First, let’s just have a small chat about cryptocurrency. As you may know, crypto asset values have crashed like the Titanic, losing US$2 trillion from its peak. ‘Why is that?’ you may ask. There’s a very simple answer: People have no idea what they are buying.
To better understand this, let’s work through an example using a humble plate of chicken rice (Singapore’s beloved national dish). You all know that a plate of chicken rice should costs around $4. But how do you actually know that? That’s because you know the general cost of the ingredients that goes into a plate of chicken rice.
However, what if I try to sell a plate of chicken rice to you for $400? You would obviously think that I am crazy as you know what the price should be. So, in order to relate this to crypto — why is one Bitcoin worth US$30,000 or why should it be worth US$1? Can you answer that?
You can’t. The simple reason is because there is nothing tangible about Bitcoin to allow you to gauge a price, so you will have no idea what the actual price of Bitcoin should be!
The notion of value
You see the funny thing is that I am not attempting to teach something that you do not already know. It is called value.
Now let us do the same virtual walk into the ‘equity supermarket’ located on Wall Street — the Dow Jones Industrial Index. Here, oftentimes, logic and common sense seem to be left on the sidewalks of Wall Street. Suddenly we forget the notion of value and begin buying chicken rice for $400.
Let’s say the current traded price of Company A is $1 and Company B is $100. Now, you would think that why would I pay $100 for a stock when there’s another one on the market for $1. But what if I told you that the intrinsic value of Company A is 10 cents, while the intrinsic value of Company B is $1,000. Now, it is obvious that you would want to buy Company B as it’s worth more than the price that you are buying it at.
How do you get ‘intrinsic value’?
So enough with the mental games and chicken rice. Now it is time to get real. Let’s go into the technicalities into how the experts calculate what the true value of the share price is.
For starters and a gentle reminder, the price of a share traded in the stock market is just the price that investors are willing to pay for that one share at any given moment. However, wouldn’t it be great to know what the intrinsic value is before you purchase that one share?
Two common methods used to calculate intrinsic value are ‘discounted cash flow’ (DCF) and ‘price-to-cash-flow’ (P/CF).
1. Discounted cash flow
The first method, DCF, discounts an asset’s projected future free cash flows to its present value. Sounds confusing? Fret not! Let’s just leave it at that then. If you’re interested, you can do a quick Google search and get a good working knowledge of DCF.
Using one particular DCF model, Alphabet’s intrinsic value is $98.33 per share. Hence, at the current price of around $86, you are buying Alphabet with a possible upside of 12% (not bad). Keep in mind though that DCF models require a number of assumptions for growth and discount rates.
The second method is the price-to-cash-flow ratio. Do not get confused with the other widely used valuation metric, the price-to-earnings ratio. They share similarities but I like to use P/CF ratio more than the P/E ratio as actual cash received cannot be as easily manipulated as earnings (creative accounting magic!).
Regardless, the P/CF ratio is a great and much easier way to value a business over a DCF model. Now, Alphabet has an average P/CF multiple of 17.9 over the past 10 years (chart below).
Hence, it would be reasonable to say that if you are buying Alphabet at a multiple lower than 17.9, you’re getting a bargain. But if you buy Alphabet at a multiple higher than 18.2, then you’re just overpaying.
Right now, Alphabet is trading at 12.4 times operating cash flow. So, make of that what you will (wink wink).
The fifth perspective
Hence, back to my original question: What determines a cheap or expensive stock depends on the value of what you are buying! Regardless, as with all valuation models, they are just one piece of the puzzle. You don’t buy a stock simply because it’s cheap; there are myriad other factors to consider before you place a stock in your portfolio:
- Do you understand a company’s business model?
- What are its long-term competitive advantages?
- Are you comfortable with the risks the company has?
- Does the stock fit your investment goals and risk profile?
- And much more…
Remember, being a shareholder is akin to being a part-owner of a business. And as an owner, you only want to own high-quality businesses at reasonable valuations. With valuations coming, is now the time to start looking around? You decide!