Tony Boden gives us a personal view on how to value companies.
So you have decided that you want to try your hand at investing in the stock market, therefore investing in companies.
Perhaps the most basic question a stock market investor needs to be able to ask is 'how much?' In other words, what is a company worth?
There are two truisms concerning the value of companies :
* A company is worth the discounted value of all future cashflows.
* A company is worth 'what the market is prepared to pay' (ie the current share price.)
Both of these statements are intrinsically true, but 'mostly' useless.
Taking them in turn.
The discounted value of all future cashflows
Discounted cash flow (DCF) simply reflects the fact that a pound you will receive next year is worth less than a pound in your hand today.
So in simple terms a company (or share) is worth the total (discounted) amount of cash you will receive from the company over the full time you own in it. If you never sell the share, then this becomes the sum total of all dividends you will receive from the company out to infinity.
Alternatively, if you sell the share at some point in the future then this is the sum total of all dividends you receive while you own the share plus the amount you receive when you ultimately sell the share. (In theory your sale price should be related to the DCF at that point in time)
Brilliant -- so all we need to do is forecast the company's dividends out to infinity!
Unfortunately you can only really determine this value with the benefit of hindsight. Forecasting future profits is difficult (to say the least), more so the further out you forecast -- even a very small error in your forecasts can create a massive difference in the DCF valuation.
So the DCF model is largely useless because it relies on very unreliable forecasts into the distant future.
But worry not, as I shall cover in a future article the market tends to use simpler shorthand to assess the value of the company's profits.
'What the market is prepared to pay' (i.e the current share price.)
As tradable commodities, it is clearly true that shares are only 'worth' what anyone is prepared to pay for them (ie the current share price).
This suggests that investing in individual companies is an entirely futile exercise. If one can never buy a company for less (or indeed more) than its 'true' value, then what is the point?
The answer perhaps lies in the idea of 'true' value. Others might use the term 'inherent' or 'underlying' value -- all of these terms are somewhat controversial in that without the benefit of hindsight (see DCF above) they are more or less matters of opinion.
For now I'll use the term 'intrinsic value' for want of a better term, and hang the controversy. So intrinsic value is essentially based on full DCF although we won't attempt to forecast infinity.
For a variety of reasons, the market will misjudge the 'intrinsic' value of companies. This can either be on the upside (eg the dotcom boom) or the downside (eg 'old economy' stocks during the dotcom boom.) Mostly though, any mispricing is not as widespread as in the two examples given.
Like it or not, if you invest in individual companies (or indeed anything other than a market tracker fund), you are assuming that the market is underestimating the intrinsic value of your chosen company.
Not only that, you are also hoping that at some point in the future, 'the market' will change its mind -- unless you hold to infinity, you will need to sell your shares to the market at some point.
So, in short, there are two measures of the value of a company: the 'intrinsic' value based on the fundamentals, and the market value indicated by the current share price. If you invest on the basis of Fundamental Analysis, you wish to buy when the market value is less than the 'intrinsic' value and sell when the reverse is true.
This relationship between market value and 'intrinsic' value is summed up in a rather famous quote ascribed to Warren Buffet : 'In the short term the market is a voting machine, in the long term a weighing machine.'
I'll begin to explore how to take a view of 'intrinsic' value in the following articles in this series.
More: How To Value Companies Pt 2 | How To Value Companies Pt 3 | How To Value Companies Pt4 | How To Profit From Shares
