Valuation is very important aspect in stock investing, as u must understand how much an asset is worth before purchasing it. As Buffet says, "Price is what you pay, value is what you get."
There is currently more than 10 methods to value a business.
However, the best valuation formula in the world is Discounted Cash Flow method.
Why this method?
- When you value a business, you are finding out how much cash flow can the business produce for you between now and judgement day, and you discount it back to its Present Value using a appropriate discount rate.
- "Earnings" "EPS" "Net Income" are all inaccurate. All this metrics are manipulated to include things like depreciation and unrealized capital gains, which actually does not affect the actual earnings of the company.
- Cash Flow is the best way to understand whether the business is bringing in any residual income after minusing capital and labour costing.
Discounted Cash Flow (DCF) Formula is attached below in the pictures.
You will have to input the figures as required, and u will be able to calculate how much a business is worth.
I have also attached Cash Flow formula so that u can input it into the formula.
The hardest part in this formula, is the discount rate.
Now what is a discount rate?
In this context of DCF analysis, the discount rate refers to the interest rate used to determine the present value. For example, $100 invested today in a savings scheme that offers a 10% interest rate will grow to $110. In other words, $110 (future value) when discounted by the rate of 10% is worth $100 (present value) as of today.
If one knows—or can reasonably predict—all such future cash flows (like the future value of $110), then, using a particular discount rate, the present value of such an investment can be obtained.
What Is the Right Discount Rate to Use?
What is the appropriate discount rate to use for an investment or a business project? While investing in standard assets, like treasury bonds, the risk-free rate of return is often used as the discount rate.
On the other hand, if a business is assessing the viability of a potential project, the weighted average cost of capital (WACC) may be used as a discount rate. This is the average cost the company pays for capital from borrowing or selling equity.
In either case, the net present value of all cash flows should be positive if the investment or project is to get the green light.
To simplify it for you, most investors would use 6-12% as their discount rate. The higher the discount rate, the lower the expected valuation of a stock. If u think the an investment is risky, you may use a higher discount rate. However, if you think that it is a stable company with consistent cash flow, u may use a lower discount rate.
For your information, $Berkshire Hathaway(BRK.B)$ uses a 3% discount rate to value a business/ stock before buying them. This leaves them not much room for error and a small error will be fatal for their business.
To summarize all of it, before you buy a stock, try using the formula to find out the stock's intrinsic value.
If it is undervalued, it is a good buy. If its overvalued, it is not worth to pay for it.
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