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Valuing Different Industries

April 21, 2024
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An essential part of being an active investor is think about how to value a company. This will help you to determine whether companies are potentially undervalued or overvalued.

There are a lot of different ways to value a company and the discipline itself is more an art than a science.

However, not all companies have the same structure and for some industries it makes more sense to use different metrics.

Below I will show how to potentially value stock in 4 different industries.

1. 'Normal' Industry

For a 'normal' company (e.g., Costco or Walmart) and not regulated utilities, energy companies, finance companies etc., using a standard cash flow metric is appropriate.

Example: 
Company X has a share price of R100, R10 cash from operations and spend R2 on capital expenditure. If we want a return of 10% or apply a 10% discount rate and assume that the company will grow at 2%, we can estimate a value for the company.

Free Cash Flow=R10-R2=R8
Growth Rate=2%
Discount Rate=10%

Using constant growth rate model, we get:

R8*(1.02)/(10%-2%)=R102

Company is slightly undervalued.

2. Tech Industry

An unusual characteristics of tech stocks is the fact that they give out a lot of stock based compensation to their employees. Because of this, you would probably want to subtract it from free cash flow to get a more appropriate metric.

Example:
Company Y has R10 cash from operations, R2 is spend on capital expenditure and R5 is in stock based compensation.

Adjusted Free Cash Flow=R10-R2-R5=R3
Growth Rate=2%
Discount Rate=10%

Using constant growth rate model, we get:

R3*(1.02)/(10%-2%)=R38

Company is significantly overvalued.

3. REITs

REITs are different than standard companies and usually payout a high proportion of earnings through dividends. So one way to value them is using a dividend discount model. However, we will use a similar methodology to the ones above.

Instead of using Free Cash Flow, we will use adjusted funds from operations i.e., a metric specific for REITs.

Adjusted Funds From Operations (AFFO) = Net Income + Depreciation & Amortization - Gains on Sale of Property - Capital Expenditure.

If you can estimate AFFO, you can value a REITs.
Example:

Company Z has AFFO of R11 which we can use to estimate its intrinsic value.

R11*(1.02)/(10%-8%)=R140

Company is moderately undervalued.

4. MLPs

Master Limited Partnerships are also different to standard companies with a different tax structure. It's more like a REIT and are mostly energy company, especially midstream companies. We can also use a dividend discount model since most of the earnings are paid out in the form of dividends, however, we will keep to the same valuation methodology. 

Assuming we have a midstream MLP company, we need to exchange free cash flow for distributable cash flow and then we can do the same exercise.
The distributable cash flow will normally be reported by the company in their quarterly/annual reports.

What I've talked about above is just the tip of the iceberg, but it's a good intro to get you in the habit of valuing companies and also adjusting your valuing technique based on the industry.


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