Valuation 101 – The Finance Class Boiled Down to an Actionable Understanding

Valuation

This post will focus on boiling down the concept of valuation into actionable advice. If you are planning on investing at all you should have a high level understanding of the following concepts and how they relate to stocks, bonds, real estate, and other investment vehicles.

My Background

I have worked in a Corporate M&A department for 6 years and worker directly with Wall Street analysts at all the big banks during that time as well as a bunch of consultants and Big 4 firms. This post will boil down my knowledge down for you.

Concept 1: Simple Cowboy Math

As much as you can read endless amounts of finance articles about finance and valuation (TONs of books on this topic) – in the real world decisions are often made off of gut and cowboy math. You are lying to yourself if you are a finance professional and disagree…. yes there are complicated models that advise (which are highly valuable) but the decision boils down to gut and cowboy math often as a risk decision is made at the time of investment: Am I going to get a return on this investment?

Cowboy math definition: Quick math to sanity check relative expectations to anything a sophisticated Wall Street analyst tells you to see if it makes sense. As best you can this math relates to what is known and what is being told to you. The sharper the finance guy or gal, typically the quicker and more relevant the cowboy math is – relevance being the key word.

I have seen cowboy math used in the boardroom and the used car lot. Before you dismiss that you do not know how to appropriately “value something” – if you can do some quick cowboy math it will help you immensely.

Concept 2: Relative or Comparable Value

Relative value of one asset or investment to another is a core valuation technique.

• Real estate: How much did a house with comparable statistics sell for to the house I am reviewing? Price per square foot is the common cowboy may metric utilized.
• Stocks: How much is a comparable stock in the same industry trading for? Enterprise Value divided by sales, Enterprise Value divided by EBITDA, and Earnings per Share are the most common. Enterprise Value equals the full value of the company to debt and equity holders – not just shares that are public (looooong post if I define this more formally). These cowboy math statistics are readily available on yahoo finance under statistics. Here is an example of Tesla and Ford…. Tesla’s worth 4.7x Revenue while Ford is worth 1.0x of Revenue. TSLA stock info on yahoo finance

• Bonds: How much yield does this bond have vs another? How much Duration does this bond have vs another? You typically need to search google for bond ETFs for this info if you are not with a brokerage firm… I typically search “ticker fact sheet” and get a good response. Here is an example for LQD (investment grade bond etf):

Concept 3: Discounted Cash Flow

if you have been around any finance people they often Day “a dollar today is worth more than a dollar tomorrow.” This is driven by the fact that if you had cash today you can likely grow it through a savings account or something more sophisticated. Or said another way – if you give me $10K today, I would have more than $10K a year from now so I would prefer the money now! If you give me a lump sum I am either paying down debt or Increasing My Passive Income Portfolio.

So where does this come into valuation? A rental property has a cash flow, a business has cash flow, etc….. so if we wanted to value any of those we would make an assumption on their cash flow from now until you believe the cash flow will go to zero and we would then DiSCOUNT those cash flows to today…. or discount the cash flow! You would discount that cash flow based on the return YOU want from the invest (eg 6% per year). Example of getting $2K over two years at 6% discount rate: $1K next year multiplied by 0.94 plus $1K the year after multiplied by 0.94 multiplied by 0.94 (twice because of two years) is equal to $1,823.60 today. The result? A valuation of what that cash flow or business or rental property etc is worth to you.

Once you have the present value you can compare that value to what you can buy or sell an investment for. Remember everyone’s perceived cash flow and discount rate is different which may result in different values…. in the financial world there are a lot of concepts like weighted average cost of capital (WACC) and risk premium calculations which I’ll blog about in future articles on how they relate to your finances.

Want to boil this down to a value of a stock? Take your valuation, subtract the debt the company owns, divide the value by the number of shares outstanding. Ta-Da – you have valued a stock.

Concept 4: The Football Field

Wallstreet guys are kind of cheesy and have been referring to a summary of valuations on one page as a “Football Field” for years. The chart does several useful things:

1. Puts everything on one page for decision making
2. Allows you to list out multiple valuation techniques so you can compare and contrast
3. Allows you to put a “range” on your valuations in a visual form. Ranges are typically driven by changing one or two small assumptions in the model… don’t forget about that cowboy math! Valuations are never exactly down to the penny. Example: Assume $2K over two years and a 5% return…. your value would be $1,852.50. So your range could be somewhere between $1,823.60 and $1,852.50.

Football Fields

Football fields can range in use:

1. Sensitivity analysis on DCF drivers… Sales, Operating Expense, Tax rates etc
2. Summary of all the valuation techniques used on one page
3. Return on investment sensitivities based on the different valuation techniques

Here is a link to google images where you can see a bunch of examples to get the idea: Google Images Search: Football Field Finance

In Conclusion

Valuation is basically the same two concepts above with finance professionals arguing over the inputs. How is this useful for you? That depends… what is most important when you start to invest is that you understand these concepts at a high level and not get intimated by finance professionals and at least understand what type of risk you are signing up for.

Tesla is a great example… everyone may think they are a great stock but from a valuation perspective you are paying up ALOT and the investment represent a lot of risk – almost all of the future cash flows of this business are more than several years out as they aren’t making any money as of the time of this post.

The same goes for any other investment or company “I have a $1M rental property portfolio” or a “$10M revenue business”…. yeah but are you making any cash flow? If not, the value of the company is all about when and if you can get it to positive cash flow.