Valuation
We will take 2 real examples here:
- General Electric
- Tesla (2015–2016)
In the case of Generic Electric, you will find Value investors that would like to get a dividend yield and buy stuff that’s relatively cheap. Value investors possess many characteristics of contrarians — they don’t follow the herd. Not only do they reject the efficient-market hypothesis, but when everyone else is buying, they’re often selling or standing back. When everyone else is selling, they’re buying or holding. Value investors don’t buy trendy stocks (because they’re typically overpriced). Instead, they invest in companies that aren’t household names if the financials check out. They also take a second look at stocks that are household names when those stocks’ prices have plummeted, believing such companies can recover from setbacks if their fundamentals remain strong and their products and services still have quality.
Value investors only care about a stock’s intrinsic value. They think about buying a stock for what it actually is: a percentage of ownership in a company. They want to own companies that they know have sound principles and sound financials, regardless of what everyone else is saying or doing. The quintessential example of a value investor is Warren Buffet.
On the other hand, you will find many Growth Investors in Tesla. They love companies that are growing fast and they don’t want the company to be very profitable today because they want to grow, they wanted to hire a lot of salespeople to grow the revenue quickly and they can be profitable one day many years from now like Amazon.
Growth investing is an investment style and strategy that is focused on increasing an investor’s capital. Growth investors typically invest in growth stocks — that is, young or small companies whose earnings are expected to increase at an above-average rate compared to their industry sector or the overall market.
Growth investing is highly attractive to many investors because buying stock in emerging companies can provide impressive returns if the companies are successful. However, such companies are untried, and thus often pose a fairly high risk.
Honourable Mention: Microsoft for years has been a growth investor but gradually it came to the value side.
There are 3 methodologies for the purpose of valuation:
# Price/Revenue Ratio or Price-to-Sales Ratio
Basically, this is calculated for the companies which don’t have earnings. This is actually a really great option for a growth investor for valuing unprofitable firms. This formula can also be used to compare 2 similar firms. The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company’s market capitalization (the number of outstanding shares multiplied by the share price) and divide it by the company’s total sales or revenue over the past 12 months. The lower the P/S ratio, the more attractive the investment. Price-to-sales provides a useful measure for sizing up stocks.
# Price/Earnings Ratio
P/E Ratio= Market value per share / Earnings per share
- The price-earnings ratio (P/E ratio) relates a company’s share price to its earnings per share.
- A high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future.
- Companies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator.
- Both Growth and Value Investors use P/E ratio for an effective analysis.
#Discounted Cash Flow
- Discounted cash flow (DCF) helps determine the value of an investment based on its future cash flows.
- The present value of expected future cash flows is arrived at by using a discount rate to calculate the discounted cash flow (DCF).
- If the discounted cash flow (DCF) is above the current cost of the investment, the opportunity could result in positive returns.
- Companies typically use the weighted average cost of capital for the discount rate, as it takes into consideration the rate of return expected by shareholders.
- The DCF has limitations, primarily that it relies on estimations on future cash flows, which could prove to be inaccurate.
Value investors love to use DCF as it’s all about what the future is worth now.
Finally, we decide a target price which is basically the average of the aforementioned ratios.
Target price = V= (P/R + DCF + P/E)/3
Since these ratios are not completely correct, averaging can normalize the margin to an error.
