Capital Markets / Investor Relations in Two Minutes or Less
Valuation Considerations Part 2
Valuation work serves as the foundation for the purchase price or basis in a stock.
Selecting the right variables and inputs can make or break your future return.
There are two variables to consider regarding valuation.
Two Primary Variables of Valuation
1. Time Frame / Horizon
2. Valuation Metrics
Our last video focused on Time Frame / Horizon. Today, we focus on valuation metrics.
Three Types of Valuation Methods
1. Discounted Cash Flow (DCF)
2. Relative Valuation
3. Other Metrics – Rule of 40 / 50
An investor can apply a DCF to any industry, but the analysis can get quite complex and suffers from uncertainty around several variables.
Therefore, our focus will be on the easiest method for stock valuation: Relative Valuation.
Relative Valuation involves calculating a common valuation ratio for a company and its peers and then comparing the results to determine over / under valuations.
Primary Relative Valuation Metrics
1. EV / Sales
2. EV / EBITDA
3. EV / FCF
Other Key Contenders
1. P/E Ratio
2. P/B Ratio
Remember, each industry typically has a preferred metric among these five.
Determining Over / Under Valuation
The best practice involves calculating each of the five metrics above and doing two things:
1. Taking the average of the five valuations
2. Creating a range of values
Knowing how current price compares to these calculations informs whether more work needs to occur to understand the valuation implications.
The ultimate goal of equity valuation is to
1. Develop a range of possible values
2. Avoid a point value carried to several decimal points!
Unlike technology, Five 9s of uptime represents a bad thing in valuation. Precision is the enemy as it can create paralysis and result in loss of capital!
Other Metrics – The Rule of 40 / 50
What Is the Rule of 40 / 50?
The Rule of method provides valuable insights into the health of the business, and is driven by how aggressive one's growth expectations are.
The equation looks at annual sales growth plus a profit margin, some examples:
Annual Sales Growth Rate + Adj. EBITDA Margin = 40 / 50
Annual Sales Growth Rate + FCF Margin = 40 / 50
Annual Sales Growth Rate + (Cash from OPS – CAPEX) = 40 / 50
What the Rule of 40 / 50 Means for Executives
1. Balance: The business should be exhibiting similar outcomes on sales and profitability
2. Business Strategy: If the business is over-levered to sales or profitability, the analysis implies you need to reinvest in the underperforming lever
Key Learnings
1. Know Your Time Frame and Proper Metric
2. Understand Relative Valuation
3. Valuation Is About Ranges
4. The Rule of Provides a lot of insights on your business!
