Investing basics: the art and science of valuing stocks – pt.2

In last weeks' article we learnt about how investors can use a fair value estimate to see beyond a stock’s present market price and determine what a company is really worth. Morningstar analysts use a discounted cash flow model to predict a company's future prospects and form the basis of this fair value estimate. 

We explored the first component of the model – estimating future cash flow by predicting a company’s growth and profits. AKA the 'art' of valuing stocks. But now we get to the 'science'.  

Step 1 - Discounting cash flows 

Once analysts estimate the future cash flows they anticipate a company to generate, they have to discount them back to the present day to account for the time value of money. 

Why? Because a dollar tomorrow is worth less than a dollar today, Morningstar direct of equity research Adam Fleck says. 

"If you have $100 today and you put it in a bank account, and it earned 2 per cent a year, you would have $102 dollars one year from now. In 2 years it will become $104.04; 3 years $106.12, and so on.” he explains. “But if we flip that, $122 dollars 10 years from now, is worth $100 dollars today, at a 2 per cent per annum interest rate." 

Step 2 - Determine a discount rate

So, how do analysts determine the discount rate? Morningstar analysts use a weighted average cost of capital, or WACC, to determine the rate at which to discount a company's future cash flows back to the present. A company's WAAC accounts for both the firm's cost of equity and its cost of debt. 

The cost of debt is relatively straightforward: It's the interest rate a company must pay to borrow money, based on the current yield on any of the bonds the company has issued. Just as a person with an excellent credit rating can borrow from banks at lower rates than someone who has missed payments in the past, financially strong and stable companies can borrow at lower rates than riskier firms. 

The cost of equity is a little more complicated, but Morningstar analysts have adopted a simplified methodology. For companies with a primary business is in Australia, they assign a cost of equity of 7.5 per cent, 9.0 per cent, 11.0 per cent, or 13.5 per cent depending on a company's level of systematic risk.

Let's go back to the A2 Milk (ASX: A2M) example we used in part one. 

Morningstar analysts view the company as an average risk company and have estimated a 9 per cent cost of equity. Then, they added 1 per cent due to the company’s exposure to China upping risk. Currently A2 Milk has no debt, meaning there is no need to include a borrowing rate in the WACC calculation.  

Step 3 - Discount the projected free cash flows to the present 

So now that we have our discount rate of 10 per cent, we can discount the projected free cash flows to the present. This is where the maths comes in. 

Here's the basic formula for discounted cash flows:

For A2 Milk, it will look like this: 

Then we calculate the 'discount factor' every year by dividing the free cash flow projected for that year by the discount factor.  

For example, in 2018, Morningstar analysts have projected A2 Milk's free cash flow to be NZ$285,363 in 2019. Discounted: 

Then, analysts add up the resulting numbers to get the present value of those cash flows of NZ$3.7 billion, and divide that figures by the number of shares outstanding for A2. This results in almost $5 per share.

A2 Milk free cash flow projections 

Source: Morningstar Australia estimates, A2 Milk company filing  

But wait, that doesn't seem right…the stock is currently trading at almost $10. What are we missing?

Step 4 - Calculate the terminal value and discount it to the present 

The last piece of the puzzle is the terminal value – also known as the perpetuity value.

Fleck says this step is necessary because companies exist much longer than 10 years, and analysts need to account for all the cash earned for all those years. However, he says it's not feasible to project a company's future cash flows out to infinity, year by year.  

To solve this problem, Fleck estimate’s a company's future cash flows for a certain period, and then estimate’s the value of all cash flows after that in one lump sum. 

The equation looks a bit technical, but it’s really quite simple:

FCFn = Free Cash Flow in the final year of the model 

g = Long Term Growth Rate 

WACC = Weighted Average Cost of Capital 

For A2 Milk: 

But we're not done yet. Fleck reminds us the terminal value is calculated at the end of the model. To find out what the value is today, Fleck says we must discount back to today.  

Therefore, the present value of our Tv is:

Step 5 - Final valuation

You've made it to the end. Congratulations! That wasn't easy. While discounted cash flow method is certainly a complicated way to value stocks, there are many benefits that come with the increased effort. 

If you didn't understand certain aspects, don't worry, you don't need to. Morningstar analysts provide you with a final valuation – their fair value estimate – which does all the hard work for you.

To reach the final valuation, Fleck and his team take 10 years of free cash flow forecasts, discounted to today plus terminal value, discounted to today minus net debt and other adjustments divided by share count equals fair value estimate. 

For A2 Milk: 

As equity holders, any debt the company has would not belong to us, Fleck notes. Therefore, need to remove that from the calculation. 

Additionally, the model didn't include any cash or other holdings A2 has today – only that generated in the future. "That’s what the third line is doing – removing debt, adding cash, and adding the firm’s holding in Synlait, another New Zealand stock," Fleck says.  

From there, we divide the equity value by the number of shares outstanding, to get our fair value/share. Et voila!

More in this series

• Investing basics: how to buy a managed fund

• Investing basics: which financial news matters?

• Investing Basics: How to build and invest your emergency fund

Emma Rapaport is a reporter with Morningstar Australia, based in Sydney.

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