How to Analyze a Potential Investment Opportunity: Part 1

Be on the lookout later this week for Part 2 of this post!

When approaching a specific company to determine what it is worth, what are some of the methods we can use? Valuation is  one of the tools people often think of. Valuation itself is a pretty broad term, but in essence what we attempt to do when we value something is to find an appropriate value that we’d be willing to pay for a company’s stock. The current market price (what the stock is trading at) is sometimes an accurate indicator of a company’s true value, but often it isn’t. I talked about why that is the case, so read that first if you haven’t already. The real problem then is to find out what this accurate value is.

Valuation typically comes in two flavors: relative and absolute. I already wrote about how to relatively value a stock (sorry for all the links!). If you don’t feel like reading that, in short we are trying to figure out if a company is undervalued or overvalued relative to it’s peers. The rationale is that since they all have similar business models, then their profits should be comparable (comparable in the sense that they can be compared). We can use ratios such as the price-to-earnings (P/E) ratio, which simply compares the stock price divided by the earnings per share the company had that year; we can use many other metrics as well.

However, absolute valuation is a bit tougher. Here, we want to find a value (or more accurately, a range of values) that corresponds to the intrinsic worth of a company.  Conceptually, this is near impossible, but business school nevertheless teaches us to believe this is true. We can create models (massive spreadsheets with multiple tabs) that will take in some inputs (such as the income statement, balance sheet, earnings estimates, interest rates, growth rates, and so on) and spit out a range of values that we should be willing to pay. Despite the fact that most of what goes into a model is speculative, some practitioners still believe that we can derive a useful figure to value a company.

Now that I’ve got you all excited to learn how to value a company, let’s take a look at a simple example. Here, we’ll use a discounted cash flow analysis (also know as a DCF) to find out what the company is worth.

Simplistically, the model looks like this:

  1. We take the company’s adjusted earnings to account for one time expenses and some other things, and we’ll call this free cash flow.
  2. We then forecast these free cash flows out over a specific time period (say 5 or 10 years) either using analyst estimates or an estimated growth rate.
  3. We then discount the company’s cash flows back to a present day value (using the company’s cost of capital).
  4. We then arrive at a net present value for the company, or what all those cash flows should be worth if we paid for them today.
  5. We can create a range of acceptable values by doing what’s known as scenario analysis. One simple example would be to vary the cost of capital and growth rates +/- 5% from the original estimate.

Sound easy enough? icon smile How to Analyze a Potential Investment Opportunity: Part 1

It isn’t. Like I said earlier, most of the calculations that go into it are estimates anyway, so how can we then trust a specific number at all when its inputs are all guesses? Who knows. But we still use them anyway. I want to walk you through this more fully, but for the sake of time, I won’t give a totally exhaustive overview. We’ll take this apart, step by step. The first piece of the equation, but perhaps hardest to understand, is free cash flow.

Free cash flow can be computed by using the following equation (see the right side for the translation):

EBIT x (1 – tax rate) (1) Start with earnings before interest but after tax
+ D&A (2) Add back in depreciation and amortization
– change in WC (3) Take out the change in working capital
– CapEx (4) Take out capital expenditures
= FCF (5) This all equals free cash flow

Unsure about the different parts? Here’s a quick definition of what each term is:

EBIT: A value that is found on the income statement, this is the company’s revenues after you subtract out depreciation and amortization (both non-cash expenses). If you left both of these in, you’d have EBITDA. This stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

D&A: Depreciation and amortization. These are also income sheet items. These are used to write off the value of equipment or intangible assets (such as goodwill) over its useful life. We have to add them back in to the calculation to get EBITDA since companies don’t report it uniquely on their balance sheet.

WC: Working capital. This is from the balance sheet. It is the amount of current assets minus the current liabilities, which basically measures the operational liquidity of a company. It is good to have a lot of net assets (assets minus debt), but if they are all illiquid assets, this can sometimes be bad.

CapEx: Capital expenditures are assets that a company invests in, such as plants, property, or equipment because they expect to derive a future benefit from it.