There are many methods for evaluating the value of a given stock; today I’d like to write about the pros and cons of a few of the more common methods.
Free Cash Flow (FCF)
Free Cash Flow is equal to Net Income + Amortization / Depreciation – Changes in Working Capital – Capital Expenditures.
What is good about free cash flow for evaluating a company is that free cash shows a company’s ability to pay down debt, buy back shares, or pay dividends in the present. These are very shareholder friendly activities. Many investors spend much effort focusing on earning estimates, however earnings often factor many “guesstimates” and balancing cost of goods sold with various depreciation rules, free cash flow focuses on the real money.
A company with declining or negative free cash flow may be forced into a debt cycle or be forced into bad deals to get financing for operations. However, a company may also have increased R&D or financing to improve operations and this may be a huge payoff in the long run. So verify each of the components of the free cash flow to determine if you like where the money is going.
Operating Cash Flow (OCF)
Operating Cash Flow = Earning Before Interest and Taxes (EBIT) + Depreciation – Taxes
This is the money a business generates through its operations. What I particularly like about this is that it adds back depreciation as this isn’t truly money spent. A common suggestion is to verify operating cash flow hasn’t fallen with improving earnings. If this happens it may be a sign that the company is using funny accounting tricks to temporarily boost earnings.
Free Cash Flow For The Firm (FCFF)
This is another measure that calculates how much cash the company has left after all it’s true expenses.
Free Cash Flow For The Firm = Operating Cash Flow – Taxes – Changes In Net Working Capital – Changes In Investments
Dividend Discount Model
The dividend discount model takes expected future dividends and brings them to present day money. The formula is Future Dividends Per Share / (Discount Rate – Dividend Growth Rate). If the outcome of the Dividend Discount Valuation is greater than the value of the stock than the stock may be undervalued. The problem I have with this formula is it’s only as good as the assumptions you make. The dividend growth rate may change suddenly because a company was paying too much in dividends and ran out of cash or your discount rate may be different than someone else’s discount rate. Whenever I have the ability to tweak a variable I may tweak that variabe to match my emotions on the stock. This is a dangerous path for my style of investing, you need to know if emotions get in your way also.
Discounted Cash Flow (DCF)
With the discounted cash flow valuation you estimate the Free Cash Flow projections as far out as reasonable and then use your discounted rate to bring those cash flows into today’s dollars. It is nearly impossible to estimate cash flow too far in the future so often after 10 years or so a simple annuity – or fixed rate of return is assumed. If you have the information to make good to great estimates of free cash flow this can be an incredibly powerful tool to compare one company to another from a true investment point, however, it is subject to being only as good as the numbers as you plug into them.
I hope you enjoyed the quick summary of fundamental valuation tools. There are many more variations of these including other types of growth models. Also, many of these valuations can also be used in various ratios like Price / Free Cash Flow to compare one stock to another.
Let me know what valuations you use and why you prefer them. Are any of them good linked with technical indicators?
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When you decide to participate in stock exchange, you want to understand clearly, what you are bidding on. When you have a comprehensive understanding, it will reduce your risks.
Very useful post. where can i find more articles about how to value a stock?