Valuing a company is an art and a science. Though most investors agree the value of a company is the "present value of future free cash flows" there is a lot of gray area within this short phrase.
We'll break it down into three parts...
1. Present value
The present value of something involves a discount rate. For instance, would you rather have $100 right now or $120 in two years?
Well, it depends on the rate of return, or the discount rate, you can get in those two years. If you generate 5% annually on the $100, in the first year you'll have $105 (1.05 * 100) and by the second year, you'll only have $110.25. Therefore, it would have been a better idea to take the $120.
But let's say you can generate an annualized return of 15%, a much harder task. By the second year, you'll have $132.25. Therefore, you should take the $100 right now.
The point is that investors have different discount rates so what looks like a bargain for one, might be too expensive for another. We'll come back to this key point later because it will make more sense in context.
2. Future
How long into the future? Next year? In ten years? There is no standard time horizon for investing. Growth stocks may be evaluated based on estimates a decade in the future, while a slow-grower may be benchmarked based on next years' earnings.
Investors neither have the same discount rates, nor the same time horizons.
Here's a made-up joke for you: A technical trader, a swing trader, a value investor, and a growth investor all walk into a bar. The bartender asks the collective, "Hey what do you think about Amazon's stock? I've heard it's been incredible for a long, long time."
The technical trader says , "Been burned by it in the past, the charts are no good."
The swing trader quips, "It's been pretty good. It whips back and forth so I like it."
The value investor exclaims, "I wouldn't touch it with a 10 foot pole!"
And the growth investor glows, "Love it. It's my biggest position."
The bartender, with a confused look on his face, goes, "I didn't realize one stock could have four different share classes."
*crickets*
HAHA. At least I'm laughing while writing this.
The point is that each of those unique investors had a totally different view on one stock because of their time horizons. You may think everyone should see the world as you do but that is rarely the case.
3. Free cash flows
Even free cash flows, the least debatable words of the phrase, can be debated. Should you add back stock based compensation? Depreciation? How about taking out growth CapEx versus maintenance CapEx? Changes in net working capital? It goes on and on; don't get me started on the manipulation of earnings.
Free cash flow is the money in your digital pockets. You can spend it. It pools up for you to impress shareholders. You can shower with it...
...yet, even it isn't black and white.
Putting It All Together
By this point you might be thinking, "Is it even possible to value a company?"
But before addressing this point, let's talk about why we should even make the effort to value companies.
Pretend you were looking to buy a house. You toured houses, you played hardball with real estate agents, you Zillow-ed night and day, until you found the perfect house.
You had budgeted enough to make a $100k down payment; you had it all set…when you get a call from the real estate agent. She starts the conversation with the words no one wants to hear, "I have some bad news…the sellers are being absurd, they now want double what they were originally asking for!"
You are dumbfounded. Is this even legal?
It's clear you can no longer afford the house.
Why don't we think of stocks the same way?
It's one thing to "speculate" that the house is going to increase in value so you take out a huge loan to pay the seller's absurd price in hopes of offloading it to some sucker down the road. But it's another to "invest" in real estate.
It's the same way with stocks. Investing is different than speculating.
Investing incorporates some type of value. Now I'm not saying speculating can't be profitable. It can. Big-time.
But the delineation can be tricky.
Let's go back to our real estate example. Let's say, after you got the "bad-news" call, you went ahead and did the deal anyway because you knew a secret.
What if you had done some deep research and realized the ground underneath the house had a rich oil reserve? You could probably still make a solid profit, even by paying double the original asking price.
That's kind of what growth investing is like. While it may seem like speculating on the outside, because price doesn't matter as much, the growth investor usually thinks there's oil underneath the house. If the oil supply runs out, she'll get burned, but if it keeps on giving…oh happy day.
Again, differences abound, even between investing styles. Usually, both sides think the other is crazy. Classic value investors think that growth investors are wild traders and growth investors think the value people are stuck in the Stone Age.
The truth probably lies somewhere in the middle.
In the real world, valuation doesn't matter until you find that the oil supply is running out.
Real-World Example (*Disclaimer: This get number-y)
Let's analyze Amazon for a second to bring everything together.
Amazon is the poster-child for growth investors. Value investors, for the most part, have shunned it as a worthy investment.
In the last four quarters, Amazon did $242 billion in revenue. Its market cap? $920 billion.
A growth investor, to judge valuation, might try to do a quick earnings model.
Let's pretend Amazon can grow sales for at 15% for the next five years.
1.15^5 * 242 = $487 billion
Then maybe Amazon can get to 10% net margins by then, factoring in its cloud services business.
So that would be $48.7 billion in net income.
And perhaps we slap on a 25x net income multiple which yields a $1.22 trillion market cap.
Then we can work backwards to find an annual return.
(1,220/920)^(1/5) - 1 = 6%
So those assumptions could yield a 6% return.
Assumptions:
15% sales growth for 5 years
10% net margins in 2024
25x PE multiple in 2024
This earnings model would be a typical valuation practice for a growth-oriented investor.
It's not so much to find an exact annual return as it is to test how probable the assumptions are. We aren't going for precision, we are going for reasonableness.
And this is the main difference between a growth and a value investor: margin of safety.
A value investor watches out for the downside and lets the upside worry about itself. For example, let's be conservative with Amazon.
Let's say growth decelerates to 10% for the next 5 years, margins contract a bit to 7% and we slap on a 20x multiple. Once again, pretty conservative estimates.
We would end up with $390 billion in sales and $27.3 billion in net income and a $546 billion market cap.
This is vastly different from Amazon's current market cap of $920 billion. Therefore, what this is saying is that the margin of safety is slim.
The growth investor is betting on a few things. Either, the company will outperform the embedded expectations within a specific time period or the company will perform well for longer than expected.
Once again, we have a case of different expectations and time horizons.
So we've covered the earnings model.
A value investor would likely look at how much cash can be extracted from Amazon's business.
Because the company is valued at $920 billion, theoretically, it needs to return $92 billion of free cash flow, in perpetuity, for a 10% return. That is effectively what a discounted cash flow tells you.
But investing is hard. Amazon will probably do $30 billion in free cash flow this year. That's a far cry from $92 billion. News flash, it's a growth company. Investors aren't buying it today so that it can stop growing and turn on the cash spigot. Investors believe Amazon will be a bigger businesses in the future and then along the road, eventually return a lot of cash to shareholders.
The thing is, nobody knows when that day will come. And while the oil (growth) keeps flowing, it doesn't really matter. However, if growth came to a screeching halt, cash flow needs to compensate.
There is a clear difference between how investors evaluate "growth" and "value" companies because there is so much more variability with growth companies. After all, you can't value a company on its earnings if it doesn't have any.
Growth investing is more akin to venture investing. A venture investor would never put a PE ratio on a portfolio company. There is just too much gray area and uncertainty. But people don't call venture investors, speculators. It's just different priorities at different stages in the lifecycle of a company.
To End
All of the above reasons explain why valuation is just as much an art as a science. Figuring out the numbers is the easy part. Remembering that there are so many different factors like discount rates, time horizons, and investing styles, is the hard part.