Rather than purely concentrating on a bottom-up approach where I value the assets, cash flow and growth to come up with a range of intrinsic values, questioning what the markets expect out of the stock adds another dimension to the valuation process.
Based on Historical Data
When performing any stock valuation, you are extrapolating numbers based on historical data, e.g., DCF could come out to $40; Graham’s formula shows the stock to be worth $65 and EPV gives a conservative $30.
Which one is correct? Can you assume that the range is $30 – $65 and invest in the company comfortably?
By figuring out what the expectations are, you can take it one step further. In other words, invert the valuation.
Understand What the Crowd Is Saying
In Mauboussin’s book "More than You Know," he writes of an experiment that was played out in a university classroom. The professor has a large jar of jelly beans and asks a student to guess how many jelly beans were contained in that jar.
The first student gives an answer way off the mark.
The professor repeats this process for each student in the room.
At the end, not one student got the correct answer. The range of values were high, with many incorrect answers.
However, the average of all the answers turned out to be the closet to the jelly bean count.
The market works like this. You have millions of individuals offering differing opinions. Value investors will provide conservative estimates, growth investors will provides extreme estimates. No single person may be correct, but over time, the value will be recognized by the market.
I’m not putting forth an argument that the market is efficient. My point is that understanding how the market thinks about the stock is important. Does Mr. Market know more than you or does he know less?
Reverse Engineering Valuation Methods
The additional questions you should now be asking yourself are the following:
1) What is this stock worth?
2) What is this stock NOT worth?
And here are a few methods of how to go about answering these questions the inverse way.
A reverse DCF valuation will help you find the expected growth rate the market is pricing in.
Set the discount rate to something that is reasonable. For small caps, a discount rate of 12-15% is desired. For large caps, 9% discount rate is satisfactory.
However, an easy way to find your desirable discount rate is:
Discount rate = Risk Free Rate + Risk Premium
Use this simple equation to see what the expectations are:
Stock price = assets + expectations (a.k.a growth or speculative value)
If the stock price is made up of a lot of assets, not much growth is expected. If the company can either perform at the GDP rate (around 4-5%) then you have a good chance of finding a winner.
If the stock price is made up of little assets, there is a likely chance that the company will disappoint in the near future.
Reverse Earnings Valuation
This reverse earnings power value next one is more complex and based off expected earnings power. Think of it as a reverse EPV.
1. Create your multiple
2. Calculate excess cash of interest bearing debt into a per share price.
3. Deduct excess cash per share price from the current market price of the stock.
4. Divide remaining amount by the multiple in step 1.
5. Determine a proper earnings growth rate or use an analyst's assumption to draw ideas from (don’t rely on the analyst's information — just use it to see what information you can derive from it).
6. Find how long it would take to grow shares from what they are currently to what Step 4 produced using the assumed growth rate.
7. Determine in your own mind using logic and rationality how feasible the proposition is based on the information at hand.
Invert the Problem to See What the Market Expects
There are other ways of reverse valuation, which I’ll walk you through another time, but one thing that becomes clear is that once you start doing this, your questioning and thought process starts to change.