Last week I covered a few essential short-term trading tools and this week I’m going to take you through a longer-term value investing tool — looking at valuations.
Have you ever wondered how a stockmarket analyst values a share? How can they confidently say what a share will be worth? And why can another analyst look at precisely the same stock and come up with a completely different figure?
We saw a classic example of this discrepancy this week with Computershare. After announcing an improved first-half earnings outlook, the share price took off. Analysts quickly upgraded their targets for the stock, with Credit Suisse setting a target price of $14.29 and Deutsche Bank upgrading their target to $12.00.
So how did two analysts come up with completely different target prices?
The answer lies in something called discounted cash flow, or DCF in short. Used well, it can be an extremely valuable long-term investment tool.
And by understanding how it works, you’ll be in a better position to make sense of those analyst valuations and decide exactly how much to rely on them.
The basic idea behind a DCF valuation is simple. When you buy a share, you are simply buying a chunk of the company’s future earnings.
While past earnings are an interesting signpost to the future, they have no bearing on your return. All you really care about is what happens next.
So a DCF valuation tries to calculate all of a company’s future earnings, then convert them into today’s dollars.
Why the conversion? Because a dollar today is worth more than a dollar next year, or the year after that.
Let’s look at that idea a little more closely.
If I gave you $10,000 today, what would you do with it? I’m sure you can think of lots of interesting answers, but one (very boring!) option would be to put it in a term deposit, earning a fairly safe 6%.
If you did that, you’d have $10,600 in a year’s time. Leave it in for another year at the same rate, and you’d have $11,236.
So what would you do if I asked you to wait two years for the money instead of giving it to you today? How much more would I need to give you to make waiting worth your while?
Looking at those figures, you might say “at least $11,236”. So, if we take 6% as our theoretical base rate of return, we can say that $11,236 in two years time is worth the same as $10,000 today.
That’s where the ‘discounted’ part of discounted cash flow comes in. When we look at a company’s future earnings, we need to discount them back to today’s dollars. That also means we have to choose a base rate of return, or discount rate — 6% in this case.
The lower the discount rate, the higher the valuation.
To see why, just imagine your term deposit rate was slashed to 3%. In that case, you’d need to invest more than $10,000 to wind up with $11,236 — $591 more. So now $11,236 in two years is suddenly worth $10,591 in today’s dollars.
To put it another way, the less you discount future earnings, the more they are worth today.
That brings us to our first problem: what discount rate should we use?
Traditionally, many analysts used what’s called the risk free rate, which in the US is considered to be the rate on US treasury bills. In Australia, the Reserve Bank’s cash rate is a reasonable proxy.
Nowadays, many see that as too low a benchmark, given the fairly reliable returns to be earned elsewhere.
But as we’ve seen, if two analysts use different discount rates, they’ll end up with different results. So you begin to see how valuations can start to diverge. But that’s only the beginning
A bigger problem is that of predicting a company’s future earnings, particularly when peering five years into the future. As an example, let’s look at Computershare’s earnings history, as captured in its earnings per share (EPS):
As you can see, Computershare’s earnings per share have risen steadily, which is great. But they haven’t risen at an even rate. That makes the future difficult to predict, even with this year’s profit guidance to help us.
Just for fun, let’s see how different assumptions can give very different results, using the classic discounted cash flow method.
The situation gets worse with cyclical stocks such as resources or energy companies. If you want to predict BHP’s earnings in two years time, you need to have a view on future prices for oil, iron ore, copper, zinc and nickel, as well as the likely direction of the Australian dollar.
Little wonder that analysts differ!
You can also see why classic value investors like Warren Buffett prefer established consumer stocks with strong pricing power and relatively steady earnings growth. Their earnings are just so much easier to predict.
So that gives you a sense of the kind of calculations underlying analyst valuations.
To set a price target, they may even go a step further — looking at how a stock and others in its sector have historically traded against their intrinsic value, then adjusting the price to match.
For now, though, it’s enough to say that any valuation is simply a guide, rather than an iron-clad verdict on the value of a share. If you’re a value investor, your aim is to leave a wide margin of error, so that any dubious assumptions come out in the wash.
If you’re interested in the topic, you might even like to try doing your own valuations. While the process is involved (too involved to cover in more detail here), it isn’t theoretically complex, and there are plenty of guides out there to help you. Benjamin Graham’s classic The Intelligent Investor is a great place to start.
And remember, you can find analyst research, including price targets and valuations, in the ‘bellintell’ section of the Bell Direct website.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.