Ask a professional investor the secret to success and he or she will likely say “Buy low, sell high.” And if there’s one skill that defines those few great investors it’s the ability to value things others have a hard time with, like multinational corporations, bonds and other financial assets. Why is valuation so central to investing and how is it done? Consider this an introductory course in the art and science of valuation. You may not make a fortune after reading this, but hopefully you'll have a better understanding of how investing is done and how hard it is to do well.
We value things every day: a can of tuna in the supermarket, an antique chair at a garage sale. But valuing financial assets—shares of stock, bonds, mortgages and more—is trickier because we don’t “use” them. They represent nothing more than a claim on money that will be ours at some point in the future. So the first step to learning valuation is to understand something finance professionals call “the time value of money,” which is just a fancy way of saying “What is a dollar tomorrow worth to you today?”
Start with the assumption that a dollar in your hand is worth more than a dollar promised for delivery in the future. There are several reasons why this should be true but the easiest to grasp is that if you had a dollar now you could invest it and collect some return. That rate of return reduces the value of future dollars and is known as a “discount rate.” By “discounting” future dollars at the discount rate investors arrive at what is known as “present value,” the value today of that money promised to you in the future. For example, an investment today of $100 with 5% interest will pay $105 in one year, so an investor is equally happy with either sum—the present value of $105 in one year is $100.
Why do we care about all this? Because every investment is a promise of future money. Consider a simple example, a Treasury bond that pays a coupon twice a year for 30 years. The math can get a little complicated but bond traders value Treasury bonds by discounting each future payment back to present value. Stocks seem very different but they aren’t: a share of stock is an ownership stake in a company but since the typical investor cannot liquidate the company (and wouldn’t want to if he or she could), the stock really represents a claim on the company’s future earnings. The only difference between a bond and a stock (in this regard) is that a bond’s payments are fixed, while the company’s future earnings are unknown.
Two basic approaches to valuation
There are as many ways to value investments as there are investors but all of them fall into two broad categories: intrinsic and relative. Just like it sounds, intrinsic valuation focuses on figuring out what a company will earn in the future and discounting to present value to come up with a number that represents the financial worth of a stock. Earnings are malleable, though, so most professionals prefer to rely on something called “free cash flow.” Free cash flow is simply the cash generated by a business not used for expenses, interest payments or reinvestment in the firm—essentially what you’d take home if you owned the business yourself.
If this sounds easy, it isn’t. For one, accurately predicting free cash flow for all but the simplest businesses is tough. For another, the discount rate used to arrive at present value is open to debate—it should reflect the risks inherent in the company and the rate of return investors expect but anyone can make up a number that fits those criteria.
It’s all relative
For these reasons investors often rely on relative methods to value stocks. Relative valuation typically means comparing a company to others in its industry or peer group. This isn’t different from the comparison shopping that we all do at the market or the way realtors look for comparable sales when setting a price for your home. One simple way investors compare companies is via their price/earnings (PE) ratio. The PE ratio is the price paid for one share of stock divided by the annual net income per share—it’s how many dollars the market is paying per dollar of earnings. Put another way, ask yourself how much you would pay today for something that generates $10 a year for you. Maybe $80 sounds right, so you would be paying a PE of 8 for this hypothetical asset. Since all stocks have a price and most companies generate positive earnings, we can use PE to contrast how expensive or cheap some stocks are to others.
Let’s say we want to value a company that earns $100 million a year but does not trade publicly. We do know that it’s a chemical company, and as a group public chemical companies trade at an average of six times earnings. We might then value this private company at the same multiple giving us a valuation of $600 million.
There are a slew of other numbers investors can use to compare companies. A few of the more popular are similar to price-earnings but divide by different numbers, for example, price-to-sales. The reason for substituting sales, (or book value or operating earnings, etc.) is that some firms don’t generate much in the way of earnings or have very volatile earnings while sales tend to be more stable. Still other methods take into account how much debt and cash a company has. We’ll tackle the advantages and disadvantages of the different methods in a future post. For now, welcome to the trickiest but most essential and rewarding part of investing.
A credit default swap (CDS) is an infamous financial instrument that earned a bad reputation from its involvement in the recent financial crisis. The term refers to swapping the risk of a loan’s default with another party. An easy way to think of a CDS is a kind of insurance for debt lenders that can be bought and sold by investors other than the lenders themselves. Credit default swaps are a recent invention dating back only to the mid-1990s.