How to value a stock audio

The main idea of this information is about valuing stocks using the net present value of cash flows (NPV). NPV applies the concept that a dollar today is worth more than a dollar in the future because money can be invested and earn a return. Analysts estimate a company's earnings and discount future cash flows to determine the current value of the stock. Assumptions and the choice of discount rate can affect the accuracy of the valuation. The example of AutoZone is given to illustrate this process. The analyst's understanding of the business and correct assumptions are crucial in estimating the company's valuation. The NPV model alone cannot determine this. Every day the financial news is full of stories about stock prices rising or falling as news regarding the company, industry or economy is released. But what drives these valuations and how can an investor decide what is the best way to value a stock? Well there are several different ways to value a stock such as the price earnings or the price to book ratio or comparing the valuation to that of other similar companies. But probably the most widely used method and in my opinion the best way to understand a company is the net present value of cash flows or NPV. To understand this idea let's take a step back. Owning a stock means owning a share of a company and consequently if the company makes a profit then the stockholder will get a share. This figure is widely reported in the financial press as the earnings per share or EPS. It's simply the earnings of the company divided by the number of shares issued. Now EPS is a bit different from cash flows but it's a good proxy especially when we are forecasting out to five years which is usually a good time scale for valuing a company. And it's also a big help to the analyst that historic and forecast EPS figures are all widely available. Okay so how can we make a stock valuation using the NPV? Well at its core NPV applies the time value of money and uses the mathematical formula. That's interesting but we can largely ignore this financial jargon. However if you are interested in these aspects and the mathematical formula in particular then you can find a good summary on Wikipedia. A link is provided in the comments below. However for our purposes I would prefer to keep it simple. NPV is actually a straightforward concept. A dollar today is worth more than a dollar tomorrow. Why? Because money available now can be invested and earn a return. Let's look at an example. Imagine you have the option to receive one dollar now or one dollar in a year. Choosing the money now is beneficial because you could invest that one dollar in a savings account with a let's say generous five percent annual interest rate. In one year you'd have one dollar five cents and in five years you would have nearly one dollar twenty eight cents. Alternatively using exactly the same concept we have to say that one dollar in the future is worth less today. We need to divide it by this potential return. We need to adjust the future amount or using the jargon we need to discount these future cash flows. That means one dollar in one year is worth ninety five cents today and a dollar in five years would be worth just seventy five cents. We can use this method to value all future cash flows not just for stocks. Bonds pay interest coupons every quarter or every six months with a large lump sum of principal coming due at maturity. Loans are a little different. They often pay down principal in installments throughout the life of the loan. All of these cash flows need to be discounted and the size, timing and discount rate will all affect the current value. But stocks are completely different. A stock doesn't pay scheduled principal or interest payments. A stockholder just owns a share of the profits if there are any. So analysts have to estimate what the earnings are going to be. Five years is usually the maximum period that an analyst can reasonably have a chance of forecasting but the value of the equity is based on cash flows into the distant future so analysts typically assume a conservative constant growth rate thereafter. Now professional analysts and diligent investors will want to complete a full analysis of revenue growth, costs both fixed and variable and possible changes in margins. However many analysts may prefer a quick back of the envelope estimation. You don't have to be a qualified accountant. We're not producing the annual report using international accounting standards but it is worth giving this stage a lot of consideration. It is these assumptions that will determine the accuracy and usefulness of the valuation. Another thing you will have to consider is what discount rate should be used to discount cash flows. This can be as complex or as simple as you like and is based on the risk of the stock or its correlation with the market as a whole. William Sharpe won the Nobel Prize for his capital asset pricing model on a related subject that is very interesting and I would recommend reading all about it but for our immediate purpose I prefer to just use the historical average which is around 9 or 10 percent. Okay that's the theory. We have to estimate the company's cash flows for five years. Estimate a terminal value and discount the cash flows back to the present. Let's take an example making clear that this is not a recommendation to buy or sell. That stocks are not suitable investments for everybody and that stocks can go down as well as up. Let's take a fairly standard company that is generating profits with a reasonably positive outlook. Let's look at AutoZone. As of April 2024 AutoZone is a leading retailer and distributor of automotive replacement parts and accessories operating over 6,000 stores across the United States, Mexico and Brazil. The company targets DIY customers and professional mechanics and garages offering a wide selection of products including batteries, brakes and engine parts as well as maintenance items such as oil, antifreeze, fluids, filters, wiper blades and accessories like car mats and seat covers. Customer service is key and AutoZone is known for its expert advice and commitment to providing vehicle owners and service providers with high quality products. The stock price has trebled over the past five years as the company has seen earnings double and revenues increase by 50%. EPS estimates for the year to August are $153 and forecast EPS growth for the next five years is 11.6% compared to 22.1% for the past five. Putting that into our discount model assuming a discount rate of 10% we take earnings per share of $146 for the past trailing 12 months. These are forecast to grow 11.6% to $163 next year and to $252.74 in year five. We need to adjust the final value using a terminal value. We could assume the asset is sold using a historic PE multiple for the stock market or estimate it by using a calculator such as this one which divides one by the discount rate minus a conservative estimated growth rate. Well now we have to make a choice. The average historic PE of the S&P for quite a long period has been around 20 and it's even higher over the past year or two. Alternatively using the terminal growth calculator we get 14.3. I prefer to be conservative. The recent high PE of the stock market in my opinion is more applicable for fast growing tech companies than an auto parts retailer. And some say the current stock market valuation is overvalued. But accepting it's a conservative assumption I am going to go with the lower 14.3 times multiple so finally we need to discount all of these numbers and sum up to get the net present value. That gives us a $3,105 compared to the recent $2,950 market price. That looks pretty close and considering the conservative multiple we have just applied along with the conservative future growth assumption of just 11% compared to the actual historic growth rate of 22%. The stock may well warrant further investigation. The assumptions we have used do make a difference. It is worth looking at the sensitivity of the valuation under different scenarios. For example if we did decide that the higher 20 times terminal multiple was valid or that growth is likely to continue at 22% or that both these upsides were valid then the new stock value would become respectively $3,890 or $4,583 or even $5,808. Of course if you think that electric cars are more reliable and will require less maintenance then AutoZone's revenues could end up collapsing in the near future. That is why it is the analyst's understanding of the business and correct assumptions that will result in a good or bad estimate of the company's valuation. The NPV model by itself cannot do that.