The theory and practice of estimating the value of various securities is the heart of investing and leads to the construction of a portfolio consistent with your risk and return objectives. The understanding of these Valuation Principles are essential to successful investing.
On this page, we will kick off the discussion with a run through of financial statement Then, we will set the table by talking about some valuation basics. Finally, we will look at how macro factors influence valuation.
Financial statements are the main source of info for major investment decisions. In this section, we will talk about the major statements. Then, describe ratios used to break down the info and find ways to use them.
In this section, we go over the major financial statements. Then, we introduce ratio analysis. Finally, we use these ratios to get feel for what’s going on in a firm.
Major Financial Statements
Statements provide info on the tools the firm can use, how these tools are financed and what the firm did with them. Firms must submit quarterly and annual reports to the SEC and include helpful info.
These statements are prepared using generally accepted accounting principles (GAAP) which are set by the Financial Accounting Standards Board (FASB). FASB allows some wiggle room, but for the most part they are the same for most firms.
It lists a stock of items which shows what asset the firm controls and how it finances those assets. It shows the current and fixed assets of the firm at a point in time.
It describes how the firm made their profits during a period of time. It lists sales, costs, and earnings. Users focus on earnings from ops after tax as the key net earnings figure.
Statement of Cash Flows
For a given period, it covers the info from the balance sheet and income statement. It shows the effects of the firm’s cash flow of income flows and changes in balance sheet items.
Cash Flow Sections
- Investing– non-current and fixed assets and the equity of other firms
- Financing– funding sources minus finance uses
- Operations– describes central part of cash flow
Free cash flow shrinks cash flow from ops to allow items needed keep the firm going. The firm must spend on certain items to maintain or expand its asset base.
Free Cash Flow Factors
- spending on new machines and IT
- buying and selling fixed assets
- payouts to common holders
Numbers by themselves have little meaning. Ratios provide helpful links between values in the data.
- Current– best known show the link between current assets and current debt
- Quick- takes the inventories out of current
- Cash– most liquid measure
- Receivables Turn- measures strength of AR
- Inventory Turn- measures time needed to turn cash
- Cash Convert Cycle– combines info from AR turn, inv. turn and AP turn
- Total Asset Turn- shows how firm uses total asset base
- Net Fixed Asset Turn- links firm’s use of fixed assets
- Equity Turn- useful to study turn of other finance parts
- Gross Profit Margins– shows basic cost structure of firms
- Operating Profit Margins– further removes overhead from gross margin
- Net profit Margin- relates net income to sales
- ROIC- relates earnings to finance structure
- ROE– key to common holders
- Debt Equity- what proportion is derived from debt compared to other finance sources
- Long-term Debt to Total Capital- shows mix of long-term funds derived from long-term debt
- Total Debt– reveals firm using long-term funds from short-term debt
- Interest Coverage– how many times earnings cover fixed debt charges
- Cash Flow Coverage– other measure besides earnings cover
- CF to Long-term Debt- relates cash flow to long-term debt
- Cash Flow to Total Debt- check to see if there is a change in short-term debt
Study of lasting growth rates looks at measures which point out how fast a firm should grow. The factors of growth are the amount of profits put back into the firm and the rate of return earned on the profits kept.
Financial statements are backward looking. Their study shows the user the firm’s ops and finance structure. It helps to look at the effects of future events on the firm’s cash flow.
Stock Value Models
Most models attempt to derive a value based on present value of cash flow. Ratios help to make these estimates.They look at a cross-section of firms and use regression models to relate P/E for sample firms.
CAPM says the key risk measure between a firm and the broader market should be how much its stock price moves when the market moves. This measure is its beta and looking at a firm’s structure gives the user useful info.
Bond rating firms assign ratings to bonds based on the issuing firm’s record in paying their trade account bills, paying taxes and handling their debt service.
Users want to know how close a firm is to going under. They look at a matched sample of firms who have gone bad and compare the data with the subject firm.
An investment is giving up funds for a period of time to receive a rate of return. It pays you back for the time which the funds were given.
- Figure your required rate of return
- Estimate your asset’s intrinsic value based cash flows and your required rate of return
- Compare the intrinsic value with the current market price to decide when to buy or not
There are two main ways to value: the top-down, three-step approach or the bottom-up, stock-picking approach. The difference between the two ways is the perceived strength of macro and sector role on single firms and their shares.
At SCM, we are top-down because of its logic and tested support. We believe it is harder to win with bottom-up because stock-pickers ignore major info from the market and the firm’s sector.
In this section we lay out the three-step process of top-down valuation. The, we get into the theory of valuation. The dividend discount model is then discussed. Finally we use what we learned to make the purchase or sale decision.
Three Step Valuation
Monetary and fiscal policy measures of the federal government affect the landscape of those firms. Their tremors affect all sectors and firms within their reach.
Sectors prosper or suffer in the near-term or long-run. Different sectors react to these changes at different points in the cycle.
You can then review and compare a single firm’s track record within the entire sector using finance ratios and cash flow values. Your final goal is to select the best stock or bond within a decent sector and include it in you holdings based on its link with all the other assets of your holdings.
Three-Step Valuation Process
- Economies and market review
- Sectors and Industries review
- Single firm and stock review
This approach goes with the asset allocation approach to the mix of risky and less risky assets in your account. Results of studies have proven its merit.
Results of Studies Supporting Three-Step Process
- Studies show most changes in a firm’s earnings could be linked to changes in macro corporate earnings and changes in fa firm’s sector with the macro earnings changes being key
- A link exists between macro stock prices and many macro series
- Studies show most of the changes in rates of return for single stocks could be explained by changes in the rates of return for the macro stock market and the stock’s sector
The value of an asset is the present value of its expected returns. You must discount the earnings stream at your required rate of return by estimating the cash flows and your rate.
Your estimate of cash flows not only measures the size but also the form, time pattern and risk. Your required rate of return is based on the risk-free rate plus an extra cushion for inflation and risk of return.
The value of bonds is easy because the size and time patterns of cash flows over its life are known.The value of a bond is the present value of the interest payments and the present value of the principal payment at the end.
Because of the complexity and importance of valuing common stocks, various techniques for getting this task done have been wanted over time: discounted cash valuation and relative valuation techniques. The major difference between the two is how one looks at cash flow.
Discounted Cash Flow Approach
The discounted cash model seems to be the right choice in determining present value but it has limits. It is very dependent on its inputs and slight errors in estimation can have big effect on final value estimates.
Measures of Cash Flow used by Discounted Model
- Dividends- flow directly to the investor, the cost of capital is used as the discount rate
- Operating Cash Flows– flows from direct costs and before payments to capital suppliers. The discount rate uses the firm’s weighted cost of capital
- Free Cash Flow to Equity– cash flow available to shareholders after payments to debt-holders and maintain in the asset base. It is discounted by the firm’s cost of equity
How an analyst implements this model depends on the firm’s position in its life cycle. She uses an infinite growth model if the firm has stable growth. A multi-stage model is used if the firm sometimes has super normal growth.
Relative Valuation Techniques
This technique contends it is possible to determine the value of an economic entity by comparing it to similar entities on the basis of several relative ratios. They compare its stock price to relevant variables which affect a stock’s value such as earnings, cash flow, book value and sales.
Relative Value Ratios
- Earnings Multiplier- price to earnings
- Price to Cash Flow– less prone to manipulation
- P/B– widely used for years
- Price to Sales– strong and consistent sales growth is a requirement for a growth company
Simpson Capital uses the relative valuation technique and its four key ratios. We also use a growth at a reasonable rate (GARP) ratio (PEG) which measures the earnings multiplier relative to its long-term growth rate.
Security markets reflect what is going on in an economy because the value of an investment is determined by its expected cash flows and required rate of return. Both are influenced by the aggregate economic environment.
The evidence indicates a strong relationship between stock prices and the economy and shows stock prices consistently turn before the economy does. It might mean markets are based on expectations or the market may be reacting to various leading indicators.
In this section we start by going over the importance of economic forecasting. Then, we talk about the how monetary variables play a part. Finally, we discuss valuation on a global basis.
The cyclical indicator approach to forecasting assumes the economy expands and contracts in discrete time frames. The cycle averages about four years.
- Leading Indicators include economic series which usually reach peaks or troughs before corresponding peaks or troughs in aggregate economic activity
- Coincidental indicators include economic time series which have peaks and troughs which roughly coincide with peaks and t roughs of the business cycle
- Lagging indicators include series which experience their peaks and troughs after those of the aggregate economy
One obvious limitation of this approach is false signals. Another problem is you might not get the original data soon enough and you need to watch the revisions. Also, no series does a good job of measuring the services sector which is the largest.
Many academic and professional observers think there is a close relationship between stock prices and various monetary variables influenced by monetary policy. The Fed controls monetary policy largely through the money supply.
Declines in the growth rates of the money supply proceed business contractions by an average of 20 months. Changes in the liquidity of bonds are transmitted to the firm level. Ultimately the stock reflects the change.
Although studies have found a relationship between the money supply and stock prices, the timing of the relationship differed. Changes in the growth rate of the money supply did not lead stock prices but consistently lagged stock returns by one to three months.
Global Market Analysis
World analysis begins by using the three-step top-down approach to the aggregate and then individual countries. The process follows through by examining individual issues.
A new element, not found in domestic investing, is the effect of exchange rates on returns. Relative inflation and interest rates influence exchange rates between two countries.
There are substantial differences in economic performance and major changes in the underlying valuation variables which indicate there should be a fairly low correlation among stock market returns for global countries.
On this page, we kicked off the discussion with a run through of financial statements. Then, we set the table by talking about some valuation basics. Finally, we looked at how macro factors influence valuation.