Valuation
What a company is worth and why. These are the concepts behind any serious attempt to answer whether a stock is expensive or cheap.
Discounted cash flow (DCF)
Discounted cash flow (DCF) is a valuation method that works out what a company is worth today from the money it is expected to generate in the future. Each future cash flow is divided by a discount factor reflecting risk and the passage of time, and the sum of them all is the value of the business. Its strength is that it forces every assumption into the open; its limit is that the result depends entirely on them.
Value = Σ FCF₍ₜ₎ ÷ (1 + WACC)ᵗ + terminal value See also: WACC · FCF · terminal value Three-stage DCF
A three-stage DCF is a discounted cash flow that splits the future into three stretches with different growth rates: a few years of explicit projection, a transition phase in which growth fades gradually, and a final phase of stable growth in perpetuity. It avoids the common error of projecting today's growth forever, which is what most inflates the valuation of fast-growing companies.
See also: DCF · terminal value WACC (weighted average cost of capital)
WACC is the average cost of financing a company, weighing what it pays on its debt and what its shareholders demand according to the share of each. In a DCF valuation it is the rate at which future cash flows are discounted: the higher the WACC, the lower the present value of the business. A one-point change in WACC can move a valuation by more than 15%.
WACC = (E÷V)·Re + (D÷V)·Rd·(1 − t) See also: CAPM · ROIC CAPM (capital asset pricing model)
CAPM is the model that estimates the return a shareholder should demand from a stock. It starts from the return on a risk-free asset, usually the sovereign bond, and adds a premium proportional to that stock's market risk, measured by its beta. It is the standard way of working out the cost of equity that then feeds into the WACC.
Re = Rf + β · (Rm − Rf) See also: beta · WACC Beta
Beta measures how much a stock moves relative to the market as a whole. A beta of 1 means the stock tends to move in line with the index; above 1 it amplifies both rises and falls; below 1 it dampens them. It is the parameter that translates market risk in the CAPM, and it is computed from historical data, so it describes the past rather than promising the future.
See also: CAPM · volatility Terminal value
Terminal value is the part of a DCF valuation that captures everything the company will generate beyond the last projected year. It is usually computed assuming constant, modest growth in perpetuity, never above the growth of the economy itself. In practice it often accounts for more than half of total value, so its assumptions deserve the same scrutiny as the year-by-year projections.
VT = FCF₍ₙ₎ · (1 + g) ÷ (WACC − g) See also: DCF · WACC Mid-year convention
The mid-year convention is a technical DCF adjustment that assumes cash flows arrive spread across the year rather than all at once on 31 December. Discounting them from the middle of the year instead of the end corrects a bias that would otherwise undervalue the company systematically. The effect is small but consistent, which is why it is standard practice in professional valuation.
See also: DCF Margin of safety
The margin of safety is the gap between the value a valuation assigns to a company and the price it trades at. Buying with a margin of safety means paying below the estimated value, so that an error in the assumptions does not automatically turn into a loss. It is the explicit acknowledgement that every valuation is an estimate, not a measurement.
See also: DCF · P/E Fundamentals
The figures that come out of the annual accounts and describe how the business is actually doing, regardless of what the share price is up to.
Free cash flow (FCF)
Free cash flow (FCF) is the money left over after a company pays its operating expenses and the investment needed to keep the business running. It is the cash actually available to repay debt, pay dividends or buy back shares, and it is the figure discounted in a DCF. Unlike accounting profit, it is hard to dress up.
FCF = operating cash flow − CapEx See also: DCF · EBITDA EBITDA
EBITDA is a company's profit before interest, taxes, depreciation and amortisation. It helps compare the operating profitability of companies with different financing or tax structures, but it deliberately ignores the cost of replacing assets, so it is not the same as cash generated. In capital-intensive businesses the gap between EBITDA and free cash flow is enormous.
See also: FCF · EV/EBITDA Enterprise value (EV)
Enterprise value (EV) is what it would cost to buy a company outright: its market capitalisation plus the debt taken on, minus the cash it already holds. Unlike market cap, EV does not depend on how the company is financed, which makes it possible to compare two firms in the same sector even if one carries heavy debt and the other none.
EV = market cap + debt − cash See also: market cap · net debt EV/EBITDA
EV/EBITDA shows how many times annual operating profit you pay to buy the whole company. It is the preferred multiple for comparing companies with very different debt levels, because both numerator and denominator sit before the effects of financing. It only means something against peers in the same sector: what is expensive in retail is cheap in software.
See also: EV · P/E P/E ratio (price-to-earnings)
The P/E ratio shows how many times annual earnings per share the market is paying for a stock. A P/E of 20 means you pay 20 years of current earnings. It is useful for comparing companies in the same sector and against their own history, but it stops meaning anything when the company is loss-making, and a low P/E usually signals a problem rather than a bargain.
P/E = price per share ÷ earnings per share See also: EV/EBITDA · margin of safety ROE (return on equity)
ROE measures how much profit a company generates for every euro put in by its shareholders. A high, sustained ROE points to a business that reinvests successfully, but it should be read alongside leverage: debt can inflate ROE without improving the underlying business at all, because it shrinks the equity sitting in the denominator.
ROE = net income ÷ shareholders’ equity See also: ROIC · net debt ROIC (return on invested capital)
ROIC measures the return a company earns on all the capital it employs, whether it comes from shareholders or lenders. Set against the WACC, it answers the decisive question of whether the company creates or destroys value: it only creates value when ROIC sustainably exceeds its cost of capital. For many investors it is the single best indicator of business quality.
ROIC = NOPAT ÷ invested capital See also: WACC · ROE Operating margin
Operating margin is the percentage of sales left as profit after operating costs, before interest and taxes. It measures the efficiency of the business itself, and its trend over the years says more about a company's health than its absolute level in any single year: a margin that narrows year after year is a warning sign even while it stays high.
Operating margin = operating profit ÷ revenue See also: EBITDA Net debt
Net debt is a company's total financial debt minus its cash and equivalents. It reflects real leverage: a company with a lot of debt but also a lot of cash is less leveraged than it looks. It is usually read divided by EBITDA, to gauge how many years of operating profit it would take to clear it; above three times, room for manoeuvre narrows.
Net debt = total financial debt − cash See also: EV · EBITDA Dividend yield
Dividend yield is the annual dividend a share pays divided by its price. It expresses the cash return a shareholder receives at the current price. An unusually high yield is usually the result of a falling price rather than a rising dividend, and deserves checking before it is read as a good sign.
Yield = annual dividend ÷ price See also: payout Payout ratio
The payout ratio is the percentage of profit a company distributes as dividends. A low payout leaves room to reinvest and to sustain the dividend through bad years; one close to or above 100% means the company is paying out everything it earns, or more, leaving the dividend exposed to any drop in results.
Payout = dividends ÷ net income See also: dividend yield Risk
How much can be lost, and how likely that is. These are the measures that turn an uncomfortable hunch into a number you can work with.
Volatility
Volatility measures how sharply an asset's price swings around its trend, and is usually expressed as the annualised standard deviation of its returns. It is the most widely used risk measure, though it has a known flaw: it treats sharp rises exactly like falls, and only the latter keep investors awake.
See also: beta · Sharpe ratio VaR (value at risk)
VaR estimates the maximum loss a portfolio should not exceed over a given horizon at a given confidence level. A 5% one-day VaR of 3% means that on 95 days out of 100 the daily loss would stay below 3%. Its limitation is obvious and famous: it says nothing whatsoever about how much can be lost on the other five days.
See also: CVaR · Monte Carlo CVaR (expected shortfall)
CVaR, also known as expected shortfall, answers exactly what VaR leaves out: the average loss across the worst scenarios, those beyond the VaR threshold. That makes it a better description of tail risk and generally the more prudent measure. If VaR tells you where the bad day starts, CVaR tells you how bad it is on average.
See also: VaR · maximum drawdown Maximum drawdown
Maximum drawdown is the largest cumulative fall from a peak to the subsequent trough over a period. It measures the worst blow suffered by someone who bought at exactly the wrong moment, and it is the figure that best predicts whether an investor can stick with a strategy: a portfolio with a 50% drawdown needs a 100% rise just to get back to where it started.
See also: CVaR · backtesting Monte Carlo simulation
A Monte Carlo simulation generates thousands of possible paths for a portfolio, each with random returns consistent with its historical volatility and correlations. Instead of a single answer it returns a distribution of outcomes with their probabilities, which lets you talk about scenarios rather than predictions. It is only as good as the assumptions feeding it.
See also: VaR · correlation Correlation
Correlation measures, between −1 and +1, how far two assets move together. Near +1 they rise and fall in step; near −1 they offset each other; near 0 they are independent. It is the basis of diversification, with one important caveat: in a crisis correlations tend to shoot towards 1, precisely when you most needed them not to.
See also: efficient frontier · Monte Carlo Sharpe ratio
The Sharpe ratio divides the return earned above the risk-free asset by the volatility taken on to get it. It answers how much was gained per unit of risk borne, and allows comparison between strategies that would make no sense judged on raw return alone: making 20% through constant lurches is not the same as making 12% without them.
Sharpe = (Rp − Rf) ÷ σp See also: volatility Efficient frontier
The efficient frontier is the set of portfolios offering the highest expected return for each level of risk. Any portfolio below that frontier can be improved: there is another combination of the same assets that returns more without taking on more risk, or takes less risk for the same return. It is the central idea of modern portfolio theory.
See also: correlation · Sharpe ratio Market and tools
Everyday vocabulary: how a listed company is sized up, and what the tools used to analyse it are called.
Market capitalisation
Market capitalisation is the market value of all a company's shares: the share price multiplied by the number of shares outstanding. It is the standard measure of a company's size and determines whether it counts as large, mid or small cap, which in turn shapes its liquidity and its presence in indices.
Market cap = price × shares outstanding See also: EV · free float Free float
Free float is the portion of a company's capital that trades freely on the market, excluding control stakes that are never sold. A small free float means less liquidity and sharper price moves in response to modest orders, something worth bearing in mind before taking a large position in a small company.
See also: market cap Screener
A screener is a filter that runs across a broad universe of securities and returns only those meeting the criteria you set, such as a P/E range, a minimum ROIC or a particular sector. It takes you from thousands of possibilities to a shortlist worth researching properly. It is a tool for ruling things out, not for deciding.
See also: P/E · ROIC Backtesting
Backtesting means running a strategy over historical data to see how it would have performed. It is useful for discarding ideas that never worked, but a good past result guarantees nothing: the main risk is fitting the strategy so tightly to history that it stops working outside it. Backtest results are simulated, never actual returns.
See also: maximum drawdown · disclaimer Insider transactions
Insider transactions are the purchases and sales of shares made by executives and board members in their own company, which must be disclosed publicly to the regulator. Purchases tend to read as a sign of confidence, since nobody knows the business better; sales admit many explanations unrelated to it, from taxes to personal liquidity, and so tell you far less.
See also: analyst consensus Analyst consensus
Analyst consensus is the average of the estimates and recommendations published by the research houses covering a stock, usually on future earnings and a price target. It is a reference point for market expectations, not a reliable forecast: its usefulness lies more in the reaction when results miss it than in how often it is right.
See also: P/E