Investing Strategy: How do you value a stock?

What are some of the elements to look for when determining intrinsic value?

I first published this in August 2023 on the Trading 212 app in the Value Investing community, under the username “Anathema”.

What do you look for when picking an investment? I thought I'd lay out my approach, I'd be interested to know if you do anything differently. It's a long one...

Multiples

I generally start with a cursory glance at P/E, P/B (nominal and tangible), and PEG. I will look at EV/EBITDA as well. I will often use MacroTrends or similar to check the current multiple against historic trends. I don't make any decisions at this point, but I believe it helps give me a bit of a flavour for the general market's view on my chosen stock.

Income Statement

I often start here.
- What is the company's revenue?
- How has it trended over last 5 - 10 years?
- What is its CAGR?
- is the company benefitting or suffering from one-off impacts like COVID or commodity prices, inflation or other externalities?

Next I look at COGS. I try to strip out depreciation and amortisation expenses, as I consider these fixed costs and not variable with revenue. If I can, I also strip out employee costs, using data available in Annual Reports. While some labour truly will flex with production, a lot is essentially fixed and would lag changes in revenue quite significantly, so I don't really consider employee costs as a variable cost either. I check Annual Reports to see if there is evidence of capitalised R&D or other employee expenses, which may indicate artificially improved reported income.

With adjustments to COGS and SG&A from above, I look at gross profit margins and trends over time. Is margin improving or shrinking? In line with or more/less rapidly than revenue?

I'm a bit particular about exceptional items. Most companies have exceptional items most years. Sometimes they are large, relative to operating expenses or revenue, and sometimes they are accounted for across a range of categories e.g. SG&A, Other Income, etc. Sometimes they are recurring, but I don't consider them 'normal' business activities, e.g. restructuring costs, sale of business or assets. I like to separate these from the underlying expenses, which normally requires reading of the Notes to the accounts. If the exceptional items materially influence the operating expenses, I want to understand whether I should be concerned. This value effectively gives me my EBIT and adjusted EBIT (excluding exceptional items).

I then look at finance income, interest expense and other financial income/expenses. Does the company make enough to pay its interest bill? Is its interest charge increasing or decreasing with time, relative to EBIT?

Then it's net profit, net margin and EPS, reported and with my adjustments. What is tax rate? How consistent are earnings? What is CAGR?  More or less than than revenue growth?

Balance Sheet

Is cash increasing or decreasing? What about debt? What about inventory? What about accounts payable and receivable? Is there evidence of deferred revenue? increases in inventory or accounts payable relative to revenue may indicate difficulties with selling stock or paying suppliers, increases in receivables may indicate supply chain difficulties.

Looking to the future... what is debt maturity profile like over next 5 years? Is this likely to be a problem for interest payments or cash reserves? How much of the asset base is intangible or related to tax positions or investments? how depreciated is the property, plant and equipment? These assets can always be impaired.

What are Cash Ratio, Quick Ratio, Current ratio, assets/liabilities and (net) debt/equity ratios? Are they consistent or improving with time?

Cash Flow

Can be complicated. But essentially:
- is operating cash flow positive?
- is operating cash flow improving with time?

- where is cash coming from and being spent, across operations, investments and financing?

- is capex keeping pace with depreciation expense?
- is Free Cash Flow positive and/or improving?

- is debt being taken out or paid off?
- how well is dividend payout supported by both earnings and operational cash flow?

Further Analysis

I like to look at return on equity, return on assets, return on Capital Employed, return on invested capital, operating cash flow to debt on nominal and adjusted income or EBIT to look for trends in business / investment efficiency.

I look at days of inventory / payables / receivables and use them to calculate the cash conversion cycle of the business. Is it increasing or decreasing? Which is the main contributor?

I look at cash runway ie if all revenue dried up tomorrow, how long could the business fund its operating expenses from its cash?

Valuation

Using the stock's beta, tax rate, debt and debt/equity ratios, I calculate WACC.

Using ranges of EPS or FCF, book value (adjusted for intangibles), EPS or FCF growth rates, WACC and Risk-free Rate all identified from the above analyses over 5+ years' of annual and quarterly reports, I use a stochastic DCF model to generate a sample of likely fair value stock prices. Then I select a price with an acceptable probability of downside risk compared to current price as my price target.

How does this compare to your approach?