I have seen many type of quantitative valuation methods in my short investing experience.
- Ones that break down CAPEX, EBIT, EBITDA, Tax Rate, R&D etc. each line projected in the future then they compute FCF to Firm, NPV etc. the excel sheet is longer than a PhD thesis.
- Others (the ones you find on the net easily) tend to use FCF from Cash Flow with 3 estimates of growth (bear, base and bull cases). They average the 3, discount it by 12%-15% and call it a day.
- Then there are those that do DCF, DDM, EPV, NetNet, all kind of valuation Technics and average them all, add 25% MOS and call it a day.
- Others prefers historical relative valuations, they take something like P/FCF or EV/EBITDA or EV/EBIT and take the average or median as a stick ward to where the stock trade at.
- Then of course we have the pure-form relative valuation folks, take your best valuation metrics P/E P/S P/B, project the denominator in the future then factor the price.
- Finally we have the charts folks.
My concerns with these approaches – Please note I am not a pro in fact I do believe I know next to nothing on this topic but still my opinions:
- The more break down and the more projects, the more room for error. Additionally a lot of line items often have different ways of being calculated depending on what is reported on the statements.
- I tend to like this approach better. It is simpler and equal weights all possible cases. Now all possible cases might be wrong, so go figure that out.
- That’s just silly. It is like adding water in salt to dilute it, just that you don’t know how much water you are actually adding.
- Intuitively I feel this makes for some interesting metrics especially for stable growth companies where one doesn’t expect a huge upside. Bubble or under-price detector?
- Just a shortcut/proxy to 2). The challenge is having the right forecast and the right denominator for that company.
- Stock prices are a random walk in the short term.
An additional method I have started to explore more and more is the use of IRR to my NPV calculation. IRR also assumes some Net Income growth but like with 2) I usually add some bear. base, bull cases and generate a sensitivity matrix.
My conclusion: For a while I was seeking precision and ended up creating excel sheets over excel sheets. Each time I would add a new model, complex formula projections etc. and couldn’t get to a conclusion whether to invest or not. These days I tend to simplify things on the quantitative side to the following:
- Does the stock have a great balance sheet?
- How is it trading to historical multiple? I use EV/EBITDA and P/FCF. Is it trading lower and higher? What’s my thesis why? Do I want to own this stock despite this variance.
- What’s the IRR assuming a pessimistic, base (GDP growth), bull (industry growth + GDP growth)? I generate a sensitivity matrix to establish if things go south how much loss am I looking at.
- Simple DCF using FCF to Firm using an 12% discount (Risk Premium + Inflation). I use the same method for IRR regarding FCF growth.
- I then look at the lowest price in the last 5 years and establish how much cash and how often and where I need to average down. I generate this in a matrix in excel. This forces me to plan future cash and plan to buy at lows if the stock gets to that point. No chickening out if the price drops.
- Am I ready to own this stock for at least the next 3 years?
If all ticks, I set up a bunch of limit orders, to the price that I want and the prices I want to average down if it ever comes to it. I would revisit outstanding limit orders depending on cash available or new opportunities.
Simply put: I shifted from precision to how wrong I might be and If i am wrong what upside do I still get by buying further down.
One thing I haven’t codified yet is averaging up. I tend to not buy upward to my cost basis yet I see the pros tend to do this a lot with money influx. If someone has some hints on that, please share. Additionally I would love to hear what your quantitative approach is or how do you build conviction to your first limit order.
Disclaimer: Consult your financial professional before making any investment decision.