Equity Values and Valuation

How much is a stock worth?

Source: Mathworks

There’s lots of approaches to question. Perhaps the simplest is to calculate all the cash that an investor expects to receive in the future, discount this to its present value, and add these up. It’s a truism in finance that an investment is worth the discounted sum of its future cash flows.

The problem comes in determining how much cash the business will generate, and how willing and able management will be to return that cash to investors. Also, investors need to estimate (i.e. guess) when non dividend-paying stocks will start to pay their shareholders. In Apple’s case, the company didn’t start paying a dividend until after Steve Jobs died—an event almost impossible to predict.

So investors use shortcuts to estimate value, ratios such as price-to-book, price-to-sales, or the price-earnings ratio—dividing the market cap of the company by an historical accounting metric. The challenge with these approaches is that they do not account for growth or risk. Also, it’s difficult to use price-earnings when a company is losing money, either because of cyclical issues or because they are at an early stage in their life cycle. Finally, while the formulas calculate a ratio, they don’t tell us what that ratio should be.

So some analysts use multivariate models that take into account earnings, dividends, growth, balance sheet factors, and other variables. These approaches create an estimate of fair value that can be compared with individual equity prices or even the entire market. What the models gain in subtlety, however, they lose in transparency. Blind adherence to a black box model can lead investors to do foolish things—like ploughing money into bank stocks at the beginning of the Financial Crisis. Those companies’ historical performance did not reflect the current economic conditions.

Pricing Optimization Model. Source: Mathworks

In the end, any model is only as good as its inputs. The old dictum of “garbage in, garbage out” especially applies to equity valuation. Enron’s managers were able to deceive analysts for years by gaming the accounting rules. Investors do well to remember what the statistician George Box observed when he concluded, “Essentially, all models are wrong, but some are useful.”

Douglas R. Tengdin, CFA

Chief Investment Officer

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