TQI Weekly - Issue #6: How To Value A Stock?
TQI Weekly - Issue #6: How To Value A Stock?
Hello and welcome back to TQI's Weekly Newsletter series. In today's note, we will discuss yet another foundational investing concept - "Valuation". A famous quote from one of the greatest investor of all time, Mr. Warren Buffett -
- suggests that - the price of an asset is not necessarily a reflection of its intrinsic value. As we know, the price of any asset (stock, bond, real estate, or even cryptocurrency) is simply a function of supply and demand for the asset in the market. However, the intrinsic or true value of an asset is the net present value of its future free cash flows. Hence, price is set by market participants, intrinsic value is driven by business fundamentals. Ideally, an investor should be buying assets below their intrinsic value, and selling assets above their intrinsic value. Since bonds have a fixed payout structure, i.e., fixed cash flows, valuing bonds is easy. However, stocks don't come with a fixed coupon. And so, the big question is -
How to value a stock?
Well, there are two major types of valuation methods - Absolute and Relative.
The relative valuation methods are based on comparative analysis of key financial ratios (like Price-to-Earnings) between the stock under evaluation and its peers [comparable companies]. On the other hand, absolute valuation methods are dependent on analysis of a company's business fundamentals - cash flows, dividends, etc. Among these, the dividend discount model (DDM) and the discounted cash flow model (DCF) are broadly used by investors. To learn more, please use this link: CFI Stock Valuation.
While there are several valuation methods out there, I believe that every asset on this planet can be valued on the basis of a discounted cash flow model. And this is precisely why we utilize a [modified] discounted free cash flow model in our investing operation at "The Quantamental Investor".
We will be discussing the specifics of TQI's valuation methodology in just a little bit; however, if you would like to get a basic (or refresh your) understanding of a DCF model, then I think the following video is a great resource:
In a nutshell, determining the fair value of a company using a DCF model involves two steps:
1) Project out the future free cash flows the business will generate over its lifetime, and
2) Discount all of these cash flows back to present, and add them together.
While the intrinsic value obtained using such a process is simply an approximation, having this process in place along with a margin of safety allows investors to invest confidently with limited downside risk.
TQI's Valuation Model
As I have shared in my research reports, TQI's valuation model is a modified version of the discounted cash flow model. The only real differentiator is the use of an IRR rate (based on growth & risk profile of a company) instead of a company's WACC (dependent on market prices and capital structure) as the discount rate in the model. While some of you might have utilized the Google sheet version of our model, I am happy to announce that a digitized version is now available.
Let's evaluate Zoom (ZM) using the TQI Valuation Model:
The exercise starts with simple data collection for inputs such as stock price, TTM revenue, and share count.
To approximate the future free cash flows for Zoom, I have used a two-step growth model: 15% CAGR growth for the first-five years, followed by terminal growth of 5% per year. These growth rate assumptions come from my nuanced understanding of Zoom's business fundamentals, product roadmap, total addressable market, and capital allocation policy.
Zoom is already producing tons of free cash flow ($1-1.5B this year), and with its high-margin profile, the business should probably deliver 30-40% FCF margin at maturity (as it did for a period in 2021). Over the next twelve months, Zoom could end up generating $1.6-2.0B in free cash flow. With a net cash balance of $5.5B, I expect Zoom's management to continue with their aggressive capital return (share buyback) program along with greater investments into R&D and S&M to drive the next phase of growth at the company. Since I do expect some M&A activity from the company, I am not including their net cash position (~$17-18 per share) in my intrinsic value calculations [this cash balance affords a greater margin of safety in this investment].
Lastly, I used a 15% discount rate (required IRR) for Zoom, which happens to be a steadily growing, highly-profitable business. For the terminal discount rate, I always use 10%, and this input is simply the returns I could generate with the market (SP500 index), which is the next best alternative for most long-term investors.
According to these results, Zoom's fair value is $90 per share. If you are inclined to add back the cash on Zoom's balance sheet to the company's intrinsic value, Zoom is worth ~$110 per share. With the stock trading at ~80, it is available a nice discount to its intrinsic value. Theoretically, buying Zoom at $90.83 would generate a 15% CAGR return over the next 5 years. How would an investor do if he/she were buying in at $80?
Predicting where a stock would trade in the short-term is impossible; however, over the long-run a stock would track its business fundamentals and obey the immutable laws of money. If the interest rates were to stay depressed, higher equity multiples would stay here. However, I work with the assumption that in the long run, interest rates will track their long-term historical average of ~5%. Inverting this number, we get a trading multiple of ~20x. And this is my base case assumption for an exit multiple for Zoom (5- years out).
By 2027, Zoom could grow from ~$80 to ~$180 at a CAGR of 17.24%. That's a solid buy in my view.
Remember, the intrinsic value and price targets we determined in this exercise are approximations of our expectation for Zoom's business, which may differ materially in reality down the line. The purpose of performing this exercise is not to nail down the precise valuation of a business, it is to generate a good approximation of what a business can do for us. If we find that current odds are favorable for long-term investors (us) even with conservative assumptions [& margin of safety], then and only then, we take a long position!
That's all there is to it! I understand that filing out a few boxes on a screen to value a company could seem too easy (compared to the archaic excel sheet models), but believe me, there's a lot of nuance behind the numbers used in our models and it is, in essence, the same old excel sheet model you may have used in the past. As an analyst and an investor, I always strive to generate the best possible approximation for any company I look into. Despite all the due diligence I perform, I could be wrong, and this is why I always try to buy stocks with a margin of safety (at a discount to intrinsic value).
Final Thoughts
Valuing a stock is an imprecise art, and I just shared how I think about valuations as an analyst/investor. You could have a different valuation process, and that's completely fine. All we need as investors is a system that works consistently. Please feel free to share your process with us in the comments section below (this could benefit other members). At the end of the day, we are all here to learn and grow as investors!
If you want to start using TQI Valuation Model, please sign up at our website to access: https://www.tqig.org/tqi-valuation-model.
Thank you so much for reading TQI Weekly! If you enjoyed it, please subscribe to the newsletter. For more insights and early access to TQI Weekly, consider joining my free investing community - TQI Network.
Last but not least, I have some exciting launch news. My Seeking Alpha Marketplace service - "The Quantamental Investor" is now live, and you are welcome to join. To learn more about this service, please read this note: "Launching The Quantamental Investor: Active Investing, Proactive Risk Management".
Have a great day. Until next time, ciao!