- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
Intrinsic valuation models and methodology
What is the best methodology for value investors to use when calculating intrinsic value? Is it P/E, NTA, dividend discount or a discounted cash flow model?
The hallmark of successful value investing, proven by the undisputable success of Warren Buffett, is buying a company when its share price is considerably below its intrinsic value.
By ‘intrinsic value’ we mean ‘true’ value – the sum total of a business’s worth based on its earnings, dividends, equity and debt. How the business performs is after all how you as a shareholder make money.
Finding the right intrinsic value methodology
When it comes to calculating intrinsic value, what is the right methodology to use?
Here are some useful guidelines to help you wade through the many ways of valuing a company – drawing on certain assumptions about key financial information like profits, dividends or assets.
Generally speaking, valuation methods can be divided into either absolute or relative valuation models.
Absolute valuation models
Including dividend discount, discounted cash flow (DCF), and asset-based models, absolute valuation models search for the intrinsic value of an investment based on fundamentals (like dividends, cash flow and growth rates for a single company). By comparison, the relative valuation models are designed to compare a company with its industry peers, using ratios like the price earnings ratio (P/E).
Relative valuation models
Relative valuation models are considerably easier and faster to complete than their absolute counterparts, so many investors and analysts start their analysis with this method first.
The most popular valuation models
First up, let’s look at the universally popular P/E model in more detail.
Price earnings ratio is the most commonly used (and often abused) valuation tool due to its focus on company earnings, a primary driver of an investment’s value. It is usually calculated as (current) share price / (historical) earnings per share
But you can’t begin to value a company using a price earnings ratio until you know:
A. what its actual earnings are and
B. what multiple to apply to those earnings.
A price earnings valuation is more meaningfully applied to companies with an established history of consistent earnings that are indicative of the normal cash flows the business earns.
It may not be an exact science, but an earnings multiple is arrived at by rigorously assessing a company's long term performance – the quality of its business, management’s track-record – and then comparing it to both domestic and global peers. While a relatively high price earnings ratio should reflect a company’s quality and growth potential, it may also mean that the company is overvalued. If the price earnings ratio of the stock you’re trying to value is lower than the price earnings multiple of a comparable business, it may be regarded as relatively undervalued.
Different businesses will have different growth profiles. It is not always easy to assess whether a high or low price earnings ratio reflects high or low growth prospects, or if it is a reflection of relative value. Price earnings ratios will be unhelpful in trying to evaluate companies with negative or highly volatile earnings.
The price earnings ratio does reveal what the market is prepared to pay for the current earnings per share of a company. However due to the weaknesses outlined above, many investors (and also Skaffold) prefer to rely on absolute models to establish what a company is worth.
Dividend yield and cash yield valuation methods can also be useful ways to value a business, but like the price earnings ratio, they’re best applied to companies with a long history of sustainable earnings and cash flow plus steady dividend payouts.
A net tangible assets (NTA) per share calculation – total assets less intangible assets less total liabilities, divided by number of shares on issue – can give you an indication of value, it’s important to remember that inventories can be overstated and fixed assets can be difficult to sell. NTA also does not take into account the earning power of those assets.
The dividend discount model calculates the ‘true’ value of a firm – based on the dividends the company pays its shareholders – so it should provide a reasonable value for how much shares should be worth. But while this intrinsic value model may be useful for evaluating mature blue-chip companies with quality underlying earnings per share, it’s of little help to you if the company actually doesn’t pay a dividend.
Equally important, the dividend alone won’t tell you either how affordable it was or how sustainable it is at current levels. To get a snapshot of dividend affordability, keep an eye on whether earnings per share and dividends are growing at the same rate, and check to ensure the corresponding payout ratio is equally consistent.
Where a company doesn't pay a dividend or where the dividend pattern is irregular, a discounted cash flow model might be a more appropriate measure of value. In the absence of dividends, the discounted cash flow model uses a firm's discounted future cash flows to value the business.
While discounted cash flow models can vary significantly, the most common two-step variation includes:
A. the free cash flows – typically forecasted for five to ten years – and
B. a terminal value calculation which incorporates all the cash flows beyond this forecasted period.
But remember, this model can’t be deployed successfully unless a company has free cash flows that are not only predictable but also positive. The easiest asset to value with a DCF model is a government bond, where the cash flows are certain. As certainty of cash flows decreases, the accuracy of a discounted cash flow model also decreases. While mature companies with a strong cash flow are relatively suited to a DCF model, small, high-growth firms can be problematic. The discounted cash flow model is often used to value resource companies, where the cash flows have a limited life due to the limited mine life.
It’s important to remember that all (valuation) methodologies should contribute to unearthing what the world’s most successful investor Warren Buffett called a company’s intrinsic value (IV).
Skaffold's basic intrinsic value calculation is:
(Return on equity (ROE) x equity per share) / Required Return (RR)
Skaffold automatically calculates a Required Return (RR) specific to the type of business being valued.
The most comparable publicly available calculation model to Skaffold’s unique formula is the Residual income valuation model.
Using intrinsic value to find the best value stocks
While it’s never an exact science, intrinsic value – the sum total of the business’s worth based on earnings, dividends, equity and debt – can only be arrived at through significant ‘fundamental’ analysis. Rather than overly relying on comparative performance indicators, like a price earnings ratio, Warren Buffett prefers to concentrate on a company's financial statements over time and assess its management, markets and future growth potential.
Buffett uses intrinsic value to identify superior stocks through the quality of their underlying business. He believes that companies capable of growing their intrinsic value are also more likely to provide increasing capital growth to your portfolio – which is what investing in the share market is all about.
As an informed value investor, you need to understand that the gap between price and value – safety margin – won’t last forever. Buffett argues that share price and intrinsic value will at some future time start to converge, and there’s no shortage of share market history to prove that he’s right.
By estimating forecast intrinsic valuations for each (profitable) stock – derived by earnings, dividends, equity and profit forecasts from consensus analysts – Skaffold can help you decide whether a buy or sell decision makes sense. Given that intrinsic calculations are only ever an estimate, it also makes sense to apply a Safety Margin to that valuation to allow for uncertainty.
Skaffold estimates up to ten years of historical intrinsic valuations plus three years of forecast valuations for thousands of stocks in listed businesses. Here's how valuations are presented in Skaffold stock research software.