we select the preferred multiple?

Below is the process for how we determine which above ratio is appropriate for the stock you’re viewing.

 

 

How do we know which companies should we compare to?

Once you have selected a multiple, the next step is to compare the multiple for the company you are valuing to the same multiples of similar companies. The question is, which companies should we compare to?

The investment industry uses the term ‘peers’ to describe companies that are similar to each other. They may be competitors, but they may also just be companies producing similar products in similar conditions. There are a range of factors that go into selecting a group of peers, and it can actually be quite a challenging thing to do. Factors that can be included are basics like the industry and country and company is in, as well as more detailed factors like its growth stage, margins and assets.

Investment professionals who focus on a particular group of companies for a long time develop a good intuitive sense for who a company’s peers are. At Simply Wall St, we have developed a tool that builds this intuition using thousands of data points and sophisticated techniques. This allows you to do a relative valuation using a high quality set of comparisons that are relevant to the stock in question.

Can I modify the peers to compare to?

Yes. Users have the option to change peers and the valuation ratio by simply clicking the Edit Peers and the Ratio beside it. Be mindful, however, that this will not change the result of the analysis in the report. The result of the analysis will still based on the default peers and ratio.

 

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Historical Price to Earnings/Book/Sales Ratio

This additional chart shows how the ratios moved over time - up to five years period.

Note, however, that this does not contribute any scores into the snowflake as there's no specific parameter being assess here. 

 

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Comparison to Industry

(Price to Earnings/Book/Sales Ratio Ratio vs Industry)

While comparing with peers is very helpful, sometimes you may also want to cast a wider net to gain a greater perspective. Comparing your target company to the whole industry can help you to understand how its valuation compares to a wider range of companies. This can be particularly useful to identify if your company sits in a niche that is valued much higher or lower than the industry as a whole.

While companies might be in the same industry, they are often at different stages of the business cycle. Comparing the company you're viewing to the industry gives a greater perspective of where the stock sits in regard to valuation and growth within a wider group of companies. Therefore, it’s important to assess comparative valuations within an industry with context of where each company is on their own lifecycle. Earlier high growth companies can attract higher valuations from investors based off their future potential, whereas more established and lower growth businesses in the same industry might attract lower valuation multiples because of their comparatively lower growth prospects.

What we check:

If it’s below the industry average, it will pass this check, if it’s higher, it will fail this check.

 

In the below example for NasdaqGS:MSFT, it’s current P/E ratio in the chart is 33x which is lower compared to its peer average of 43.5x. Hence, it passed this check.

 

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Simply Wall St Fair Ratio

Relative valuation is great, because it’s fairly simple. All you need is a metric, and a group of companies to compare to. But that simplicity comes at a cost - it means that you aren’t valuing the company on a fundamental basis.

What is Fair Ratio?

The Fair Ratio is essentially a model developed by Simply Wall St that estimates the Fair Ratio based on the company’s growth and risk. This model combines relative and fundamental valuation approaches. It uses thousands of data points to determine the market's willingness to pay for growth given a specific level of risk.

Fundamental valuation focuses on the properties of the company itself, and relies on inputs and assumptions being put into different models to generate an estimate of fair value. Using fundamental valuation models like the Discounted Cash Flow (DCF) suffer from a different problem to relative valuations. To reliably value a company using this technique, you need a lot of data. Essentially, this data needs to tell you two things;

1. How much the company is growing, and

2. How risky that growth is.

Growth, and risk. If we can understand how the market prices both of these elements then we can bridge the gap between relative and fundamental valuation. The Simply Wall St Fair Ratio does just that. We’ve used thousands of data points, and developed a model that tells us how much the market wants to pay for growth, with a specified level of risk.

Simply put, for every market and industry, we’ve calculated the correlating growth and risk factors that are statistically significant in determining the market’s sentiment towards a stock.

The Fair Ratio is part of Simply Wall St’s continuous efforts to use data to push the boundaries of understanding potential value.

For each company, we can then compare any valuation metric, be it P/E, P/S or P/B, to our expectation of what the market would pay. The variance, either over or under, is where the opportunity may lie.

For example, NasdaqGS:MSFT in the below illustration, its current P/E ratio of 32.1x is lower compared to our Fair PE Ratio of 65x, hence it passed this check.

 

 

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Analysts Price Targets

Our final check in valuation is to assess what analyst’s think of a stock. Analysts covering a company do extensive research on the underlying business and its prospects and they provide what’s known as a price target. This price target is essentially an indication of where they think the stock price could be trading at in the future, based on their research and forecasts of the business’ prospects.

However, not all analysts have the same price target for a stock, because they may have different assumptions. That's why we have developed the Analyst Price Targets check. It not only incorporates the range of analyst’s current price targets and compares them to the current stock price, but it also shows us how previous price targets have compared to actual share price performance over time.

 

The Analysts Price Target check tells us whether there might be an upside opportunity with the stock, and more importantly, if we should have confidence in that consensus price target. You can see in the chart how this is represented, and the table above it provides a summary.

The blue line represents the stock’s historical share price over the past 2 years. The purple line represents the consensus price target, which is the average of all the analyst’s price targets looking forward 1 year. That’s why the purple line doesn’t start at the same spot as the blue line. The purple dot represents what the consensus price target was from analysts at the time of the blue dot. As for the shaded triangle, that represents what the range of price targets from analysts were, from highest to lowest, depending on the date your cursor is over.

As you move your cursor over the chart, you’ll see how this range of estimates changed over time, depending on what the range of price targets were from analysts. This can tell us how accurate analysts’ price targets were historically based on where the blue line ended up, and also, how closely analysts agreed with each other. The shaded range will be green if the stock was at a greater than 20% discount to the consensus price target, and the shaded area will show up as red if it was trading at anything less than a 20% discount.

In the table above the chart, you’ll see the “Confidence” section represents how closely analysts agreed with each other. Confidence will read “Good” if the lowest and highest estimates are within 15% of the consensus price target, which tells us that analysts largely agree with each other on the stock’s prospects. However confidence will read “Low” if the highest and lowest estimates are more than 15% away from the consensus, meaning analysts don’t agree with each other.

This is because we did some extensive data analysis, and found that if analysts’ forecasts are close to each other, then that forecast is more likely to be reliable.

There are two criteria needed for a company to pass the analysts price target check. Firstly, the current share price must be at least 20% below the consensus price target. This is to indicate if there might be any decent upside opportunity with the stock. And secondly, the dispersion from the consensus must be less than 15%, meaning analysts expectations are largely the same. This second part essentially gives us a level of confidence about the expectations, because if the range of expectations were much wider, it would be difficult to have any level of confidence about the consensus estimate.

If the stock passes both those checks, it will have one point added to the valuation snowflake score. However, if either of those criteria are not met, it will fail and no point will be added to the snowflake.

 

 

 

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Video Guide:
How to use the Simply Wall St Valuation Section