Stock Valuation: Theory vs Practice
Business Schools and other Finance colleges teach the following main methods (not in order of priority) to value a company.
Comparison - Look at the other firms in that industry/geography/… and value similar to those firms. For example if Salesforce has a PE ratio of 100, it is justified to pay similar ratios for other Saas (Software as a Service) companies as they are assumed to grow exponentially. Comparative ratios could be Price to Earnings, Price to Sales, or much more speculative ones like number of eyeballs per day at the website etc.
Discounted Cash Flow (DCF) Method - Start with the current financials of the firm. Estimate the profits for every year going forward into the future. After a large number of years (say 10), assign a terminal value to the profits. Discount back the future profits using a discount rate - typically used one is WACC (Weighted Average Cost of Capital) to reach at PV (Present Value) of profits. Then assign a multiple to the profits and you have the current value of the firm. This is the method budding analysts spend months practising to get an A from their professors.
In real life, things work a bit (actually a lot !) differently. Let us look at both the above methods and their utiilty in real investing
Comparison - While paying comparable price is a reasonable shortcut in most situations in life, it does not mean it is correct. Especially when your own money is on the line. (This is why those who play with OPM - Other People’s Money - often pay exorbitant prices in the hope of explosive gains). If you lose money, it will hurt. And not just mentally. I speak from experience. The problem with using comparables is that they are not exact or even close at times - like an orange to an apple. Companies in similar areas could have vast differences in their strategy, execution, management ability etc. For example, Amazon ($AMZN) has always been valued at a high level. Many “investors” have paid a high price for other firms thinking they are the next Amazon. In addition to its other strengths, Amazon had a highly capable and driven leader in Jeff Bezos. He was able to ignore decades of market gurus feedback and always focused on the long-term.
To summarize, comparisons are a shortcut way of pricing, and only help the buyer to believe they have a rational framework, when there is none.
Discounted Cash Flow - This is a comprehensive and mathematically correct model that applies rigor to achieve a valuation. You would think this is science and math backed, so it is the right answer. Nope. Look at the number of assumptions in the model. Discount rate, future growth, terminal value….The biggest assumption that matters is discount rate. No one knows what is the right answer. It depends on many factors, including the interest rate that the Fed sets for the entire economy. And it can change quickly. All Wall St analysts show DCF as part of their research reports, and everyone uses a different value of the discount rate. And it matters. Even a small change in the rate % has a huge impact on the valuation, reaching a range that makes it almost worthless. Actually worst than worthless. It will give you a false sense of accuracy. Remember it is better to be approximately right than precisely incorrect.
Thus, DCF is a method used to show (and to believe) preciseness in valuation, but with almost no value for real investors.
Now the question arises, if we don’t use this, what do we use ?
That answer is both simple and complex, and we cover it in our courses in depth.