Fundamental Analysis Valuation?

[Intro]

I've been reading a lot about valuation of stocks to try and estimate a target share price for the future. Partly for my own knowledge in trading but also for a job interview I have coming up to be an equity analyst (trainee).

I'm a bit confused. I've read that P/E ratios are commonly used to value companies and EV/EBITDA more so, along with many others. How would I use this to forecast a target share price in future?

Secondly, another method I'm aware of is the discounted cash flow. When you arrive at a NPV of the future cash flows and terminal cash flow you figure out the equity value and divide it by the total number of outstanding shares to get the forecast share price (I think).

Which of the above would be most useful to calculate a target share price and how would you forecast future P/E ratios and EV/EBITDA?

Any help on this would be appreciated.

 

[cr6196]

1. You wouldn't use P/E ratio to directly value the company (don't forget you need to use per share earnings not total), P/E is a relative valuation technique. It is used most commonly to find undervalued securities within a group, sector or market.

So examples, if you had to value a private company you might look at the earnings per share, find a similar group of companies to see what multiple they are selling at and then apply this to the private company's EPS, so if it was earning $1 and similar companies were selling at a multiple of 2 then the company is conceivably worth $2 per share. Don't forget you would need to multiply it back out by the number of shares to get the total value.
The same logic applies with another public company. Keep in mind though it is a relative valuation, so it relies heavily on market values which could be badly skewed. EV/EBITA attempts to get around this somewhat by using Enterprise value...again though this is used in pretty much the same way.

2. What is more useful DCF or relative valuation? That is a very difficult question. DCF is sometimes hard to calculate, you have to estimate net income, capital expenditures, changes in working capital and net debt issuance sometimes for 10 years in advance. (Most sell side analysts don't use DCF as it takes more time, but using it will probably stop the biggest mistakes).

Personally, I used a 2stage 3 year DCF for a few weeks when i was learning but it is a massive headache to estimate all these figures. Another alternative is the Dividend Discount model btw. The main problem with using ratios is that they rely usually on some form of market valuation. You can estimate your own PE but this is honestly little better and a total mind****.

My solution is just to use a stable growth reverse DCF(only estimates growth and next years FCFE) and see what the market is valuing equity at, if you brought this up in an interview it might be impressive as it is a relatively new technique. If that hasn't answered anything just ask again or PM me.

The most important point to remember though is that P/E is a relative valuation and DCF gives you your own value for equity. I found that it didn't make sense until I did some myself.
Good luck

 

[Intro]

That's very helpful, thank you.

Where did you learn about doing a reverse DCF?

For the interview I'm expecting to be told to pitch a stock, my target share price and how I got there so I guess I'm trying to figure out how to do this.

I had looked at the Dividend Discount model but more as a back up to some other valuation techniques to sense check valuation.

 

[cr6196]

i didn't, i started doing it myself as i am pretty skeptical of forecasting so i decided to see what the market was estimating and then i found James Montier uses it (he wrote a textbook on behavioral investing and mentions it in there but he goes into detail in an interview online somewhere). Incidentally, he uses analyst estimates and does 10 years in his, i just use a stable growth DCF because i don't have access to the same level of information as he does.

I would think they are looking to see your reasoning, i.e how you get to your answer not what it is. I would add i'm at university in 2nd yr so i haven't applied but i am going to shortly for internships, i'm only applying to two though as every firm has a different approach, it makes a big difference if your applying for a sell side or buy side position.

There are only 2 real types of valuation: quantitative and qualitative. Quantitative is using stuff like DCF and P/E. Qualitative is stuff like management and industry trends. You have to include both and they are core to any valuation process.

The quantitative process is often quite personal, if you choose a certain method you will have to justify it. The differences in methods are often based on how comfortable you feel with making predictions, in my process I try to avoid this at all costs.

Qualitative analysis often relies on a base of assumptions that you have assumed will happen or are true to reach your valuation conclusion. Again you have to really think through this stuff and know what your assuming.

If you have a bit of time, I'd look at Damodaran "Investment valuation", its what I looked at. I can e-mail you a copy if you don't have it. The process is often personal though and I would imagine most people would put forward ideas based on qualitative industry trend projections, this is probably a mistake e.g people need computer stuff buy google. So if you just use strong reasoning and look at a few ideas as it will be obvious if you just looked at one and tried to skew your valuation, again something that most will probably do. Play to your strengths and make an independent, interesting valuation.

 

[Intro]

One of the issues is that often each bank (the role is sell side) uses quite specific valuation techniques and in an interview I'll be expected to provide a qualitative account for why the stock is a good un and back it up with some quantitative reasoning as to how i've arrived at my valuation. It's difficult to know what they'll be looking for in an answer but i'm almost certain that saying 'currently trading at $90 and I'd add a 10% premium based on my afore mentioned qualitative factors' wouldn't suffice.

The investment valuation book would be good, check your PMs.

 

[cr6196]

yeh agreed. You sound like you know what your doing there. I am not too sure of sell side myself but a well argued DCF sounds like it wouldn't go amiss, they will definitely appreciate that you put thought into it even if your off base. Fwiw i've found that you can make projections but qualitative arguments always make or break valuations...sort of like you can't polish a turd...an example might be something like HMV, Game Group or Bloomsbury, they are all valued around or under book value i.e their quantitatively cheap but the industry trends probablly aren't with them

Good luck