Buying low and selling high is the simple concept that leads to investing success or failure. The hard part is figuring out when a stock is actually cheap, or when it’s too expensive. What’s the definition of cheap when it comes to a floating stock price? Is a $10 stock cheap and a $100 stock expensive? The answer to that question is: it depends.
Some investors recommend looking at the Price/Earnings ratio (PE) to figure out if the stock is cheap, where a low PE means that the earnings relative to price are high and therefore the stock is inexpensive. The problem with the PE ratio is that knowing whether the PE ratio itself is high or low depends on how it compares to other companies in the same industry. For instance, a stock with a PE ratio of 18 might seem like it has a low PE ratio, but if the other companies in its industry have a PE ratio below 10 that may not be as good as you initially thought. Comparing PE ratios across industries is risky and is not recommended because the economics and earnings for companies with different business models could vary significantly.
Discounted Cashflow Model
To find the company’s intrinsic value we will use a discounted cash flow model. A discounted cash flow model is based on the premise that the intrinsic value of a stock is equal to the present value of all of the company’s future free cash flows. The model we will use is the following:
(1 + r)t
(r – g)
Where t is the time period in years, FCF is the Free Cash Flow in a given year, i is the FCF growth rate, r is the discount rate, and g is the growth rate in the long term.
The first part of the equation below calculates what the present value of the FCF for the next 10 years.
(1 + r)t
The second part of the equation will calculate the present value of the FCF beyond 10 years.
(r – g)
Dividing the FCF from the first 10 years and beyond by the number of shares outstanding will get you the estimated intrinsic value per share for the company based on the free cash flow it generates. You can see an example of these calculations by clicking here.
Intrinsic Stock Value Calculator
If you want to skip doing the math by hand and save time looking up company information you can use our Intrinsic Stock Value Calculator. The calculator allows you to either type in all of the values manually by filling out the stock’s ticker symbol, current share price, market cap, and shares outstanding, or by having the calculator look those values up for you.
Note that market cap and shares outstanding should be entered in millions, for example, a 500,000,000 market cap would be entered as 500. The faster method of using the calculator is to type in a ticker symbol and click the Lookup link to have the calculator retrieve that information about the stock automatically. Let’s look at how it works using Western Digital Corporation (WDC) stock as our example. Here are the steps to calculate the intrinsic value:
- The first step is to lookup WDC and click the Lookup link.
- Next you will add the projected free cash flow (FCF) and select a FCF growth rate. The Cash Flow Statement in Google Finance shows the following data from which you can calculate the FCF and FCF growth rate for the past 4 years:
2015 2014 2013 2012 Cash from Operating Activities 2,242.00 2,816.00 3,119.00 3,067.00 Capital Expenditures -612 -628 -952 -717 Free Cash Flow 1,630.00 2,188.00 2,167.00 2,350.00 % Increase Over Previous Year -26% 1% -8%
As you can see WDC has had FCF over $2 Billion for three out of the last 4 years. This would be a good time to look up more historical data and determine why there was a dip in the most recent year. For the purposes of this example we will assume that WDC will generate $1.7 Billion in FCF and have a 3% growth rate. Read our post on how to calculate free cash flow to get a more in depth analysis of determining FCF and the FCF growth rate.
- The next step is to evaluate the level of risk for the company. The level of risk is important because it will be used as the discount rate (r). A Below Average risk level is equal to a 9% discount rate, an Average risk level results in a discount rate of 10.5%, while an Above Average risk level is equal to a 12% discount rate, and a Risky stock results in a 15% discount rate. The more risky the company the more you have to discount the value of its future cash flow. We will assume an Average Risk level for WDC in this example.
- The last data point is to select the current and expected market conditions. If the market is currently in a recession, you would select Down Market, if it’s in a bull market and general upward trend you would select Rising Market. The market conditions selected translate to the the long term growth rate g in the discounted cash flow model where the down market sets a 2% growth rate and a rising market will result in a 3% long term growth rate. Will assume a Rising Market in our example.
- Clicking the Submit button will provide the calculated Intrinsic Value for WDC stock.
The result for our example is that the Intrinsic Value is $98.36 per share. Given that the stock is currently trading at $80.02 per share which is below the calculated intrinsic value, this would indicate that you have found a bargain, and further research might be in order to determine whether to move forward with actually purchasing the stock. The Intrinsic Stock Value Calculator will denote stocks that are trading below their intrinsic value in green text indicating a positive result, or red text indicating that the stock is trading above it’s intrinsic value and you may want to avoid it.
You may have noticed that a Margin of Safety metric is shown for stocks that are trading below their intrinsic values. The margin of safety is essentially a measure of how much room for error you have in your calculations. Typically you should look for a margin of safety above 20% and hopefully over 30% to seriously consider purchasing a stock. In our WDC example the Margin of Safety is 33.42% meaning that this particular company may be a safer bet to invest in.
There are many assumptions that you have to make in selecting discount rates, FCF, and growth rates, and in order to ensure that you’ve made correct assumptions you should review all of the company’s financial statements and annual reports. That research along with the use of a discounted cash flow valuation will go a long way towards success in Value Investing.