By Rajat Sharma
In his letter to Berkshire Hathaway shareholders in 1992, Warren Buffet wrote:
“Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
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The success of all investing depends upon ability to predict the future, more importantly, the ability to forecast future growth and then estimating the underlying value which a stock offers at its current price.
2 important questions arise at this point:
- How do you value a stock based on its current price?
- When should you sell a value stock?
[I] Valuing The Stock Based On Its Current Price
How you value a stock depends on a whole host of qualitative and quantitative aspects including its past financial record, future prospects, quality and competence of the management, industry and economic outlook etc. In terms of valuations there are two popular techniques – the Price Earnings Method and The Discounted Cash Flow Analysis.
Given its simplicity, everyone uses the Price to Earnings Method of valuing a stock. For the purpose of this explanation, let’s take the example of a FMCG company and calculate its fair value based on the revenue it is expected to generate in future i.e. The Discounted Cash Flow Analysis.
Company A sells chocolates & cookies and is currently sitting on accumulated cash reserves of $ 8,000. Company A’s share currently trades at $ 200.
While going through its exchange filings, you realized that Company A applied for a bank loan of $ 12,000. Based on Company A’s recent press releases and other publicly available information you have a strong hunch that Company A is planning to set up two new units to diversify into ice-creams.
If you believe that neither of the two units will perform as expected or that it is a bad idea for Company A to get into the ice cream business then of course, you will not go beyond this point in your investigation.
Assumption 1 – Below Average Growth (of 10%)
Your first assumption factors in that one of the units of the company will not perform as expected and the other one will do as expected.
Assumption 2 – Expected Growth (20%)
Your second assumption is based on the assumption that both the units will do as expected.
Assumption 3 – Outstanding Growth (30%)
Both units will outperform.
Further, let’s say that the current cash flow of the company is $ 3,999. Based on your growth assumptions, you can calculate the present value of future cash flows using the Discounted Cash Flow (DCF) calculator available at the end of this page.
(Note: the calculator will have existing data. You can overwrite this data to get results. All assumptions including discount rate and terminal growth can be changed. Enter your base year free cash flow assumption in the first line and 3 different growth assumptions to see the Fair value based on your assumptions.)
The present value of Company A’s stocks based on DCF analysis in the three scenarios above will be
|Assumption 1||Assumption 2||Assumption 3|
What do results of your assumptions tell you?
Put in the simplest way, the resultant prices, suggest that “if your growth assumptions were to come true then the current price of the stock should be that much”.
Since the current price of the stock is $ 200, it would be a great buy if Assumption 3 were to play out. In that case you are getting something worth $ 610 at $ 200 – THAT’S A WHOPPING 67.21% DISCOUNT!!
In a more realistic world where things go as expected you will get something worth $295 at $200. Still a 32.20% Discount! (Assumption 2)
In value investing terminology, the alternate word for ‘Discount’ is – Margin of Safety.
Margin of Safety - Coined by Benjamin Graham and David Dodd, in their 1934 book “Security Analysis”, the term ‘Margin of Safety’ can be defined as “the difference between the intrinsic value of a stock and its market price”. Put in a different way, it is the value of a business which is determined by the facts or the true value as opposed to the market price of a business.
Assumption 1 of below average growth - you will be paying $ 200 to buy something only worth $ 129, of course you should avoid it.
[II] When To Sell A Value Stock?
In the short term, price of Company A’s stock will move based on many other factors in addition to the performance of its core business. During any 10 year period, there will certainly be economic slowdowns and market crashes, delays in execution, and regulatory and other unforeseen obstacles all of which may negatively impact the stock price.
Over a longer period however, these things even out and the price moves based on company’s fundamentals. For this reason, an investor should also keep a margin of safety with reference to time i.e. if you think it will take 10 years before the new units become operational be prepared to hold the stock for 15 years.
In value investing like in any other discipline investment returns depend, to varying degrees, on how things pan out in future. During year 1 to 10 (above), analysts and investors will form their buy / sell decisions based on the likelihood of success of the company’s new ice cream units. Consequently the price of the stock will also move on that basis. As completion of units draws nearer, the stock price will appreciate if things progress as expected.
Once the story has played out completely, the stock will trade in range substantially higher than its present range. In value investing it is not important to have a fixed target price in mind. The belief that in future the stock will trade substantially higher is favoured over smaller fixed targets.
Be willing to spend enough time for the businesses to mature and for things to happen. When you think about ‘value’, your end product is Returns but your raw material is Time.
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