So you want to learn how to value stocks like Warren Buffett does. Right now you will learn what methods exist for the fundamental valuation of companies and how analysts evaluate stocks.
You often see analyst recommendations to “buy,” “sell,” or “hold.” How do analysts know to buy one share and sell another? To do this, “specially qualified persons” in investment firms calculate the value of the issuing companies and their shares, or use fintech software development services. If the resulting value is higher than the market price of the stock, the stock is considered undervalued and a “buy” recommendation is given. If the market price is higher than the calculated price, the stock is considered overvalued and a “sell” recommendation is given. If they are roughly equal, the recommendation is “hold.”
There are two most common methods of evaluating a company’s stock. When it is necessary to estimate the intrinsic value of a stock, these two methods are the most used.
The first method is called the discounted cash flow (DCF) method, which is more complicated and more reliable.
The second method is called “multiple method (coefficients)” (it’s simpler, that’s why everyone loves it so much).
Let’s look at both methods in order.
The discounted cash flow method
A stock rises according to the profits the company generates and investors’ expectations of the profits the company will generate in the future. It is the cash flow of the company that causes the shares to go up.
Remember how stocks in American Internet companies rose in the late 1990s? They weren’t profitable yet, but shareholders had high expectations for the millions of these Internet projects they would bring. Those expectations were not met and stocks crashed, but that’s another story.
To use this method, we must first forecast the performance of the company over the next five years. This forecast gives us insight into future revenue, earnings, debt, depreciation, and other key metrics for the business.
Of course, to make such a forecast, we must have a very good understanding of the company’s business and the outlook for the entire industry in which the company operates. We have to be able to forecast the company’s revenue for each of the next five years and all other metrics. That is the main challenge.
Knowing the future cash flows of a company, we can estimate how much the company and its shares should be worth today. To do this, we resort to discounting or converting the future value of the company to its present value.
Future cash flows are converted to present value at a specified interest rate (discount rate) using a special formula. This is how we obtain the present value of the company. We then divide this value by the number of shares outstanding and obtain the estimated value per share.
If the current market price of a stock is less than the estimated value, the stock is considered undervalued and we buy it. If it’s higher, it’s overpriced and you sell it.
Now let us consider the second method of fundamental analysis: the “method of multipliers.” This is probably the most popular and widespread equity analysis method among investors. This method is popular due to its simplicity, as it is sufficient to calculate a series of simple ratios based on the finances of the company and compare the ratios obtained with the same ratios of similar companies. These comparisons based on multiples provide information on whether a stock is overvalued or undervalued relative to the shares of other companies.
Take, for example, everyone’s favorite p / e ratio (market price per share / net income per share). If the multiple p / e is 5, it means that investors who buy shares in Company A are willing to pay for them at a rate of $ 5 per $ 1 of annual net income.