Pricing A Stock

The analysts of www.rationalinvesting.com describe how they determine the true value of a stock.

by Manish Aurora
of rationalinvesting.com

The aim of this exercise is to reasonably project the Free Cash Flow (FCF) of a firm and discount it to the present on a per share basis resulting in the stock's Present Value. Free Cash Flow is the cash income or outflow of a firm, including capital expenditures required but ignoring non-cash charges. Please take a look at the accompanying spreadsheet. We place drivers of risk at the top left, and the resulting values to the right.

The 10 Year Treasury Yield, the price at which the US government borrows money for 10 years, is currently 6.5%. This price drives interest rates across the economy and around the world.

Historical Returns of Stocks Above Treasuries are assumed to be 5.5%. This number is higher for small caps but we keep it uniform and play with the beta to tune risk further. This means that investors require a 12% annual return to compensate for the risk in investing in stocks as opposed to government debt.

Beta is the correlation of a stock's returns with a proxy of the entire market (such as the Russell 2000 index). It defines the risk of the stock as the ratio of its monthly volatility to that of the index. Tech stocks are generally far more volatile than the broad indexes. However, we cap our Beta at 2. The reason is a substantial amount of day-to-day volatility in Internet stocks is a recent phenomenon and its effect on long term risk is very unclear. 2 is a very high beta, and reflects immaturity or bankruptcy risk priced into a firm. Betas below one (stocks less risky than the overall market) generally belong to REIT's and utilities and pharmaceuticals that do not move in tandem with indexes.

Growth Retention
This is the change of the growth rate from year to year. For the mathematically inclined, this is the second derivative of revenue. Using a fixed number allows us to project (a slowdown in) growth without making any judgment calls. The current year's estimate may be altered based on news or management statements, but future years are always a mathematical function of past growth. Such retention is typically north of 50% and less than 90%. This methodology is an innovation of www.rationalinvesting.com .

Terminal Growth is driven by growth rate retention but can be entered explicitly. It is the long term growth rate assumed in the model to price the stock. This should be in a band around nominal GDP growth (currently 5.5%). We allow for higher than GDP terminal growth for the very rapidly growing firms, but rarely into double digits.

We then focus on the Terminal Cost Structure of the firm, trying to see where comparable firms are and what the most likely scenario of costs is going forward for that firm and that industry sector. All costs and capital expenditures are projected as a percentage of revenues. The question we ask ourselves is "What sort of returns would attract investment into this sector? What sort of margins can this business sustain?" For a product that requires several years of negative cash flow to create and has continuing high branding costs, a 20% margin seems reasonable. The second question is "What sort of cost structure is required to continue to grow this firm? Which expenditures drive revenue? What capital expenditure will be required to sustain infrastructure?" And we ignore non-cash costs except one.

The non-cash cost we pay attention to is equity issuance. Most Internet firms are raising cash by selling stock. They are also paying employees in equity, because they are unable to offer the stability of larger firms. So a projection of equity issuance is an important variable. We usually project retention of share issuance at half the retention of revenue growth.

The resulting difference between revenue and cash costs gives us the FCF of the firm going forward. When the FCF and the terminal value of the firm are divided by the projected number of shares outstanding and discounted using Treasury + 5.5% * Beta, we get the Present Value of the stock. (Treasury+5.5% is the interest rate necessary to compensate investors for investing in stocks. We multiply this by Beta, the risk of this particular stock, to arrive at the total annual return any investor will expect in the particular stock being analyzed.)

The terminal value is calculated using the formula for a growing annuity. In the case of a high growth firm bleeding cash, terminal value represents the majority of the value of the stock, making it, contrary to current Wall Street opinion, rather sensitive to interest rates.

This modeling exercise can yield many surprises and has helped validate (or destroy!!) a lot of business models.

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