Stock Valuation Model

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Stock Valuation Model for

Sales per year, $ mln			Number of shares outstanding, mln
Average cost of sales, % of sales			Initial discount rate, %
Current adjusted sales growth rate, % per year
Terminal sales growth rate (in 25 years), % per year			Fair value, $ per share
Sales growth rate decline per yer, %			Market price, $ per share (as of )
Real cost of stock options, $ mln			Upside (downside) potential, %

Sales Forecast, $ mln

Net Income Forecast, $ mln

Sales Growth Forecast, %

Free Cash Flow Forecast, $ mln


Valuation Ratios
P/E Ratio
Price to Sales
Price to Book
Price to Tangible Book
Price to Cash Flow
Price to Free Cash Flow

Growth Rates
Sales Growth Rate
Sales - 3 Yr. Growth Rate
EPS Growth Rate
EPS - 3 Yr. Growth Rate
Capital Spending Gr. Rate
Cap. Spend. - 3 Yr. Gr. Rate

Financial Strength
Quick Ratio
Current Ratio
LT Debt to Equity
Total Debt to Equity
Interest Coverage

Managem't Effectiveness
Return On Assets
Ret/ On Assets - 3 Yr. Avg.
Return On Total Capital
Ret/ On T. Cap. - 3 Yr. Avg.
Return On Equity
Return On Equity - 3 Yr. Avg.
Asset Turnover

Profitability Ratios
Gross Margin
Gross Margin - 3 Yr. Avg.
EBITDA Margin
EBITDA Margin - 3 Yr. Avg.
Operating Margin
Oper. Margin - 3 Yr. Avg.
Pre-Tax Margin
Pre-Tax Margin - 3 Yr. Avg.
Net Profit Margin
Net Profit Margin - 3 Yr. Avg.
Effective Tax Rate
Eff/ Tax Rate - 3 Yr. Avg.
Payout Ratio

Stock Valuation Model Fundamentals

We believe that any company has its intrinsic value, which we also call fair value (FV). This value is determined by fair value of its net assets and future cash-generating ability. Fair value calculation is not a precise science, as the ultimate test of any valuation model, the market price now and in the future, is inherently unpredictable. Therefore, there are many valuation models out there. Vast majority of them is totally useless in predicting future market price of a company’s equity (or stock value) as they do not incorporate all major economic relations affecting fair value of an asset.
A good model is always based on profound understanding key “drivers” determining valuation of a particular asset. For equity valuation, we believe that there are five key factors determining fair value of any company:

                1.   revenue growth and profitability prospects (long-term growth and profitability forecast);
                2.   internal capital effectiveness (annualized rate of return on new invested capital);
                3.   real cost of stock options employee compensation;
                4.   net value of equity minus goodwill;
                5.   financial leverage (measure of risk); and
                6.   current and expected future interest rate environment.

In our valuation model we place specific emphasis on projecting revenue. Revenue growth of a company is the best gauge of demand for the company’s products and/or services and, therefore, the main factor determining long-term prospects of the company’s business. Projections about future revenue growth rates are based primarily on analysis of historical revenue growth rates and reasonable assumptions about their changes in the future. Historical data should be adjusted for acquisitions to determine organic growth rates.
Once fair value of equity is determined, it is compared with current market price of equity to assess investment attractiveness of a particular company (stock). It should be noted, however, that interpreting results of any stock valuation model is an art in itself. The resulting fair value estimate in absolute terms is very dependent on assumptions about performance of the company and economic environment: the result only is good as good are underlying assumptions. However, even you are skeptical about assumptions, you can still benefit from a model as it can provide an investor with relative over- or under-valuation of different companies.

Revenue Growth and Profitability

Revenues or sales of a company are determined by just two factors: 1) demand for the company’s products and services and 2) ability of the company to meet this demand. Normally, growing revenues are indicative of strong business fundamentals. However, the picture is distorted by introduction of new products and acquisitions/divestitures.
        Ideally, revenue growth of each product and service should be analyzed separately. Unfortunately, in most cases this is not possible based on publicly available information. Therefore, for analysis of historical revenue growth data, we devised a mechanism which indirectly measures the effect of “non-organic growth factors” and allows making necessary adjustments for the purpose of revenue growth forecasting. This mechanism is based on measuring what we define as “production capital” and “production base.” These are, respectively, a measurement of capital and a measurement of fixed/intangible assets involved in production of goods or provision of services.
        After revenue growth, profitability is the second most important factor in forecasting future financial performance of a company. If for established companies operating in mature stable markets forecasting profitability is quite easy (it is assumed to be basically the same or slightly lower then it is currently), for companies operating in rapidly growing or declining markets it becomes a major undertaking.
        The uniqueness of our approach is in forecasting separately fixed and variable operating expenses. It allows us successfully apply the same valuation model for the widest possible range of companies, including loss-making start-ups.

Internal Capital Effectiveness

We measure internal capital effectiveness by estimating annualized rate of return on new invested capital (RRNIC).. RRNIC in principle is similar (but not identical) to return on incremental invested capital (ROIIC) used by some companies, notably by McDonald’s Corporation. In our opinion, RRNIC is the best measure available for measuring company management’s effectiveness.
Compared with the cost of capital (weighted-average of cost of borrowed funds or interest on loans and implied cost of equity for the company), it is also the best indication of whether the company creates or destroys shareholders’ value: the value is created if RRNIC exceeds the cost of capital, otherwise it is destroyed.

Cost of Stock Options

All companies are currently required to expense costs associated with stock options grants to employees. The value of option grants is calculated using permitted fair value methods, primarily the Black-Scholes options valuation model. We believe, however, that in assessing financial performance of a company, this practice is of little practical value as its results are almost guaranteed to differ greatly from the actual future costs.
In our model, on the other hand, we account for real cost of stock options employee compensation which for any given reporting period we define as the difference between the market price of the company’s stock when options were exercises and their exercise price multiplied by the number of shares. Basically, this is a difference between what the company could have received by selling the stares at a stock exchange and what it actually received. We believe that this difference is a very real and immediate cost to the company.
The real cost of stock options employee compensation for many companies greatly exceeds its income-statement cost and is one of the prime factors in equity valuation. Net income adjusted for this cost shows true performance of a company from the point of view of shareholders. For many companies such adjusted performance is miserable.

Net Value of Equity minus Goodwill

We use the net value of equity minus goodwill (NVEMGW) as a proxy for the fair value of a company’s net assets and the minimal value of the company’s equity. In our model, when fair value calculations based on projected future cash flows yield a value less than NVEMGW, we raise it to the level of NVEMGW. Therefore, in essence, NVEMGW serves as a floor for equity valuation.

Interest Rate Environment

Current and expected future interest rate environment affects return expectations on investments and, therefore, have a direct impact on the discount rate. Interest rates are determined primarily by the following factors:
  - level of expected inflation;
  - rate of return (adjusted for risk) on available investment
    opportunities; and
  - money supply and demand relationship.
        Generally, depending on a time horizon of a valuation model, corresponding yields of U.S. Treasury strip bonds are used as risk-free rates for particular years ahead. The discount rate, in principle, consists of a risk-free rate and a risk premium.

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