There are 3 different methods of doing a stock valuation.
- Simple Price / Earning (PE) Ratio & PEG
- Discounted Cash Flow (DCF)
- Discounted Earning Per Share (EPS)
Simple PE Ratio & PEG
As a general guideline, a company is at its fair value if the PE is about 15. If the PE ratio less than 15, it is considered under value, and vice versa. I also do a quick comparison of current PE versus the average PE historically. I will pay special attention to the stock price movement if the current PE is more higher than the historical PE average.
PEG refers PE ratio divided by company growth rate. PEG = 1 means that PE growth rate is the same as the company growth rate (measured by either EPS growth rate or net operating cash flow growth rate)
If PEG < 1, the stock price is under value.
If PEG > 1, the stock price is over value.
If PEG = 1, the stock price is at its fair value.
Discounted Cash Flow Model (DCF)
This model is to estimate the company next 10 years net operating cash flow (Future Value, FV) and re-calculate to the Present Value (PV), and add all ten years PV together. The intrinsic value can be calculated after dividing the total number of shares,. The assumption made is the company must be able to generate cash growth consistently with a CAGR (Compounded Annual Growth Rate) which computed from the past history of net operating cash flow.
Net Operating Cash Flow information can be found from the company annual reports, under the Cash Flow Statement.
Discounted Earning Per Share Model (EPS)
Similar to the DCF model, but this time Earning Per Share is being looked into. EPS information can be found at the Income Statement by getting the Net Earning number and divided by the total number of shares. By looking at the historical EPS, a CAGR for EPS growth can be calculated.
By bringing all the 10 years FV of EPS to PV, adding them together give an intrinsic value of the stock.
Valuation of a stocks need some financial background and need some practice. Two key areas to pay attention to:
(1) Where to find the information? All the financial statement can be found from the annual reports by going to the company web site. Another way is to get the summarised information from the website like Shareinvestor (for Singapore Stocks), Morningstar & MSN Money (for US Stocks)
(2) Understand the Financial Fundamental & Definitions like Present Value, Future Value, Discount Rate, CAGR and also practise how to use them. I use the financial calculator to calculate the CAGR and instrinsic value calculator to calculate the intrinsic value of the stocks. I got those simple software (formula in excel form) from my investment course.
I found that DCF model is a better model although it is a little more complicated because Cash Flow is not easily manipulated by the company accountant and cash is always easily be audited. If the company business model is solid, the net operating cash flow grows consistently every year. On the other hand, good EPS numbers do not mean the company is increasing the sales revenue and gaining competitive advantage to expand the market share. EPS can be manipulated easily as the company accountant can add whatever provision they want, using different amortization or depreciation method or using different revenue recognition method. Furthermore, the company can make the EPS more attractive by buying back shares, doing all sorts of cost cutting internally (like selling company fixed assets) to make the number looks nice.
After the intrinsic value is calculated, I compare the current stock price with the intrinsic value. If the current stock price is at least 20% discount to the intrinsic value, I will put the stocks in my watchlist and wait for the right time to buy. I will share in the next post on how I time my entry.
This Post Has 12 Comments
1) Negative Cash Flow figure.
I tried to do DCF model calculation for Intrinsic Value (IV), and happen to see the Cash Flow figure (Cash from Operating Activities) in the Cash Flow statement are some Negative Figure ( eg, out of 10 years, 3 years negative figure ), how should I proceed for the calculation?
2) Cash Flow Growth Rate (CFGR) – Negative.
What happen if to see CFGR turn Nagative after the calculation of using CAGR method, and inventually affect the Intrinsic Value (IV). Whereas, when i use EPS Growth Rate Method, it is fine ( positive EPS Growth Rate (EPSGW) with CAGR method). I am doubt which One is to be used or Truested ( to Caluculate of IV by using CFGR or EPSGR )?
Thanks for helping.
(1) The assumption used in DCF method is the company can continuously generate CONSISTENT & POSITIVE cash flow for the next 10 years. This means that the Cash Flow CAGR is constant throughout the next 10 years. DCF method will not work if the CAGR is not consistent or there is negative cash flow.
(2) If DCF cannot be used (due to negative cash flow), you can use Discount EPS and again the assumption is the company able to generate CONSISTENT and POSITIVE EPS for the next 10 years.
All valuation methods are base on ASSUMPTION. They use PAST result to PREDICT future performance. It is important to read the Earning report every quarter to double check whether the assumptions you made are still valid in your IV calculation. Analysts are doing the same thing every quarter when the earning is released. That’s the reason why you always see Analyst Recommendation on “Upgrade / Downgrade / Hold” for certain stocks after the earning is released.
Hope my explanation helps.
thanks for the Explanation
I have another doubt:
Since PEG = PE/Annual EPS Growth,
and Hence Annual EPS Growth = PE/PEG
Can i use this Annual EPS Growth and apply into the ‘EPS Growth Rate’ field in the IV calculator ? or I should calculate the EPS Growth Rate seperately by using CAGR method.?
[the reason is because, I notice these 2 figures ( one taken from PE/PEG and another taken from CAGR) does not provide me a tally figure (or close figure), instead they give me huge different]
Pls take note that you cannot calculate from the formula of “Annual EPS Growth = PE / PEG”, Annual Growth Rate is not calculated in this way. The Growth rate is calculated using CAGR for the past few years. You may use 3 years, 5, years or 10 years depends on your stock.
If you don’t want to calculate the CAGR by yourself, you can go to Reuters to get the Growth Rate (EPS – 5 Yr. Growth Rate) under “Financials” Tab. Just take this number and put into your IV calculator and you will get the stock’s Intrinsic Value.
I understand your logic by using different formula to get the growth rate. Are you an Engineer? Please take note that Engineering’s logic of doing calculation is slightly different from Financial’s logic. I have engineering background and I know how’s the engineering folks think. 🙂
Thanks for the info and explanation again.
Yes. I can see the EPS GR from Reuters…Yes. I have no issue for spending times calculating the EPS GR, just I’d like to ensure my calculation formula/way is accurate method, and after seeing your explanation and compare it with Reuter’s data, I have already clear my doubt and confident with my calculations.
Right, I was an Engineer, in IT Network. The similarity with the Financial is that I am also looking Charts, Statistic Calculations vs threshold setting. 🙂
This Intrinsic Value calculation using different valuation methods is not an easy stuff.
Glad that you are able to get the numbers and clear your doubts.
I saw your intrinsic-value (IV) posting for APPLE (AAPL) in https://mystocksinvesting.com/category/intrinsic-value/.
can i know how do u measure the 1-3 Years Cash Flow Growth Rate (CFGR) and 4-10 CFGR ? ( i mean what is the number of year-period to be taken in order to be applied for CAGR calculation for 1-3 years CFGR and 4-10 years CFGR).
# Cash Flow Growth Rate (1-3 Years) = 19.35%
# Cash Flow Growth Rate (4-10 Years) = 15%
The reason I split into 2 stages of growth rate is I don’t believe AAPL will grow at about 20% year over year for the next 10 years. AAPL should not have any problems growing at 20% for next 3 years because they still have iPad3, iPhone 4S, iPhone 5, Apple TV lining up for the impressive growth. However, there is no visibility beyond year 4 onwards and that’s why I cap the growth rate at 15%.
Some of the small companies can grow more than 50% in a year but it is unrealistic to assume 50% CAGR for the next 10 years. You can tweak your IV calculation to this method for small and fast growing company.
IC. however, may I know how to calculate or plug in the number ‘15%’? Is it base on some specific depreciation calculation from 20% ?
If you look at EPS growth rate at Reuters: 5 years growth rate for AAPL is 64.95, Industry is 12.44, Sector is 9.60.
You have to make your judgement what is the reasonable long term growth rate for AAPL. Personally I feel 10% is too low for AAPL because I don’t think AAPL grows “below” the Industry average of 12.44. 20% growth rate is too aggressive for Technology company for long term (reason: no technology product can last for 10 years) . Thus, I plug something in between which is 15% growth rate.
There is no right or wrong by using different numbers. All Stock Analysts make their estimation base on their understanding of the company and whether they believe the company story. You can use 10% or even lower growth rate if you don’t believe in AAPL story. If you believe AAPL can come out even better products in the next few years, you can even plug in the growth rate as high as 50%. It is all up to you. IV is all base on assumption and judgement. Everyone can become analyst thus I don’t take Analyst’s price target at the face value. I always look at their assumptions and evaluate whether those assumptions make sense to me.
Marubozu .. Thanks!!