Putting a Pricetag on Stocks part 2

By | October 15, 2013

I have discussed how to put a pricetag on stocks on this article, and I now continue my discussion here. This is the third way of valuing stocks. Please note that there are so many ways to value stocks and not just these three. I simply hope to provide you with a few of the hundreds out there.

3. Free cash flows model

At the end of the day, it all boils down to the cash you are going to get. Hence, another way to value a company is to see how much cash it will generate in the future.

Valuing your money this way is as simple as getting all the future cash flows and dividing them with the number of stocks the company has. That’s the idea. Getting the number of stocks the company has is easy. You just have to check your online stock exchange. Getting the future cash flows is another matter altogether.

You will have to prepare a financial analysis for it. The more detailed (and therefore more difficult) it is, the more reliable your model would be.

The formula would look a lot like this:

  Net Income
plus/less Working capital changes
plus Non cash expenses (like depreciation)
less Capital expenditures
  Net cash flows

 

Let’s break it down.

Net Income is the net income the company has earned for the year.

Working capital changes is the change in your current assets and liabilities. Current assets are your cash, receivable, inventory, etc. Current liabilities are your accounts payable, accrued expenses etc. Working capital is current assets less current liabilities. The assumption with the working capital is that these are the operational needs of the company every year. Your current assets would be used to cover your annual operations and your current liabilities. It affects your cash flows because your income does not always translate to cash. For example, you get an income of $1,000, but all of these are receivables from customers – in which case you have no cash receipts. Or maybe you get an income of $1,000 and your payables increased by $500 – in which case the $500 disbursement has not been made and you have a net cash flow of $1,500.

The International Accounting Standards and tax regulations also expenditures that will benefit other periods should not be expensed on the year that the cash disbursement was made, but the expense should be distributed across the years the benefit will be experienced. Hence, capital expenditures are capitalized to property plant and equipment (PPE) and depreciated. The cash disbursement happened on the first year, but the depreciation affects your net income in other years. Hence, there is no related cash outflow for depreciation and this should be removed in your model.

Capital expenditures, as discussed above, do not necessarily affect your bottom line, but are cash outflows nonetheless. Hence, these should be included in the analysis.

This format should be performed for all the years that you expect the company to operate. The details of how these should be done will be discussed in another article. You can assume that there’s no growth nor change year after year, though. Then you will need to get the present value of all the cash flows the company will earn every year – and that is your future cash flows as discussed earlier.

Growing money does take time and effort, and you can see companies paying millions to have the valuation of their preferred stocks. The outline of what was discussed above is basically what those consultants who are paid millions do.

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