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There are many different ways to value a company - from the simple price-to-earnings (P/E), dividend yield and price/earnings to growth (PEG) ratios to the more complex Du Pont and dividend discount models.
But the most popular method by far, which is used by pretty much every asset manager I speak to, is the discounted cash flow (DCF) model.
The formula and process are complex but at the heart of the process is the notion that if you are buying a stock, ultimately you’re buying future cash flows.
As a result, the DCF model tries to determine how much cash, adjusted for the time value of money, one would receive from an investment.
This notion of the time value of money is important - R10 today is worth a lot more than R10 will be worth in a decade.
So a DCF gives a net present value of the company and if the price at which you can buy the stock is below this net present value, then the stock is considered cheap.
The first part of the process is to decide how far into the future to determine future cash flows. In truth, it's an educated guess on a company’s revenue growth.
Eventually that growth flattens out and hits the terminal growth period.
So one would decide, for example, that revenue growth will be 25% a year for five years before dropping to a terminal rate of say 12% a year thereafter.
This growth rate would depend on the company’s product or service, and issues such as barriers to entry and competition in the space, amongst other things. ?
A low-margin industry that is very competitive would have low growth rates and hit terminal rates fairly quickly.
Conversely, an industry with a high barrier to entry that has high margins would take longer to achieve terminal growth rates.
This revenue growth figure shouldn’t be a thumb suck. One can create complex spreadsheets that work out future growth.
Inputs would include not only the revenue growth, but also margins, cost increases and the like.
A lot can go wrong with these assumptions, but as Tshepo Madiba of Seriti Asset Management once commented to me: while a lot of assumptions need to be made, they can be measured against the company's results once they are released.
If the assumption on, for example, margin growth was wrong, not only can the error be spotted, but one can also try to understand how the error was made.
Assumptions can then be corrected for the next period.
This actually makes it more likely that future assumptions will be accurate. Perhaps accuracy is the wrong word; being more correct is really the aim as it is unlikely that estimates will ever be 100% accurate. It is about being as correct as possible.
This is an excerpt from an article that originally appeared in the 29 October 2015 edition of finweek. Buy and download the magazine here.
