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Investing Basics: How Do You Value a Company? Part II

“Whether we’re talking about socks or stocks, I like buying quality merchandise, when it is marked down.” -Warren Buffett

Just like any purchase we make, we should be looking to buy a stock when it is below its intrinsic value. However, how do we find out the intrinsic value of a company? In this article, the second of my series on valuations, I will be looking at three valuation methods that investors can use to value a stock. In the first, I took a look at price-to-book, price-to-earnings and price-to-sales ratios.

Discounted cash flow model

The discounted cash flow (DCF) model is a method of valuing a company based on its future cash flows. In this method of valuation, investors need to estimate the future cash flow over the next five year period and then estimate a terminal value to account for all the cash flows beyond the forecast period.

Admittedly, this method of valuation can be a tedious affair and requires multiple assumptions, both on free cash flow and the discount rate. But if we plug in conservative estimates, the DCF model gives investors an idea of a conservative value of the company. Fellow Fool, Chong Ser Jing, wrote an in-depth article on the DCF model here.

Price-to-free cash flow

The price-to-free cash flow (PFCF) is another useful method of valuing a company. This method is useful for companies that are not yet profitable but are generating free cash flows from their businesses.

Mathematically, the free cash flow of the company can be calculated by subtracting the company’s capital expenditures from its operating cash flow. Free cash flows measures a company’s ability to generate cash, which can be used to reinvest in the company, pay dividends or make acquisitions, among other things.

When we divide the company’s market cap by its free cash flow, we get the PFCF. Like the price-to-earnings multiple, there is no hard and fast rule as to what price-to-free cash flow multiple each company should command. It depends on earnings growth potential, debt, return on equity, management and outlook. However, the PFCF multiple can be useful when we compare the PFCF of similar companies or compare the company’s current PFCF multiple with historical data.

Distribution or dividend yield

Lastly, the dividend or distribution yield is a measure of the income that is earned through dividends against the price that we pay for a stock or REIT. This is especially important for companies or REITs that have a stable dividend policy.

REITs, for instance, are required to pay out at least 90% of their distributable income to unitholders and hence, the distribution yield is a useful metric to see if they are good investments.

However, it is also important to take note that a high yield may not always be a good thing. Investors need to take into account whether the dividend or distribution paid out is sustainable in the future. This can be done by looking at earnings potential, dividend payout ratios and free cash flows of the company or REIT.

The Foolish bottom line

The three metrics shared above are useful ways to value a stock or a REIT. However, each of them have their limitations.

The DCF method requires multiple assumptions, which can skew the final valuation estimate, while the PFCF method can be very volatile if a company’s capital expenditures are inconsistent. The dividend yield can also be skewed if companies give out additional dividends during a year or are paying out unsustainably high dividends. As such, investors should ensure they are familiar with each valuation technique and when they should be using them.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned.