Investing basics: the art and science of valuing stocks – pt.1
Morningstar analysts’ fair value estimate for stocks helps investors see beyond the present market price and determine what a company is really worth.
Mentioned: The a2 Milk Co Ltd (A2M)
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Morningstar analysts’ fair value estimate for stocks helps investors see beyond the present market price and determine what a company is really worth.
But have you ever wondered how Morningstar analysts get from here…
…to here?
Source: Morningstar Australia
Morningstar director of equity research Adam Fleck says it's not about putting lots of lines on a chart or deriving meaning from the tea leaves.
Fleck says there's a both an art, and a science to valuing stocks. An art in deeply understanding the company, the product, the customers and the competitive landscape, and a science in being able to marry those understandings with the financial statements.
Ultimately, Morningstar analysts believe a company's intrinsic worth is linked to the future cash flows it can generate.
Why cash flows?
"Because cash is king," Fleck says. "Cash is what is actually coming in and out of the company that the management can do things with. And free cash flow is what's used to do things that interest investors such as paying dividends, paying down debt, or buying back stock."
Make sense? If not, don't worry. In this article we're going to explore how Morningstar equity analysts value stocks using listed milk and infant formula company A2 Milk (ASX: A2M) as an example.
What is a fair value estimate?
It's early Saturday morning. You roll up to an auction, ready to bid a hot piece of Sydney real estate. The auctioneer stands out front, gavel in hand, and soon a small crowd begins to form – some there the buy, but most just to watch.
He starts the bidding at the price guide, $600,000, but soon the other bidders get excited, paddles are flying, tension builds, and suddenly the price is up – $850,000, $860,000, $865,000.
The auctioneer points at you – "sir/madam are you going to make a bid?"
The calculation you have to make next is one which takes into consideration a variety of factors. Ultimately you must rise above the heat of the auction to establish how much you think the property is actually worth, thinking about location, quality of the neighbourhood, future value, whether there's space to extend the bathroom...
Buying a stock is a similar process. On a digital exchange, millions of stocks trade every day, and the price of each stock will move depending on current popularity and the market's whims. An investor must determine a stock's fair value, or intrinsic value, before they decide to buy. It's no easy task.
At Morningstar, equity analysts do this for you, calculating what they think the long-term intrinsic value of a stock is, helping you see beyond the present market price. Analysts believe that over time, the share price will reflect the intrinsic value of the underlying business.
Uncovering a company's fair value
Forecasting is hard. But a good analyst who has spent years getting to know an industry well, can use informed assumptions and technical analysis to successfully predict a company's future revenue and growth prospects.
Morningstar analysts use a valuation method known as a discounted cash flow, or DCF. The key behind a DCF model is relatively simple: a stock's worth is equal to the present value of all its estimated future cash flows, minus an appropriate discount rate.
Step 1 – Estimating future cash flows
Future cash flows refer to how much cash the analyst believes the company is going to generate in the future after spending the money necessary to keep the company growing at its current rate. Many variables go into estimating those cash flows, but among the most important are the company's future sales growth and future profit margins.
Predicting growth
Predicting a company's future revenue needs detective work. Beyond the company's top line revenue figures, analysts will consider a variety of additional factors including:
- customer base
- product quality
- industry trends,
- economic data, and
- a company's competitive advantages
For example, let's look at A2 Milk's historical revenue growth:
A2 Milk historical revenue growth
Source: a2Milk company filings
Looking at that strong revenue growth over the past five years, you might be tempted to think: wow, it's accelerating each year, 80 per cent might be next.
But this is unlikely to get you to the correct figure, Fleck says. "The potential pitfalls of only looking at revenue is you don't know exactly what's driving that revenue, and it's hard to make an assumption when you don't know the component parts."
Instead, Fleck breaks up A2's revenue, looking deeply into geography – where A2's product is consumed, where it's sold, the type of products each market consumes, gathers insights into the volume growth of infant formula, the price growth of the infant formula market, and movements in A2's market share. He then uses these estimations to predict how much A2's revenue will grow, on average, for the next ten years.
Predicting profits margins
Determining a company's future operating profits also needs creative thought. For A2 Milk, historical EBIT margins– earnings before interest and tax – look great:
A2 Milk historical EBIT and margins
Source: a2Milk company filings
But just like revenue, Fleck says investors have to be cautious about extrapolating the past into the future.
"You could be tempted to look at the past couple years and conclude that the company can again lift margins by 5 per cent in 2019. But this would be too optimistic," he warns.
Again – he'll need to dig deeper, looking to A2's competitors to determine the current margins for infant formula, and estimate how much larger margins can get.
Once an analyst estimates the cash flows they expect the company to generate in the future, they have to discount those future cash flows back to the present to account for the time value of money.
Next week: Step 2 – Discounting future cash flows
More in this series
• 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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