Some Tips to Measure the Valuation of a Stock

What is valuation? Valuation is a set of processes to measure a company’s/stock’s intrinsic value. An intrinsic value itself is a fair value of a stock/company that is defined by an investor, based on its condition & potency. The intrinsic value of a stock can be different for each investor. For instance, investor A & B are doing an analysis of Company X at the same time. Investor A is very optimistic towards Company X prospect due to several reasons. While on the other hand, investor B is very pessimistic towards Company X prospect in the future. In truth, it is possible that company X is not as good as or as bad as the opinion of both investor A & B. This is why, it is very important for us as an investor to do a comprehensive quantitative & qualitative analysis before we value a business, so we can have a more objective view of a particular stock.

In practicality point of view, an investor can compare the current stock intrinsic value versus its market price. If the intrinsic value is higher than the market price, then we can say that the stock is undervalued, and vice versa (or at fair price if the intrinsic value is more or less equal to its market price).

We can divide valuation into two:

1.      Absolute valuation

In absolute valuation, investor will use an intrinsic value that is calculated from the company’s asset value plus its growth potential in the future.

Example: Imagine if you are valuing a shop-house. To calculate its intrinsic value, you will price the shop-house from its land price including with its building, material, furniture, etc. Moreover, another factor that may impact the valuation is the potency of the shop-house to generate cash-flow in the future.

There is an analysis method that is often used in absolute valuation called the discounted cash flow model (DCF). This method values an investment based on its ability to generate cash-flow in the future. The way to apply DCF in valuing an investment is by predicting the amount of free cash flow generated in the future, and discounted it using the time value of money. In predicting this, an investor has to include some qualitative & quantitative factors and also the company’s plan (e.g expansion plan, industry trend, and competition that may have an impact to the company’s financial & cash flow performance). The information produced by our assumptions, can be utilized as the base assumptions for other financial projections. Starting from the company’s income statement, balance sheet, and cash flow statement.

However, one of the weaknesses from DCF method is that the method needs longer time frame and very sensitive towards our assumptions. That is why, DCF method is only popular and often used by institutional & professional investor.

2.      Relative valuation

In relative valuation, investor will compare the price of a particular stock to other stocks within a similar industry.

Example: We still use the shop-house example above. Now we illustrate if we compare the shop-house that we bought versus the neighboring shop-house.

We can use relative valuation by industry average technique. This method will compare a company within a similar industry or with other companies that more or less still neck to neck. Some comparison metrics that are widely use for instance: Price to earnings ratio (P/E), price to book ratio (PBV), and so on & so forth (you can easily google for price to earning & price to book ratio).

If a Company has lower ratio comparing to its peers, while the prospect or other factors are the same, we can assume that the stock of this particular Company is undervalued. For example, Company X has P/E 20x while the industry average has P/E 40x.

Next technique that we can use is price band technique. This method compares current stock price to its price in the past to see whether the current price is too cheap or expensive. To draw a picture, the current P/E ratio of Company X is 5x, while in average, the P/E ratio for the last 3 years are 12x.

Nevertheless, both of the techniques above may have their own biases. Firstly, industry average bias. This bias happens when we assume that all the companies within a particular industry have similar quality. Whereas, each of those companies might have their own potency & prospect. The differences among those companies can be seen from their revenue, business stability, growth potential, efficiency, profitability, company’s position within the industry (market leader or not), and management quality.

Secondly, price band bias. Before we understand what is the bias, let us understand the method first. Price band method is a method that comparing company’s ratios (like P/E & PBV) in the present vs in the past (historically), with assumption that the ratios will go back to the average number. For instance, the average of Company A P/E ratio in the last 10 years is 12x, and currently, its P/E ratio is around 5x. We can assume that currently, the stock is being undervalued. To see whether the stock is currently overvalued, undervalued, or fair priced, you can use 5 lines of standard deviation:

The orange line shows us the average standard deviation (fair value). If the stock price/ratio is below the orange line, that means the stock is currently undervalued, vice versa (blue & green line). In summary, orange line means fair value; Gray & red line mean undervalue; Blue & green line mean overvalue.

The bias of this method is that when we are assuming that the company’s condition does not change. Whereas, a company’s quality & prospect might change over the time comparing to its historical. If the company’s quality & prospect in the present are better, it is possible that the P/E ratio is higher than in the past, vice versa. In conclusion, it is very important for us investors to do thorough qualitative analysis first before we can use the relative valuation technique.

Now, we will try to use the relative valuation to find the intrinsic value of a Company. How to do it? We will multiply the next year net income to P/E target that we already defined before. Here, current Earning per Share (EPS) is TTM (Trailing Twelve Months) or in other words, the total of 4 EPS in the last 4 quarters. We can get the EPS number by dividing company’s net income to the total shares of the company. For example:

Company X in year 2022 had net income amounting to $100 million, and the total shares are 1 million shares. Hence, the company EPS TTM is 100 million divided by 1 million = IDR 100.

Next is growth rate (estimation). This is the growth rate of the company in the next 1 year. We can define the growth rate by projecting few factors in the qualitative analysis. For instance, when we were doing qualitative analysis, we knew that the property industry will grow around 10% due to lower interest rate stimulation from the government. Furthermore, we also know that Company X is the pioneer of property brand X that makes it more popular in the property market. This will become the competitive advantage for Company X. Due to those advantages, we can estimate that the future net income of Company X will grow around 15%, higher than the industry average (10%). If we multiply it with the 2022 net income, then we can predict that in 2023, the net income of Company X is IDR 115 million. The growth of the net income & the EPS will always stay the same if there is no change in the number of share outstanding. To get the 2023 EPS, we can just easily divide the 2023 projection net income IDR 115 million to total outstanding shares 1 million (assuming no change in total outstanding shares) = IDR 115 (EPS is also grow by 15%).

The last component that we need to determine is the P/E ratio. Just like the price band example above, we can aim the P/E ratio according to the standard deviation mean line. By assessing the historical performance & operational of Company X, we aim that Company X shall have 20x P/E. However, if we spot that there is change to the Company’s fundamental, we can increase or decrease our P/E ratio target, depending on our consideration. If we are using all the assumptions above, then the “true” fair value of Company X stock is: Projected EPS x Target P/E = IDR 115 x 20 = IDR 2300/share.

Nevertheless, you need to remember that when we are doing valuation analysis, there are so many assumptions that we make, and it will never be 100% accurate. There will always be some factors that we can never predict such as COVID-19 that definitely affect the company’s performance. This is why it is very important to define the Margin of Safety (the difference between a stock market price vs intrinsic price). For investor, it is very important to understand the Margin of Safety (MoS) concept. You can define the MoS with this formula:

Stock intrinsic value X (100% - Defined MoS)

Please keep in mind, that MoS is subjective for each investor. As an example, the intrinsic value of Company Z is IDR 1000. Let us say, you use MoS 30%, then you can only buy the stock at the price of IDR 700 (use the formula above).

Finally, no matter what kind of valuation technique that you are using, each method definitely has its flaws and strength. The most important thing is the assumptions that you are using when you analyze a stock (e.g company’s prospect, growth estimation, and so many other external factors). Hence, to manage your risk in investment, Margin of Safety is super important.

Happy Investing!