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In the News: Stock Valuation
In
February 2015, Bloomberg reported that Tesla chairman and CEO Elon
Musk had indicated that Tesla’s market valuation would approach $700
billion in a decade, up from approximately $27 billion at the time.
Musk said, “Our market cap would be basically the same as Apple’s is
today.”
It's
not unusual for managers of publicly held firms to suggest that their
companies’ stocks are undervalued, but it is rare for them to make
precise projections about the future valuation of their firms’ equity.
After all, a firm’s stock price is not entirely within a company’s
control. Investor sentiment, competition, and the regulatory
environment are just some of the factors affecting a stock’s
valuation.
In
this article, we take a closer look at a key topic in the Claritas
course of study—stock valuation (Module 4, Investment Instruments)—to
understand how investors can evaluate investment opportunities. For
example, valuation helps investors uncover underpriced or overpriced
securities, and an enterprising investor will take advantage of these
mispricings.
Approaches to Stock Valuation
There are three basic approaches to the valuation of common stock:
discounted cash flow valuation, relative valuation, and asset-based
valuation.
Discounted Cash Flow Valuation
The discounted cash flow (DCF) approach takes into account the time
value of money.
It estimates the value of a security as the present value of all
future cash flows—that is, dividends and the proceeds from
selling—that the investor expects to receive from the security.
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The DCF valuation approach relies on an analysis of the unique
characteristics of the company issuing the shares, such as the
company’s ability to generate earnings, the expected growth rate
of earnings, and the level of risk associated with the company’s
business. |
An Example of Discounted Cash Flow Valuation
On 1
January 2015, an investor expects Volkswagen to generate dividends of
€4.00 per share at the end of 2015, €4.20 per share at the end of
2016, and €4.50 per share at the end of 2017. The investor also
estimates that the stock price of Volkswagen will trade at €150.00 per
share at the end of 2017. The investor considers the risks associated
with the investment and concludes that a discount rate (the rate used
to calculate the present value of some future amount) of 14% is
appropriate.
The
investor computes the present value of the expected cash flows as
follows:
The
investor’s estimated value of Volkswagen on a per share basis is
€111.02. If the shares of Volkswagen are priced at less than €111.02
on 1 January 2015, the investor may conclude that the stock is
undervalued and decide to buy it. Alternatively, if the stock trades
at more than €111.02, the investor may conclude that the stock is
overvalued.
Relative
Valuation
The
relative valuation approach estimates the value of a common share as
the multiple of some measure, such as earnings per share (EPS) or
revenue per share.
The multiple is determined based on price and the relevant measure for
publicly traded, comparable equity securities.
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The key assumption of the relative valuation approach is that
common shares of companies with similar risk and return
characteristics should have similar values. |
An
Example of Relative Valuation
An
investor is estimating the value of an airline’s common stock on a per
share basis. The airline in question generates annual EPS of €2.00 and
exhibits risk and return characteristics that are in line with the
industry average. The investor finds that the average
price-to-earnings multiple, or P/E, for the industry is 9. Using
relative valuation, the investor estimates that the value of the
airline’s stock, on a per share basis, is €18.00 (= €2.00 x 9).
Asset-Based Valuation
The
asset-based valuation approach estimates the value of common stock by
calculating a company’s net asset value, which is the difference
between the value of a company’s total assets and its outstanding
liabilities.
The asset-based valuation approach implicitly assumes that the company
is liquidated, sells all its assets, and then pays off all its
liabilities. The residual value after paying off all liabilities is
the value to shareholders.
It is
important to note that some asset values on the balance sheet are
based on historical cost (the cost when they were purchased), and the
actual market value of these assets may be very different. For
instance, the value of land on a company’s balance sheet, typically
carried at historical cost, may be quite different from its current
market value. As a result, using asset values taken directly from the
balance sheet may provide a misleading estimate. To improve the
accuracy of the value estimate, current market values should be
estimated instead.
Also,
some assets, including some internally developed intangible assets,
such as a brand or reputation, may not be included on the balance
sheet because of financial reporting rules. Thus, it is important when
using asset-based valuation to estimate reasonable values for all of a
company’s assets, which can be very challenging to do.
Bottom
Line: Stock Valuation
Valuing common shares is an imprecise science and different valuation
methodologies can yield different results. Nevertheless, valuation
should be considered a foundational component of the investment
decision-making process. It is the process by which investors can make
a reasoned determination about whether Tesla will be able to duplicate
Apple’s success and warrant a market capitalization of $700 billion.
© 2015 CFA Institute. All
Rights Reserved. |