So, what to do? Well, we like companies whose DCF-derived per-share intrinsic value estimate is higher than their share price. What does this mean? Well, the P/E ratio itself isn't going to help you much in making a good decision based on valuation. One stock with a 15x P/E is cheap, while the other stock with a 15x P/E is expensive. Same multiple of 15x, but a completely different meaning behind it. In this other case, the stock would be considered expensive, even with a price-observed P/E ratio of 10 (which is below the market average)! Or, the DCF might say that a company should trade at 10x earnings on the basis of its unique cash-based characteristics, while it is trading at 15x. In this case, the stock would be considered cheap. The DCF might say that a company should trade at 30x-40x earnings on the basis of its unique cash-based characteristics, while the stock may only be trading at 15x. By adding the net cash on a company's balance sheet to the present value of its future expected enterprise free cash flows and then dividing that sum by shares outstanding, one arrives at the DCF-derived value of a company on a per-share basis.Ĭomparing this DCF-derived per-share intrinsic value estimate with the share price then provides an indication of whether a company's shares are overpriced or underpriced. In most cases, almost every qualitative measure converges into these two cash-based sources -meaning that you could have an opinion about the company's strategy, its management team, a new product launch, and the list goes on and on, but everything must (eventually) find its way into the discounted cash-flow model through these cash-based sources. ![]() The market buys and sells (and sets the price) based on an estimate of the company's value, and a company's intrinsic value is derived primarily by its cash-based sources, which are net cash on the balance sheet and future expected traditional free cash flow, as defined by net cash from operations less all capital spending. There's a tangible reason, for example, why a company like Apple has a market cap in the trillions of dollars while other stocks may be penny stocks. Apple's Robust Cash-Based Sources of Intrinsic Value Let's see how this concept comes into play with Apple Inc. The cash-based sources of intrinsic value within the discounted cash flow process are the key determinants behind a company's P/E ratio, and some companies should have a high P/E ratio while other companies should have a low P/E ratio. The takeaway is to be very cautious making any decision based solely on the level of P/E ratios or other valuation multiples. The CFA Institute blog published a recent article on this topic here. What matters is what the value-derived P/E ratio (the DCF-derived value per share divided by earnings per share) should be in relation to the price-observed P/E ratio on the market, not whether the price-observed P/E ratio, itself, is high or low. On the other hand, if a company has a huge net debt position, pays hefty outlays in terms of dividends relative to free cash flow, and is experiencing organic growth headwinds, a P/E multiple of 10x might actually be expensive for that stock (even as it is trading below the average market multiple). For example, if the company has a huge net cash position and tremendous future free cash flow potential, the company might be fairly valued at 30x-40x this year's earnings and cheap at 15x. its share price divided by earnings per share is 15) could be cheap or it could be expensive. ![]() For example, a stock that has a price-observed P/E ratio of 15x (i.e. This may be slightly different than you might be used to with respect to valuation multiple analysis, where one might buy a stock because its multiple looks low relative to peers or relative to history, or something else.īut there's a lot of problems with just looking at the valuation multiple of a company. CatLane/iStock Unreleased via Getty Imagesĭo you believe that stock prices actually mean something? We do.Īs part of our stock-selection process, we build a discounted cash-flow ("DCF") valuation model where we estimate the intrinsic value per share of companies.
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