What do investors use to value a stock? discounted cash flow or trading multiples?

Question

I am from Corporate Finance and I would want to understand which metrics buy-side investors use in order to choose a stock they would want to invest in? Do investors value companies by using DCF or market multiples? How much discount (in percentage) do investors require to say that a stock is undervalued?

Answer 1

The approaches vary. But it is safe to say that many buy-siders have dispensed with valuation altogether in favor of screening. Benjamin Graham, for example, recomended to buy stocks that meet all of the following criteria:

E/P > 2 x AAA corporate bond yield
P/E < 40% of the average P/E for all stocks over the last 5 years
Dividend Yield > 2/3 x AAA corporate bond yield
Price < 2/3 of Tangible Book Value [See Note 1]
Price < 2/3 of Net Current Asset Value (NCAV) [See Note 2]
Debt to Equity Ratio (Book Value) < 1
Current Assets > 2 x Current Liabilities
Debt < 2 x Net Current Assets
Historical Growth in EPS (over last 10 years) > 7%
No more than two years of declining earnings over the previous ten years

Note 1. Tangible Book Value is computed by subtracting the value of intangible assets such as goodwill from the total book value.
Note 2. Net Current Asset Value (NCAV) is defined as liquid current assets including cash minus current liabilities.

Other investors use their own screens. Joel Greenblatt, for example, recommends the following approach:

1. Define your target universe.
2. Rank all stocks in your target universe by return on capital (the highest return gets rank 1, the second-highest, 2, and so on).
3. Rank all stocks in your target universe by earnings yield (the highest yield gets rank 1, the second-highest, 2, and so on).
4. Add two ranks together for each stock.
5. Buy stocks with the highest combined rank.

Answer 2

1

Answer 3

Both can be used. However, generally individual investors buying shares would use multiple like PE or PEG. Some one looking to buy the business in its entirety would more likely use DCF techniques.Main reason being requirement of data for DCF is more and the business buyer can influence the out come with "what if" situations, which a small shareholder can not.

Answer 4

It really depends on the stock and the market that they are in. Some use DCF others with multiples. A general rule is that if the company has solid management and good financials people want to invest in it. Another way is that if you look at their market semiconductors as an example, some people will look at the difference in their multiples and try to figure out why there is a difference. What you're asking is really complicated and I hope this helps a little.

Answer 5

Personally I use a variant of the DCF model (with an estimate of future S&P 500 performance as the discounting mechanism) and hunt for stocks that trade at at least a 30% discount to their intrinsic value. Of course I have a relatively long term investing time horizon which is often necessary for the intrinsic value and market value of a stock to align.

I also pay attention to a stock's Return on equity, and it's cash position (I like companies with a lot of cash and no debt.) And of course you need to go and actually evaluate the business prospects of the company itself before you buy in, and check to make sure that there have been no one time events that make the company appear more attractive than it actually is. (Take a glance at OFIX to see what I mean.)

Of course this is just what I do. Good luck.

Answer 6

looking at PE is the best way to pick the right stock, suppose you buy some banking stocks , which generally tade at PE of less than 10, than averaging at lower level is the best strategy to invest, for e.g.
u buy a stock at 65(pe 8) and again buy it at 60(pe7.5) than at 55 ( 6.87)
now downside chance is 30% at this level
u can start booking profit at regular intervel
buying stocks at higher PE is risky at averaging