how to value equities

how to value equities Educational research August 2016 Summary Our recommendation to buy, sell or hold a share depends on our assessment of expected return versus expected risk. Share price First, the difference between a company s share price and what we believe its shares are worth determines if a share is fairly valued, overvalued or undervalued. Secondly, the likelihood that future developments differ from our forecasts determines whether a share offers sufficient upside or downside to compensate for forecasting risk. Using a step-by-step approach a risk-adjusted recommendation is determined. For this we: 1. Assess what a company is worth (fair value) We determine a company s fair value by adding up all its expected future cash earnings, discounted to today s prices. 2. Compare the fair value and share price A share price below fair value indicates potential upside. Above fair value, shares become less attractive or possibly even outright expensive. 3. Adjust for risk (uncertainty rating) We cope with uncertainty by requiring a margin of safety before making recommendations. The more uncertain the fair value estimate, the greater the margin of safety needed before a stock will trigger a recommendation change. Fair value Price relative to Above Below,, Source: Morningstar, ABN AMRO Private Banking Uncertainty rating Uncertainty rating low medium high very high or extreme +25% -8% +35% -15% +55% -22% +75% -30% 4. Determine the recommendation The deviation of the share price from its fair value, relative to pre-defined ranges per uncertainty rating, determines the final recommendation to buy, hold or sell a stock. If you have questions or comments about this publication, contact the Global Investment Communications team at I-Comms.Global@nl.abnamro.com > 1

How to value equities There is more to equity investing than simply selecting good companies and avoiding bad ones. Even the best company can be a poor investment when the buying price is too high. Each company has an intrinsic value based on its future earnings and losses. Few companies are priced at this intrinsic value though as markets tend to exaggerate. To separate the signal from the noise, ABN AMRO s research specialists thoroughly evaluate company fundamentals and determine what companies are worth. This document outlines ABN AMRO s step-by-step approach for valuing equities. It will help you to better understand our, or recommendations. To invest or not to invest? That is the question Our approach to equity investing is best explained using an example. We shall use two fictitious companies, Dos and Cinco who produce a similar product. Both companies have successfully patented these products. Dos will lose its protection in two years. Cinco, however, has five years. Assume that they will not introduce a new product to make up for the loss of income caused by losing the patent protection. Investors need to decide to buy or keep one or both companies. But how can this be determined? Look beyond price-to-earnings ratios More information is required on current market prices, earnings prospects and the composition of the balance sheet, to come to a proper recommendation. Both companies shares are traded on the stock exchange for 100 euros each. They are expected to earn 10 euros per share this year, with earnings measured by the company s cash flow 1. A simple valuation metric based on price-to-cash flow values both companies at 10 (100 euro/10 euro). Because their valuation is alike, investors looking only at such metrics would not prefer one company over the other. Instinctively, however, one should conclude that Cinco is the better investment of the two. It will generate three additional years of cash flows before its patent expires and should, at equal valuation, be preferred to Dos. Does this make Cinco a good investment? Our step-by-step approach Our recommendation to buy, sell or hold a share depends on the difference between the share price and what we believe the shares are worth. We determine a risk-adjusted recommendation using the following steps: 1. assess what a company is worth; 2. compare the fair value and share price; 3. adjust for forecasting risk; and 4. determine the recommendation. Detail 1: assess what a company is worth We first estimate what Cinco is worth by computing its theoretical fair value. There are several ways of doing this. We calculate a company s fair value by adding up all its expected future cash earnings. The fair value we come to is known as the discounted cash flow (DCF) value. DCF models are quite complex. They offer our equity analysts and specialists a lot of flexibility in the assumptions that determine the fair value. Before adding them up, future cash flows are modified by the notion that one euro today is worth more than one euro in a couple of years time; this is called the time value of money. For this, future cash flows are discounted, or reduced, by the company s costs of capital 2. Normally investors demand a higher return to compensate for higher risk, and so the estimated cost of capital is higher for companies with a riskier business model. Dos has the higher discount factor. As risk rises, Dos theoretical fair value drops. Based on discounted cash flows, Dos and Cinco have fair values of 50 euros and 100 euros respectively. Detail 2: compare the fair value and share price This fair value of discounted future cash flows may now be compared to the share price. A share price below fair value indicates that shares are cheap. Above fair value, shares become less attractive or just too expensive. The market prices Cinco exactly at its fair value (100/100 = 100%) and Dos at double its fair value (100/50 = 200%). We still have a bit more work to do: The price-to-fair value leaves too much room for (mis)interpretation. Should a biotech start-up be valued equal to a rock-solid food producer with predictable earnings and cash flows, both trading 10% below fair value? The obvious answer is no. In the next step we show you how we adjust for forecasting risk. 1 Cash flow: the net amount of cash generated and used by a company in a year. 2 Company s costs of capital: the average cost of equity and debt. > 2

Detail 3: adjust for forecasting risk In step 1 we showed you that a company is worth less when risk increases. To further adjust for the risk that our forecasts deviate from actual future earnings, we work out and use a company s Uncertainty Rating. Companies with predictable cash flows and considerable competitive advantages have Low uncertainty and are considered relatively safe. Riskier or more cyclical businesses imply a lower level of earnings predictability, which, in turn, leads to an uncertainty rating ranging from Medium or High or Very High or, exceptionally, Extreme. We use the uncertainty rating and base our recommendation on the expected return and risk in Step 4. After analysing both companies fundamentals, the equity analysts have labelled Dos as High Uncertainty and Cinco as Medium Uncertainty. Detail 4: determine the recommendation The recommendation to buy, hold or sell a stock depends on whether a company s shares trade above or below fair value, and also on how far the share price has drifted from fair value. For this we compare the share price s relative deviation to fair value to pre-defined ranges for each uncertainty rating. Figure 1 shows different ranges around fair value for each uncertainty rating. A narrow range is used for Low-uncertainty companies. The range grows wider as uncertainty increases. A company with limited earnings visibility must be cheaper to get a rating than a company with very predictable earnings. This follows the basic rule of investing that investors demand a higher return to compensate for higher risk. For a Low-uncertainty company, the recommendation is downgraded from to when the share price moves more than 25% above fair value. The share price needs to exceed fair value by 35%, 55% or 75% respectively for a downgrade to for companies with Medium, High and Very High uncertainty. Finally, we upgrade a share from to when its shares are priced 8% below fair value when it is a Low-uncertainty company. For riskier businesses, the shares need to become even cheaper for an upgrade to. Having determined that the market is pricing Cinco exactly at its fair value, this translates into a recommendation. Should Cinco s share price increase by 35% or more, then the recommendation of this Medium-uncertainty company changes from to. A 15% drop triggers an upgrade to. There is still some value in Cinco s shares for investors who already own them. Investors not owning Cinco could consider more attractively valued alternatives. Dos is trading 100% above its fair value of 50 euros, which, whatever the uncertainty rating, triggers a recommendation. Recommended List ABN AMRO s equity specialists place a small number of companies on the Recommended List. By doing so, they indicate that they see these companies as the long-term winners in ABN AMRO s industries or themes of choice. The shares selected typically fit the needs of clients that buy shares with the intention of holding them for at least one year. Figure 1: Balancing expected risk and return Price relative to Above Below Uncertainty rating low medium high very high or extreme +25% -8% +35% -15% +55% -22% +75% -30% Source: Morningstar, ABN AMRO Private Banking > 3

Frequently asked questions Q: Who determines the fair value and the recommendation? A: Morningstar provides the fundamental equity research on individual global stocks with large market values. Morningstar is a leading provider of independent investment research and has no banking or brokerage activities. The four-step approach presented in this document applies to equity research by Morningstar. Coverage of Benelux equities is provided by ABN AMRO Markets and German equities are covered by Independent Research. The three providers apply somewhat different approaches in their analysis. What they have in common is that companies trading well above their intrinsic value are considered expensive and should be avoided. Likewise, shares priced well below intrinsic value trigger a positive recommendation. Additionally, ABN AMRO s equity experts screen the entire equity universe for longer-term opportunities, which will be added to the Recommended List. Q: What is the difference between a Morningstar rating and an ABN AMRO recommendation? A: ABN AMRO uses a rating system which provides its clients with a straightforward,, or recommendation. Morningstar rates each stock with 1, 2, 3, 4, or 5 stars. Both rating systems are based on the same price-to-fair-value approach. ABN AMRO s recommendations relate to the five Morningstar star ratings as shown in the following table. Figure 2: Morningstar rating versus ABN AMRO recommendation Morningstar ABN AMRO ***** (5-Star) **** (4-Star) H *** (3-Star) ** (2-Star) S * (1 -Star) H Close to the ****/*** border, 4-Star companies may still be a S Close to the **/* border, 2-Star companies may still be a Q: How do you avoid recommendations flipping back and forth when the share price moves around the recommendation pivot? A: The recommendation of a Low-uncertainty company is downgraded from to when the market price moves 25% above its fair value (see figure 1). If the share price then starts moving sideways just above and below this pivotal point, changes from to and back to could occur. Such frequent recommendation changes are confusing and undesirable. They do not take account of the fact that, when priced well above fair value, a stock is an unattractive investment and should be treated as such. A relatively small drop in the share price does not change this observation. To avoid frequent recommendation changes around pivotal points, we wait for the share price to fall to a level that is 22% above its fair value (instead of 25%) before upgrading the recommendation from to. This observation margin grows wider for companies with higher uncertainty ratings. Note that we do something similar for shares trading around the -to- pivot. Here the share price needs to rise by 3% for Low-uncertainty companies for a downgrade from to to take effect. This margin too increases to almost 10% for High-uncertainty companies. Q: A share is trading above fair value, should I sell? A: Not necessarily. Shares priced above fair value have either a or a recommendation. For -rated companies our advice is straightforward; we suggest you sell them immediately. Whether or not you should reduce positions in -rated companies depends on your investment objectives and on how far the share price has moved above fair value. You may notice in figure 1 that shares will not be downgraded to unless, conditional to the uncertainty rating, they trade 25% to as much as 75% above fair value. When the recommendation is a and the share price moves above its fair value, more opportunistic clients with a short- to medium-term investment horizon of up to six months might consider reducing positions. When you are invested in companies based on longerterm expectations, you could consider holding on to the shares and sell when the share price clearly exceeds fair value. Q: Besides price changes, what else may cause a recommendation change? A: Every recommendation is based on the gap between what we believe a company is worth and what investors are willing to pay for it today. Moves in share prices are the prime cause for a shift in this relationship and subsequent recommendation changes. However, an upgrade or downgrade can also follow changes in a company s fundamentals, such as a change in strategy or a shift in the competitive landscape. These fundamental drivers could affect a company s fair value estimate or its uncertainty rating; the second and the third variable determining the recommendation. Alterations in one or both of these factors, large enough to impact the balance between expected risk and return, can also result in a change of opinion. For more information, please contact your relationship manager or investment advisor. > 4

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