I’m trying to calculate a target share price using a simple financial model. In fact, I want to the model to be as simple as possible. Are these calculations correct? Here are the steps: 1) projects revenues to year 3 2) multiply year 3 revenues by year 3 operating margin. result is year 3 EBIT. 3) multiply year 3 EBIT by (1 - tax rate). result is year 3 NOPAT. 4) multiply year 3 NOPAT by terminal multiple (I used the historical PE multiple in this case). result is firm value 5) subtracted value of total debt from firm value. result is total equity value. 6) divided equity value by expected year 3 share count. result is target share price. 7) calculated the annual return. So say my target share price was 30% above my current share price. I would then say this stock has a 3 year annualized return of 9.1%. Note that since I didn’t use a discount rate, it’s up to the reader to determine if 9.1% is a sufficient return for this company. Any major flaws here? I know it’s not the most thorough way to do it–I’m just looking for something that is 1) correct, and 2) simple.

Forgot to subtract out interest in step 3 Also need to factor in Div’s in years 1-2. You should solve for IRR after adding them. Also, your return is really (1.30)^.5-1 = 14%, since multiplying year 3 earnings by a PE multiple gives you the value of the company at the beginning of year 3/end of year 2.

>>Also need to factor in Div’s in years 1-2. You should solve for IRR after adding them. Sounds good. >>>Also, your return is really (1.30)^.5-1 = 14%, since multiplying year 3 earnings >>>by a PE multiple gives you the value of the company at the beginning of >>>year 3/end of year 2. So this would be treating the terminal multiple as a forward multiple…hmm I can see how this makes sense. But would it be *wrong* to use a trailing multiple for the terminal multiple? Thanks!

That could be a target share price for 3 years down the line. It assumes that the company will not substantially change its business lines (introduce new products, discontinue products, merge or be acquired). Obviously it assumes your revenue estimates and growth are sound too. Your assumption about PE is suspect for such turbulent times. PEs are probably going down as people get more risk averse. You could use a long term average, I guess. Usually firm value is computed with (Firm Value)/(EBITDA or FCFF) multiples, and not PE, which is used more for equity. Interest payments surely must figure in here somewhere, since you’re valuing equity. I’m embarrassed to say that I can’t remember how they fit in. Usually you don’t use interest payments to compute firm value, and you are subtracting debt… so maybe that’s right after all. I’d be more comfortable using a FCFE estimate over FCFF. (I’ll be watching this thread to listen to someone else discuss how to handle the interest payments). Also there is no real model for any cash flows between now and three years from now. ahahah tells you that you need to account for any dividends that come in between now and then when talking about total return… they are relevant for computing the *current* intrinsic value, but I guess they aren’t terribly relevant for projecting a future stock price.

bchadwick Wrote: ------------------------------------------------------- > Also there is no real model for any cash flows > between now and three years from now. ahahah > tells you that you need to account for any > dividends that come in between now and then when > talking about total return… they are relevant > for computing the *current* intrinsic value, but I > guess they aren’t terribly relevant for projecting > a future stock price. This was more to calculate returns, not terminal value

you cannot use PE - that uses equity valuation basis, you are doing firm valuation. you need to use EV/NOPAT ratio (using forward or trailing NOPAT, depending on whether you want a forward/trailing ratio. getting that ratio may be more trouble than its worth. you may be better off doing equity valuation, using Net Income instead, if you want, you can assume different debt ratio/interest costs from current values. then you can use PE or long term (full cycle average PE).

>>>Forgot to subtract out interest in step 3 Wait, I don’t think I should do this, since in step 4 I’m trying to find the firm value, not the equity value. >>>you cannot use PE - that uses equity valuation basis, you are doing firm valuation. Yes, this is a good point.

I guess another question I have is: - is this a legitimate way to go about valuing a stock? Or should only a true FCF model (with a discount rate and adjustments for WC and capex) be used?

there are many approaches to valuation - there is no one right answer. its a range concept. its always best to come at it from multiple approaches, and develop a synthesis view, but thats a luxury really - a simple single approach if done correctly gets you into the general range.

It’s not a bad way to get a terminal value for a stock, but that’s not the same as valuing a stock. Even with dividends and an IRR, you get an expected return, but what’s the appropriate PV for that kind of return. You could compare the IRR to the RFR and ask yourself if the spread is appropriate for the risk you are taking… that risk comes from systemic risks that you’ll get a different result because of economic and industry factors, specific company risk that something will affect that company alone, and then of course modeling risk that your assumptions aren’t really good to begin with. Is 9.8% IRR compared to 3% RFR good? Well, it depends on how risky the investment is. So, it’s a useful input into a valuation, but it’s not really a valuation itself.

bchadwick Wrote: ------------------------------------------------------- > It’s not a bad way to get a terminal value for a > stock, but that’s not the same as valuing a > stock. > > Even with dividends and an IRR, you get an > expected return, but what’s the appropriate PV for > that kind of return. You could compare the IRR to > the RFR and ask yourself if the spread is > appropriate for the risk you are taking… that > risk comes from systemic risks that you’ll get a > different result because of economic and industry > factors, specific company risk that something will > affect that company alone, and then of course > modeling risk that your assumptions aren’t really > good to begin with. > > Is 9.8% IRR compared to 3% RFR good? Well, it > depends on how risky the investment is. > > So, it’s a useful input into a valuation, but it’s > not really a valuation itself. Much more, in a market like this is IRR a meaningful measure?