Intrinsic and Relative Valuation Methods
Discounted cash flows, discount rates, sensitivity analysis; multiples, reversion to the mean, and comps
Investors, analysts, and the media often tout popular valuation metrics such as target prices, P/E multiples, and P/S multiples, amongst others.
In isolation, these numbers may have very little meaning.
Before jumping to any conclusions, investors should seek to understand where these metrics come from and how to interpret them. Headline numbers may not always be what they seem.
Valuing a company is a complicated process due to the inherently uncertain future. When evaluating an investment opportunity, investors should apply their own discretion to ensure they know what they are buying and what price they are paying. In order to do so effectively, it is important to understand common valuation methods.
Intrinsic Valuation: Discounted Cash Flows
At the most foundational level, a company is valuable because of the cash the company will return to investors over time. A stock is a pro rata share of all of the future cash that the business will generate.
The present value, therefore, is calculated as the sum of discounted future cash flows.
Discounting involves the time value of money. Determining the discount rate can be a complex topic. In short, investors price in the opportunity cost of alternative uses of capital. When considering investments in equities, investors may use the long-term average returns of the stock market or another benchmark specific to a particular industry or segment.
To give a simple illustration of how cash flows translates to value, consider an investment opportunity that will return $100 in the first year and grow those returns by 10% for each of the next five years.
If an investor believes the 10% growth to be realistic and a 9% discount rate to be appropriate, the fair present value for this opportunity would be roughly $467, which is less than the total sum of $611 that was paid out to the investor over time.
Because companies tend to be long-lived, investors also need to consider what happens after the modeled horizon. One option would be to simply extend the model to the full expected lifespan of 30, 50, 100+ years. Alternatively, and more typically, investors consider an element of terminal value, considering operation in perpetuity.
To determine the terminal value component, investors apply a terminal growth rate, g, to the free cash flow from the last year of the model. The following formula calculates the value for growth in perpetuity, using the discount rate, r.
Because terminal value is calculated at the end of the time horizon in the model, it must then be discounted to present day using the discount rate.
If the illustrative investment opportunity were to last indefinitely, it would be worth closer to $1,854 today, a significant boost over the $467 valuation.
The terminal value is a significant contributor to the present day value. In order to most accurately model an investment opportunity, the time horizon for explicit projections should ideally stretch until the company reaches maturity, which may very well be more than five years.
This is the core process that analysts and investors use to determine the intrinsic value of a particular investment.
Analyzing the Results
As for interpreting the valuation results:
If the current stock price is equal to the net present value, then investors should expect returns equal to the discount rate.
If the current stock price is above the net present value, then the stock is overvalued, and investors should expect to receive returns below the discount rate.
If the current stock price is below the net present value, then the stock is undervalued, and investors should expect to receive returns above the discount rate.
However, because the future is uncertain, there is no exact or absolute answer for net present value.
Models rely on a set of assumptions including short-term projections, discount rate, and terminal growth rates. Varying any one of these can have a significant effect on the valuation Different analysts may apply different assumptions and expectations, resulting in different results. The precision, and confidence, with which models are presented can be misleading.
Investors may benefit from assessing the underlying range of possibilities. Considering variations across growth rates and discount rates produces a broad spectrum and investors can use their own discretion to assess the probabilities, or likelihood, of various outcomes.
Whether creating their own model or analyzing an analyst’s model, investors that understand the mechanics and importance of the key assumptions will be at an advantage in assessing the range of possible fair values for any particular investment.
Relative Valuation: Multiples
While intrinsic value is derived from investment opportunity itself, relative valuation methods rely on comparison.
Valuation multiples, including price to earnings (P/E), price to sales (P/S), price to book value (P/B), price to free cash flow (P/FCF), and enterprise value to next twelve month’s revenue (EV/NTM), are a quick and easy way to benchmark prices.
Reversion to the Mean
Certain companies and industries may trade at relatively stable multiples. Prices will inevitably vary, causing prices to be above or below the expected multiple. Investors may be able to benefit from a reversion to the mean.
The graph below shows the price and earnings per share of Johnson and Johnson over time. The orange line represents a P/E of 15. The blue line represents a P/E of 17.82, the normal P/E, or the average at which JNJ has traded at over time.
There was a clear period of undervaluation beginning in 2006 and leading up until 2013. During this time, shares of JNJ traded below the normal P/E rate. An investment in JNJ during that period would have resulted in strong performance to date.
A note of caution: this behavior is easy to identify in hindsight. In the moment, it is not always clear. While the price could revert to the previous mean, it could also establish a new, lower mean going forward.
Comparing Across Companies
Multiples are often used to compare prices across different companies.
Consider the following scenarios:
Company A has $10 in earnings and trades at $100. It has a P/E of 10.
Company B has $1 in earnings and trades at $100. It has a P/E of 100.
Which is a better investment?
Is company B, with a P/E of 100, overvalued?
These simple data points are not sufficient to make an assessment. One multiple in isolation does not give sufficient indication about how the company operates.
Valuation multiples are static data points. They represent a point-in-time connection between value and a single operating metric. Notably lacking is any indication on important factors such as the quality of earnings, the efficiency in converting earnings to free cash flow, sustainability of growth over time, and any other competitive advantages.
Different companies on different trajectories may have significantly different multiples.
Companies with higher growth and stronger returns on invested capital tend to have higher multiples that are sustained over time.
Veeva Systems is the industry cloud for the life sciences industry, providing a suite of software and services including CRM, data management, and data analytics solutions. Veeva has been able to maintain strong growth rates and returns on invested capital, consistently above 25% and 11% respectively.
Analyzed through ratios, Veeva seems to be consistently priced at high multiples, with P/E sustained in the high 70s and 80s.
On the other hand, a company like AT&T may seem cheap based on multiples alone. Shares tend to trade below a P/E of 16 and are currently trading at 9.44.
Analyzing the quality of the operations gives additional insight: sales growth seems to teeter and return on capital demonstrates a steady decline over time from 7.4% in 2015 to 4.3% in 2020.
The lower quality of operations may be the cause of the market’s repricing to a lower multiple.
While multiples may be useful when applied to like companies, they should not be simply taken at face value to determine whether an investment is over or undervalued.
Multiples as Secondary Concerns
In the case of Veeva, AT&T, or any other company, valuation multiples are an expression of the company’s price in relation to a particular operating metric.
Multiples do not determine the price. Rather the operations, the cashflow, and ultimately the company’s value is what sets the price. Multiples describe the current state.
This helps explain why different multiples may be used for different types of companies. P/E is typically the first choice. Asset heavy companies may prefer P/B. Companies without earnings may prefer P/S. There is no right or wrong multiple.
Conclusion
The value of a company ultimately depends on its ability to generate free cash flow for investors. Because there are many assumptions baked into a discounted cash flow model, investors should apply their own discretion as to the realm of possibilities and probabilities.
Multiples are most valuable when comparing similar operations, whether the same company at different times or different companies. Multiples can be considered a shortcut, giving a quick assessment in lieu of a full financial model. Investors should be weary of placing too much emphasis on multiples without considering the surrounding context.
