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How to measure the value of companies
Value investing is the pursuit of buying stocks that are currently trading at a discount to their intrinsic value. The idea being, that that discount is likely the result of a short term disappointment, and the share price will – in the long run – turn upwards toward its true value (making you a profit).
So how do you know if a stock is good value?
A lot of people use multiples, Price to Earnings, Price to Book, Enterprise value to Ebita. But a more in depth way is called Discounted Cash Flow analysis (DCF). DCF looks at the future projected cashflows of a business and then 'discounts' them back to today's value, based on the average cost required to generate that profit, also taking into account the company's growth.
Even if you're not looking forward (working with earnings forecasts), going through the steps of understandings a valuation based on a company's cashflows can uncover useful insights about the business and whether it's one you should be investing in. Let's dive into the different metrics.
NOPAT / NOPLAT
NOPLAT stands for Net Operating Profit Less Adjusted Taxes and it represents the profits generated from the company's core operations, once you've subtracted tax. It's a more accurate measure of profit than say say Net Income – because it's not affected by financing structure / interests payment etc. – and EBIT because it deducts the taxes that inevitably have to be paid. The difference between NOPAT and NOPLAT is that NOPLAT also takes into account tax deferrals, offsetting tax payments into different years, which in some businesses can result in large differences between the two.
Looking at our chart, we can see that NOPLAT has been rather flat at Big Lots over the past few years, with the exception of a better 2018.
NET INVESTMENT
Net investment looks at the amount of capital that is invested back into the business, such as in its plant, property and equipment and working capital (and goodwill). Is a company regularly investing in up-keeping and expanding the assets that make its revenue? In the example of Big Lots, investment declined from 2016 to 2018 (when it had the good NOPLAT year), followed by (then) record investment in Q1 2019 and then a massive increase in 2020, which is likely the result of emergency measures to deal with covid19.
Net Investment = Invested Capital[current timeframe] - Invested Capital[previous timeframe]
Investment Rate (IR)
Investment Rate is the portion of NOPLAT invested back into the business (Net Investment). Looking at at 2019, Big Lots invested 160% of its NOPLAT back into the business, but prior to that % IR was negative.
IR = Net Investment / NOPLAT
Return on Invested Capital (IR)
ROICC is the return the company earns on each dollar invested into its assets. Before its run of re-investment in the business in 2019, the company reached a peak efficiency of 21.5% - each $100 of investment brought in $21.50 in NOPLAT. Problem was, they weren't investing as much. As soon as they did , ROICC drops to 15%. Comparing this multiple with similar companies will give further clues as to whether this is a good return on invested capital or not.
ROIC = NOPLAT / Invested Capital
GROWTH (g)
Is the rate at which the company's NOPLAT grows each year. It's expressed as:
g = ROIC * IR
If a company gets a good return on its assets and its consistently investing back into the business to increase those assets, then you have a great recipe for growth. As we've seen with other metric, growth was actually declining at Big Lots until 2019 but has now rocketed upwards.
Percentage of Debt & Equity
At this point, it's good to have a quick sense check on the percent of equity to debt. If a company has too much debt its risk of bankruptcy clearly increases significantly. A good rule of thumb I've heard is no more than 2x debt (66%) to equity (33%), although it'll vary by industry. Looking at our example, Big Lots took out a lot of debt in Q1 2020 as a result of covid, but this has consistently diminished into the year, back into reasonable levels. Further insight can again be found by comparing against similar publicly listed businesses.
Cost of Debt
Going a bit further into the business's debt structure, you can deduce the company's cost of debt by dividing its interest payment by its total debt. This is reveals the average % the company pays for its debts. In the case of Big Lots, the cost of its debt seems relatively cheap, but again checking against the industry average will uncover more insight. In fact, this 'cost' will be lower because of the 'Interest Shield' debt payments have in reducing taxes.
Cost of Debt = Interest / Total Debt
Weighted Average Cost of Capital
Cost of debt is only part of the equation. You also need to know the cost of equity, which is the % amount of return investors expect for the risk they incur investing in the company rather than a risk free alternative. Calculating the cost of equity is quite complicated:
Cost Of Equity = Risk Free Rate +Beta*(Market Rate Of Return - RiskFreeRate
(Because my Pine scripting is not quite there, I have instead taken the average rate of return equity holders have historically expected from markets which is 7% in the US and 6% in the UK.)
Once you have both the cost of debt and the cost of equity you can calculate the Weighted Average Cost of Capital, or how much on average it costs the rate that a company is expected to pay on average to all its security holders to finance its assets. The formula for WACC is:
WACC = Value of Equity/TotalValue* Cost of Equity + (Value of Debt/TotalValue)*(CostOfDebt*( 1 -Corporate Tax Rate))
All super complex, but in essence, if 50% of the capital structure is debt holders expecting 1% return, and 50% is shareholders hoping for a 6% return, then the average return expected by stakeholders is 3.5%. As we know for Big Lots the Return on Invested Capital is circa 15%, and so there is a clear profit margin on its operations to pay its security holders with.
Value
The hardest one of all to calculate. You can derive the Discounted Cash Flow valuation of the business by multiplying its Operating Profits by its growth and return on invested capital, divided by the weighted average cost of its capital (accounting for growth potential).
As a formula this is:
Value = NOPLAT * (1 - g/ROIC) / WACC - g
The reason this a more in-depth measure of value than say Price to Earnings is because this formula also takes into account not only earnings but also expected growth AND the efficiency of assets to generate a return.
As mentioned, I've reach the limits of my Pine script here, but if it is coded correctly, this suggest Big Lots is trading at a small discounted rate.
You can also take this formula for any business' future projected cashflow to understand how the price will change in the future (and therefore whether there's a profit opportunity to be found).
Conclusion
That's it! Hopefully it's clear that doing a deeper dive into key value metric uncovers a lot of colour and understanding of exactly how the business has been operated to date and whether the market might be underestimating (or not) it today
Thanks for reading!
So how do you know if a stock is good value?
A lot of people use multiples, Price to Earnings, Price to Book, Enterprise value to Ebita. But a more in depth way is called Discounted Cash Flow analysis (DCF). DCF looks at the future projected cashflows of a business and then 'discounts' them back to today's value, based on the average cost required to generate that profit, also taking into account the company's growth.
Even if you're not looking forward (working with earnings forecasts), going through the steps of understandings a valuation based on a company's cashflows can uncover useful insights about the business and whether it's one you should be investing in. Let's dive into the different metrics.
NOPAT / NOPLAT
NOPLAT stands for Net Operating Profit Less Adjusted Taxes and it represents the profits generated from the company's core operations, once you've subtracted tax. It's a more accurate measure of profit than say say Net Income – because it's not affected by financing structure / interests payment etc. – and EBIT because it deducts the taxes that inevitably have to be paid. The difference between NOPAT and NOPLAT is that NOPLAT also takes into account tax deferrals, offsetting tax payments into different years, which in some businesses can result in large differences between the two.
Looking at our chart, we can see that NOPLAT has been rather flat at Big Lots over the past few years, with the exception of a better 2018.
NET INVESTMENT
Net investment looks at the amount of capital that is invested back into the business, such as in its plant, property and equipment and working capital (and goodwill). Is a company regularly investing in up-keeping and expanding the assets that make its revenue? In the example of Big Lots, investment declined from 2016 to 2018 (when it had the good NOPLAT year), followed by (then) record investment in Q1 2019 and then a massive increase in 2020, which is likely the result of emergency measures to deal with covid19.
Net Investment = Invested Capital[current timeframe] - Invested Capital[previous timeframe]
Investment Rate (IR)
Investment Rate is the portion of NOPLAT invested back into the business (Net Investment). Looking at at 2019, Big Lots invested 160% of its NOPLAT back into the business, but prior to that % IR was negative.
IR = Net Investment / NOPLAT
Return on Invested Capital (IR)
ROICC is the return the company earns on each dollar invested into its assets. Before its run of re-investment in the business in 2019, the company reached a peak efficiency of 21.5% - each $100 of investment brought in $21.50 in NOPLAT. Problem was, they weren't investing as much. As soon as they did , ROICC drops to 15%. Comparing this multiple with similar companies will give further clues as to whether this is a good return on invested capital or not.
ROIC = NOPLAT / Invested Capital
GROWTH (g)
Is the rate at which the company's NOPLAT grows each year. It's expressed as:
g = ROIC * IR
If a company gets a good return on its assets and its consistently investing back into the business to increase those assets, then you have a great recipe for growth. As we've seen with other metric, growth was actually declining at Big Lots until 2019 but has now rocketed upwards.
Percentage of Debt & Equity
At this point, it's good to have a quick sense check on the percent of equity to debt. If a company has too much debt its risk of bankruptcy clearly increases significantly. A good rule of thumb I've heard is no more than 2x debt (66%) to equity (33%), although it'll vary by industry. Looking at our example, Big Lots took out a lot of debt in Q1 2020 as a result of covid, but this has consistently diminished into the year, back into reasonable levels. Further insight can again be found by comparing against similar publicly listed businesses.
Cost of Debt
Going a bit further into the business's debt structure, you can deduce the company's cost of debt by dividing its interest payment by its total debt. This is reveals the average % the company pays for its debts. In the case of Big Lots, the cost of its debt seems relatively cheap, but again checking against the industry average will uncover more insight. In fact, this 'cost' will be lower because of the 'Interest Shield' debt payments have in reducing taxes.
Cost of Debt = Interest / Total Debt
Weighted Average Cost of Capital
Cost of debt is only part of the equation. You also need to know the cost of equity, which is the % amount of return investors expect for the risk they incur investing in the company rather than a risk free alternative. Calculating the cost of equity is quite complicated:
Cost Of Equity = Risk Free Rate +Beta*(Market Rate Of Return - RiskFreeRate
(Because my Pine scripting is not quite there, I have instead taken the average rate of return equity holders have historically expected from markets which is 7% in the US and 6% in the UK.)
Once you have both the cost of debt and the cost of equity you can calculate the Weighted Average Cost of Capital, or how much on average it costs the rate that a company is expected to pay on average to all its security holders to finance its assets. The formula for WACC is:
WACC = Value of Equity/TotalValue* Cost of Equity + (Value of Debt/TotalValue)*(CostOfDebt*( 1 -Corporate Tax Rate))
All super complex, but in essence, if 50% of the capital structure is debt holders expecting 1% return, and 50% is shareholders hoping for a 6% return, then the average return expected by stakeholders is 3.5%. As we know for Big Lots the Return on Invested Capital is circa 15%, and so there is a clear profit margin on its operations to pay its security holders with.
Value
The hardest one of all to calculate. You can derive the Discounted Cash Flow valuation of the business by multiplying its Operating Profits by its growth and return on invested capital, divided by the weighted average cost of its capital (accounting for growth potential).
As a formula this is:
Value = NOPLAT * (1 - g/ROIC) / WACC - g
The reason this a more in-depth measure of value than say Price to Earnings is because this formula also takes into account not only earnings but also expected growth AND the efficiency of assets to generate a return.
As mentioned, I've reach the limits of my Pine script here, but if it is coded correctly, this suggest Big Lots is trading at a small discounted rate.
You can also take this formula for any business' future projected cashflow to understand how the price will change in the future (and therefore whether there's a profit opportunity to be found).
Conclusion
That's it! Hopefully it's clear that doing a deeper dive into key value metric uncovers a lot of colour and understanding of exactly how the business has been operated to date and whether the market might be underestimating (or not) it today
Thanks for reading!
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