Nov 17, 2014 The Art of Valuation Jujitsu : Part 1
Bruce Lee is widely considered the most influential martial artist of all time. The actor, filmmaker, and instructor founded the art of Jeet Kune Do on the premise that “there is no superior art.” Rather, his objective was to flow from one art to another utilizing the techniques most appropriate for the situation at hand. Similarly, I would argue that there is no perfect valuation method. Each method provides unique insights into the company being analyzed. For this reason, I suggest evaluating a company using multiple methods, selecting those that best fit the characteristics of the company.
The valuation techniques you will use fall into two broad categories: absolute and relative value techniques. With relative value techniques, a company’s price multiple is compared to those of other, similar companies. If the company’s price multiple is less than average multiple of the other companies, then the stock is undervalued relative to the peer group. Without question, the most common relative value measure is the price-to-earnings or P/E ratio. Given some of the limitations of the P/E ratio, which are discussed later, enterprise value-to-EBITDA (EV/EBITDA) is another important component of your relative value toolkit.
With absolute value methods, a stock’s intrinsic value is estimated based on the company’s future cash flows. While there are several types of absolute value models, free cash flow models are the most common. With a free cash flow model, an investor estimates a company’s future free cash flow and then discounts those cash flows back to the present to see what they are worth in today’s dollars. That is why you will hear these models referred to a discounted cash flow or DCF models. If the present value of future cash flows is greater than the current market value, then the stock is undervalued based on your analysis.
In my opinion, absolute value models provide a more complete picture of the fundamental drivers of a stock, but there are times when relative valuation will yield an equally good estimate of value (e.g., when earnings and cash flow for companies in an industry are narrowly distributed). That said, there is nothing that says you can’t use both.
As you begin using these techniques, remember that valuation is subjective, and equally important, an investor’s opinion of the value of a company will and should change with new information. But by continually evaluating a company from multiple perspectives, you can determine when a stock is cheap or expensive.
is the first of a five-part series on valuation. Part 2 includes a detailed review of relative value techniques. Then, in Part 3, I demonstrate how a relative value analysis is conducted on a publicly traded company using three case studies. Part 4 is dedicated to absolute value techniques; specifically, I discuss the theory behind them and walk through a hypothetical example. Then, in Part 5, I apply those techniques to a publically traded company.
Let’s get started!
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