If you’re looking at a potential stock purchase, no doubt you’re trying to determine what this stock is worth before you make your decision. No one wants to buy a stock that declines in value right after you buy it. Many people look at the Price-to-Earnings (P/E) ratio, or the Price per Share divided by the Earnings per Share, as a way to determine whether or not a stock is expensive compared with the rest of the market. There are other ways to attempt to determine the value of a stock, one of which is to complete a stock “valuation”, in which you look at the company’s current and projected performance in order to determine a stock’s worth. This is a very complicated process with many assumptions that must be made during the analysis – in fact, it takes a whole course in MBA school to outline the steps – so it’s impossible to touch on all of the considerations in one article. However, we can introduce the highlights so that you can see the difficulties in using this method to determine a stock’s worth.
In completing the stock valuation, you’ll first want to look at the company’s historical performance. Specifically, you’ll want to consider the company’s income statements and balance sheets over the past several years. In doing this, you will want to come up with the company’s Earnings Before Income Taxes (EBIT) and Net Operating Profit Less Adjusted Taxes (NOPLAT). These numbers sound complicated, but you are merely determined earnings before and after taxes for the company in question. Once you have determined these numbers, you will add back the company’s depreciation to come to a gross cash flow from operations. You’ll then determine the yearly investment in net working capital by subtracting current operating liabilities from current operating assets. Next, you’ll need to consider the company’s gross investment, which is the investment in net working capital, plus the capital expenditures and increase in other long-term assets. Finally, you’ll come to what you are really looking for – the company’s Free Cash Flow (FCF), which is the gross cash flow from operations minus the gross investment and any investment in goodwill.
At this point, I know what you’re thinking – how am I going to come up with all of these numbers? Actually, taking these numbers from the company’s financial statements is the easy part of the stock valuation. The tough part comes next – projecting what these numbers will be for the next ten years. You will need to estimate these values based on the historical data that you have looked at, as well as the future expectations for the company. The most important consideration is sales growth, as this number is the trigger for all other values. You may want to adjust your sales growth value throughout the stock valuation as it is difficult for many companies to maintain the same sales growth number over time.
Finally, you’ll determine the company’s continuing value by using the free cash flows that you previously estimated. You’ll subtract the company’s debt from the company’s continuing value to come up with the value of the company’s equity. To conclude, you’ll divide the value of the company’s equity by the number of shares outstanding to come to what the value of the company’s stock should be.
As you can see, determining the value of a company’s stock using this method is not only time-consuming, it can be confusing. There are many assumptions that must be made and one wrong move can mean that your stock valuation is way-off. If you do want to use this method for valuing stocks, you should use McKinsey and Company’s “Valuation: Measuring and Managing the Value of Companies” as a guide in this process, as it offers many helpful hints in making assumptions and completing this analysis.