How To Value A Company
- Posted by Leigh Drogen
- on June 1st, 2012
I received an email yesterday from someone in the social finance community who I’ve seen around for quite some time. He asked a pretty straight up question, no frills, he asks:
“You have stated several times that you dont use DFC models and such in order to determine the value of a company. Since you are running Estimize, wouldn’t it be appropriate if you opened up to some transparency and blogged about the actual input in your stock analysis.”
I’m not sure where the connection to Estimize comes in, as we don’t derive valuations on the site based on the data shared, but we’ll skip that. The question of how I personally value a company is a good one.
So here’s the really simple answer, I don’t.
I was indoctrinated very early on, and still believe to this day, that the equity of a company is worth exactly what it’s trading at today. There is no way to “value a company” besides looking at exactly what the market cap is right now. That’s your value.
A lot of people philisophically disagree with that, and a very small portion of those people even make a great deal of money investing based on the fact that what I just said is wrong. A very small portion.
That’s my philosophical view, which definitely filters down into how I think about the practical decisions of buying and selling equities. But there is obviously a lot more nuance than that, so here’s the longer version.
The person states that I don’t use DCF models to value a company. This isn’t completely accurate. DCF modeling is just one model, amongst MANY, which produces a value connected to a specific formula. For anyone, or any web site (you know who you guys are) to say that this is how a company should be valued is ridiculous to say the least. In certain cases, running a DCF model can give you great insight into how the market is thinking about a company versus some historical norms in that pricing model. And sometimes, you can make a lot of money by playing mean reversion within that model.
Again, it has nothing to do with DCF being “the way” or even “a way” to determine the value of a company, it is simply a formula that you can exploit to make money based on historical norms in that measure being far from their mean. It takes a lot of skill to execute this strategy, you can often get caught long in stocks like Research In Motion which are in secular decline, not just out of whack in the short term.
There are obviously many other fundamental valuation methodologies like price to earnings, price to sales, and price to book. Like DCF, these ratios are just statistical measures which can and should be reviewed for divergence from their mean.
So what specific inputs go into my equity analysis? The short answer is, a lot of them. I am an information freak, my advantage is that I synthesize information very well. I’m very good at boiling down a lot of data in my mind, many different view points, and understanding where the opportunities are. I have very few orthodoxies, momentum might be the only one.
Here’s the long answer. I really like to look at price to sales ratios for high growth companies in high growth sectors. I look for multiple expansion. This usually takes place when the market doesn’t quite understand the fundamental opportunity of a company or industry, and I believe it will become apparent in the near future. When that happens you often get multiple expansion, especially in companies growing revenue quickly, over 20% YOY.
If you trade growth stocks, most of your gains will always be from multiple expansion, not the underlying earnings of the company. Multiple expansion is what takes place in huge moves of 50%+. So the key is to find companies with low price to sales multiples, relative either to their history or their industry, where you believe either the growth of the company is going to accelerate significantly, or, the market is going to reprice the multiple.
A good example recently and a stock I’ve been extremely bullish on for quite some time is Whole Foods. Yes the company is growing quickly, by the multiple has expanded, even more rapidly than I expected. The market has repriced it for higher growth.
So that’s how I look at fundamental valuation. It’s not a matter of “what the company is really worth”, that’s a useless way of thinking, because it’s worth whatever it’s worth right now. The key is to understand where the fundamental metrics are headed, and how the view of the market, in terms of the multiples, will change based on your fundamental projections. Then you can set soft price targets, and manage risk around those targets.
It’s not rocket science, it really isn’t.
Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see the Disclaimer page for a full disclaimer.
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Leigh Drogen is the founder and chief investment officer of Surfview Capital, LLC, a New York based investment management firm employing an intermediate term long/short momentum strategy. More »
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