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08/05/2015

How to Select the Optimal Valuation Method to Build Better Price Targets (Part 2 of 3)


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Pros & Cons SmallIn my prior post I discussed the importance of identifying the optimal valuation method, which includes researching the valuation method used by most other equity analysts who cover the sector and stock being researched.

In this entry, I delve into the pros and cons of the most popular valuation methods. To ensure I wasn’t missing one of the more popular valuation methods, I researched the topic and came across two studies, one from the U.S. and one from the U.K. Given that buy-side analysts don’t publish their reports, these studies relied entirely on sell-side analysts and therefore they may not be representative of buy-side analyst’s work. The studies were conducted independent of one another and therefore shouldn’t be viewed comparatively. Instead, they provide an idea of the top 5 valuation methods used by equity research analysts in their respective markets. Having been based in London for part of my career, I can verify DCF is more extensively used in Europe than in the U.S.

US

US

Source: Information Content of Equity Analyst Reports, Paul Asquith, Michael B. Mikhail, Andrea S. Au, 2004

 

UK

UK

The Use of Valuation Models by U.K. Investment Analysts. The European Accounting Review, Imam, Barker, & Chubb, 2008

Callout: If you don’t know the shortcomings of your favored valuation method, take the time to learn it or suffer the risk of a bad stock call

Just because a valuation method is widely used does that make it the best? Not necessarily, but as noted in my last entry, don’t rely on a less-used valuation method as the sole basis for a stock recommendation unless you think the market will come around to your thinking (or it yields an insight that will become apparent to those using the more commonly-accepted valuation method).

There are shortcomings to every valuation method and so none can be held up as the “best.” With that said, the closer we get to applying a multiple to the company’s free cash flows, the more likely we’ll get an accurate valuation. Here are the benefits and limitations of the most popular valuation methods:

Method

Benefits

Limitations

All Multiple-based methods below (P/E, PEG, P/S, P/B)

  • Relatively simple and quick to perform
  • Multiple may not be computed in the same manner by all market participants, namely, the underlying financial data can be trailingforward, or current year
  • Rarely includes financial forecasts beyond the next 18 months
  • Unlike DCF, a company’s expected growth rate and risk are not explicit inputs to the valuation (except for the “G” in the PEG ratio), making it difficult to compare companies on these dimensions

P/E

  • Understood by all because it’s the most commonly used valuation method
  •  Company management has more flexibility to manipulate earnings than cash flow
  • Does not capture cash available to shareholders

PEG

  • Incorporates earnings growth rate (preferably over multiple future periods), which makes comparisons among companies and, potentially across sectors, more plausible (but not perfect)
  •  Earnings growth is not the same as the more important free cash flow growth
  • No widely-accepted method to compute the growth rate (next 12-months, 2-years, 3-years?)
  • If using consensus estimates, may be difficult to find reliable long-term growth forecasts

P/FCF

  • Incorporates free cash flow, which is the best measure of value
  • Unlike DCF, it considers only one time period of free cash flow
  • Methodology can vary for reasons mentioned above as well as in estimating level of capital expenditures (maintenance vs. forecast)

P/S

  • Can be helpful if there are no earnings or cash flow
  • Sales do not equate to free cash flow, which is the true measure of value

P/B

  • For a select industries where assets can be valued using a public-market price, may be a good proxy for measuring a firm’s equity value
  • For most sectors, book value rarely equates to the company’s market value of equity
  • Book value can be subjectively influenced by interpretation of accounting rules, which can make comparisons between companies meaningless

Dividend yield

  • Can be helpful to measure a floor when stocks collapse
  • Dividends are not the same as free cash flow, although they often move in tandem
  • Difficult to forecast when management will cut a dividend

DCF and RI

  • Capture a company’s ability to generate free cash flow over the life of the enterprise, which is the best measure of value
  • Helps to place the focus on the level and returns from incremental capital spending (ROIC)
  • More likely to identify overheated and oversold stocks and markets than multiples-based methods
  • Can be highly sensitive to minor input changes for factors difficult to quantify, such as the equity risk premium and terminal growth rate
  • More time consuming because multiple periods are required for forecast
  • Complex models are prone to mistakes and offer more opportunities to reverse engineer a value
  • At times of highly-priced equity markets, methods may be challenged to find any attractive equity investments
  • Added complexity when comparing companies across borders due to measuring various sovereign “risk-free” rates

This is the second in a three-part post on valuation. In my last entry, I’ll provide a flow chart for selecting the optimal valuation method(s). 

AnalystSolutions has developed a workshop to help analysts create more accurate price targets which covers the “T” of TIER™: Apply Practical Valuation Techniques for More Accurate Price Targets 

This Best Practices Bulletin™ targets activity #3, “Make Accurate Stock Recommendations” within our GAMMA PI™ framework.

©AnalystSolutions LLC All rights reserved. James J. Valentine, CFA is author of Best Practices for Equity Research Analysts, founder of AnalystSolutions and was a top-ranked equity research analyst for ten consecutive years.

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