You know the saying: “price is what you pay value is what you get”. If I remember correctly it’s Warren Buffet who said it, and it speaks directly to the disparity that can exist between a company’s stock price and the value of its underlying assets.

Value creating investment decisions

All investors whether individuals picking stocks or corporate chief financial officers choosing between capital projects should strive to identify and make value creating investment decisions were the prices paid for assets are less than or equal to what they might be worth.

A value creating investment is one that has a positive net present value, were the benefits we received from the investment over time exceed the amount we invest all viewed in today’s dollars.  When investors and capital providers lose sight of fundamental finance principles economic catastrophe can ensue so today.

Tools for evaluating a company’s stock

EBITDA (earnings before interest taxes depreciation and amortization) – is calculated by taking a company’s income from operations as disclosed on the face of the income statement and adding back depreciation and amortization expense disclosed in the statement of cash flows.

Free cash flows – are the cash flows that a firm generates from its normal and recurring operations less what it spends on capital expenditures things like property plant and equipment. This is perhaps the most critical accounting metric for stock valuation because the residual or leftover cash the firm generates after investing in its own business is really what should support a company’s stock price.

Market capitalization (or the market value of equity) –  is the total stock market value for a particular company. It is simply calculated by multiplying the total number of shares of stock the company has outstanding times stock price.

Enterprise value –  Is the sum of the market value of a company’s equity plus the market value of the company’s net debt. The net debt is the amount of long-term data company has outstanding less the cash it owns, and enterprise value reflects the total market value of a firm.

Valuing stocks, a fundamental analysis

The general approach to valuing stocks is known as fundamental analysis which entails an examination of quantitative and qualitative factors that might impact the company’s value. These might include a review of the company’s financial statements and ratios, its projected free cash flows its management team strategy and competition and even macroeconomic factors.

The goal of fundamental analysis is to determine whether a stock is undervalued and something we should buy or overvalued and something we should likely avoid or even bet against.  This is a common approach in valuing any sort of investment we simply compare one particular investment to one that is similar.

In the context of valuation one should always review a company’s market capitalization and enterprise value what the market is saying the company is worth as compared to actual accounting data or counting metrics including those we discussed in this course.

Discounted equity or stock valuation models

Discounted equity or stock valuation models involve several steps:

  1. compute the company’s free cash flows for the past few years by examining historical financial statements. we do this by focusing on the statement of cash flows examining the operating cash flows the company has reported the interest expense it has reported and the capital expenditures it has made.
  2. project the future free cash flows based on historical analysis we just performed and our best bet as to what the future free cash flows might look like. Clearly this involves an analysis about the company’s products the markets in which it sells them macroeconomic forecasts and some good old intuition.
  3. estimate the company’s weighted average cost of capital. In the long run we would normally expect companies to grow at some steady rate once they hit a certain size or level of sales

  4. discount free cash flows to present value by using a firm’s weighted average cost of capital which we discussed in our last lecture.At this point we will have our best estimate as to the present value of the company’s expected free cash flows an estimate of its overall value.

  5. compare this result to the company’s total enterprise value and make some initial observations and conclusions. The value that the markets are placing on the company and can make our initial investment conclusion whether the company appears over undervalued.