On Valuation in General
It seems to me that it doesn't really matter how you value a stock. What matters is how the *majority* looking at the name, values that stock.
For example if your DCF is showing an undervalued stock, but that stock is a government contractor who is about to get blown away through spending cuts? Are you still going to agonize over what risk-free rate to use when rolling out a WACC? Or are you going to think "headline risk for sure, possible real hit to revenue, not a good time to buy right now".
It's too late. Before you even get to think, the stock price has dropped significantly because the market knows the contractor is getting blown away through spending cuts.
So the question becomes at its new low price, is it undervalued/overvalued. The efficient markets people will say its fairly valued.
In today's public equity markets very little has to do with actual or intrinsic value...prices are being driven off of speculation (as well as quantitative easing, lack of other options to place money (e.g. don't want to go into Europe, emerging economies are slowing, bonds pay next to nothing, etc.), among other factors.)
You're missing the point. You need to determine if the current valuation is pricing in the downside scenario already and still presents a favorable investment. Undervalued on consensus may be overvalued on someone else's more accurate estimate.
Pet peeve: One of the best ways to lose money is to argue a stock should be trading at some multiple outside of its historical range. If it trades at 8-12x, but you think you can justify 15x, don't count on that ever happening without a catalyst for revaluation. The only time you see that happen otherwise is when earnings are growing at an abnormal rate.
So you're basically saying you would go back to your revenue assumptions, say, and adjust to account for a worst-case scenario, then flow that through your DCF and come up with a min / max valued stock price (based on revised/previous revenue assumptions)? Or do you just eye-ball it and say 'we have to wait for more things to transpire'.
I do use scenario analysis, but I've never used a DCF.
To get back to your original question, unless you are looking to buy a company outright, you should know how the market values the stock, whether it's P/B, P/E, EV/EBITDA, etc. Probably the most important concept to grasp is that you need to understand the marginal buyer of stock. Deep value/distressed investors or acquirers will more likely use a DCF or EV/EBITDA, because these metrics matter most from their perspective. At the other end of the spectrum is the momentum trader who doesn't care about valuation, just that the stock keeps going. In the middle of the extremes, you have value, GARP (growth at a reasonable pace), and growth. As you climb the scale, each style is willing to pay up. This should make sense: if things are bad, you are getting into a messy situation and might need to liquidate a company for its asset value. If a company is in hyper-growth mode, you are valuing the company for its future earnings.
To me, you should have an edge on a stock when you invest, otherwise you're trading. Always know which game you are playing. I might wait for things to transpire, but someone else might be willing to take a long position and keep a tight stop to get exposure but limit potential losses.
That's a great answer. Thank you. Mind if we keep going with it?
I was under the impression that you used DCF whenever possible, combined with P/E say or comps, and that you only went to EV/EBITDA etc if you were valuing a firm with net losses or where you wanted comps to be capital structure neutral? Is this accurate? Is there a hierarchy so to speak, where you attempt to value it one way and depending on the stock, move down the list of options? Seems to me and I could be wrong, but a DCF incorporates more into a valuation than EV/EBITDA?
I never DCF. I nobody I deal with on the buy side really DCFs. They are so fickle, shit in shit out.
Think about it practically. Market multiple valuations let you easily compare a wide array of companies. DCFs involve a lot of company specific work and exhibit a lot of assumption sensitivity. They are generally used by old school value shops. A DCF is most useful if you could buy the company outright, but if no one is going to buy the company, you are assuming that over a multi-year horizon, that cash will be used to generate value that the market will recognize. Lots of things can change over that time to invalidate the thesis. That's why Graham and Dodd devotees focus on quality companies with big moats and strong management - they need to minimize business risks that pop up over their time horizons.
If you aren't buying a company outright, you are betting on how the market will be valuing the stock. That means you need to look at the market multiples. The hierarchy tends to be P/B -> P/S -> EV/EBITDA -> P/E. P/B only applies to select companies; if you are looking at P/B (for non-financials at least), it is because the book value is a pretty good proxy for liquidation value. P/S is used for companies with negative EBITDA, but with the potential to turn around the business. Everyone knows EV/EBITDA is a (poor) proxy for cash flow, but i think of it more as a valuation guideline. Anyone buying a company outright will factoring in the considerations not incorporated into EV/EBITDA. And yes, it does provide a cap structure-neutral view. P/E is what most of the rest of us use for the average company.
You do need to make sure your target price doesn't violate one of the other major valuation metrics. If you are shorting a company, a 10x P/E multiple might be reasonable, but not if it values a company below P/B when it never trades below P/B. On the upside, maybe 9x EV/EBITDA makes sense, but if it values the company above the P/E range it has ever traded at, you need to have conviction the market will be looking forward to the forward numbers that show the company is in a high growth mode.
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