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Investing basics: the art and science of valuing stocks – pt.1

Emma Rapaport  |  02 Nov 2018Text size  Decrease  Increase  |  
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"Increasing challenges reduce ANZ Bank's fair value estimate" 

"Wisetech's fair value estimate increased to $6.60" 

"Ramsay remains undervalued following fair value estimate cut" 

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…

 

A2 Milk Annual Report

 …to here? 

A2 Milk Fair Value Estimate

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." 

via GIPHY

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. 

Iceberg

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

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

A2 Milk Historical Margin Growth

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 buy a managed fund

• Investing basics: which financial news matters?

• Investing Basics: How to build and invest your emergency fund


Emma Rapaport is a reporter with Morningstar Australia, based in Sydney.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is an editor for Morningstar.com.au

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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