How to calculate the value of a company on the stock market

(BFM Bourse) – Two main methods exist to determine the value of a listed company: comparison multiples and discounted future cash flows. BFM Bourse explains what these two methods consist of.

In the stock market, a question comes up very often to determine the potential of a stock: is it overvalued or undervalued? But how do we actually determine the value of a share and/or a listed company?

Two main methods exist (we will briefly mention a third specific to conglomerates): that of multiples of comparable companies and the discounted free cash flow method. Explanations.

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The different valuation multiples

A simple approach is to look at the multiples of companies deemed comparable. The best-known multiple remains the PER (“price to earnings ratio”). This involves relating the stock price to the expected earnings per share, or the market capitalization to the total expected earnings.

Simple example: let’s imagine that we want to know if a luxury company with a market capitalization of 23 billion euros and an expected profit of 1 billion euros is undervalued.

At their current prices

, Hermès currently trades for 52 times its expected 2024 earnings, LVMH 26 times and Kering 18 times. The average PER of these three groups is thus at 32 compared to a multiple of 23 for the company in question, which therefore does not appear undervalued.

Analysts and managers can, however, apply a premium or a discount to the company in question, if it has more or less growth potential than the others (this is what explains the generous multiples of Hermès), if it faces risks, whether its governance is judged virtuous or not, or even based on its free float (the portion of its shares that are freely exchanged).

A multitude of possibilities

It is important to clearly identify the sector in question. Automobiles or banks, cyclical stocks, are much less valued on the stock market than tech or luxury goods, due to their lower growth potential and/or their less resilience to the economic cycle. Even if within the same sector, very notable differences can exist. It can also be difficult to identify good comparables. Ferrari, an automobile manufacturer, has such a unique model that analysts compare the group more to Hermès than to Mercedes.

Let us also point out that if we mentioned the PER, many other multiples exist. This can be the enterprise value compared to turnover, operating profit or profit before depreciation, accounting impairments, interest charges and taxes (Ebitda).

For certain large groups specializing in heavy goods (Airbus, Alstom), cash generation is important. It may therefore be wise to use a multiple of free cash flow, the free cash flow. This is, for example, the choice that Bank of America made to evaluate the American professional software group Salesforce.

It is even possible to relate the group’s stock market value to that of its balance sheet (“price-to-book ratio”), which makes it possible to highlight how many times its book value a company trades at.

When presenting its strategic plan, Société Générale chose to illustrate its stock market discount in this way. The bank then showed that its share was trading at 0.4 times the value of its tangible assets (“tangible book value”) compared to 0.8 times for the average of a basket of competitors such as BNP, Barclays, Crédit Agricole SA or Deutsche Bank.

The DCF method

This is the so-called “discounted cash flow” (DCF) method. The underlying idea is that a company is worth today the wealth it will create in the future via its capacity to generate cash and therefore the sum of future free cash flows.

With this in mind, free cash flow constitutes a relevant indicator, because, much more than profit which remains a simple accounting entry, it measures whether the company has received or disbursed money at the end of a financial year. “Investors have tended to focus on ‘free cash flow’ for a simple reason: it is the money available to managers once they have paid for the investments necessary to grow the business,” explains Morningstar.

To evaluate a company using this method, an investor or analyst will base themselves on free cash flow forecasts over several years. It will then “update” them, that is to say give them a value at the present moment. This amounts to reflecting the idea that a euro paid today is worth more than a euro paid in several years. Firstly because money loses value over time, due to inflation. And secondly because the investor can invest the euro received immediately over several years, unlike the future euro.

To “discount” these future flows, the investor divides them by a rate of return called the weighted average cost of capital (WACC). This rate depends on the company’s debt, the profitability required on equity and that requested by creditors on the debt. This rate of return will be squared if the flow falls in the second year, cubed for the third year, etc. In order to measure the impact of time.

Sensitive point: once the cash flows have been determined and discounted, the investor must also calculate a “terminal value” of the company over the last year of the projection. There are two solutions for this. Either it applies an exit multiple observed on comparable companies. Either it retains “normative” growth in free cash flow. And on this basis he applies a so-called “Gordon Shapiro” formula, which reports the last cash flow of the period divided by the difference between the WACC and the normative growth rate of free cash flow. We have made a simplified example at the end of this article to illustrate our point.

Once this terminal value of the company is calculated, the investor discounts it and adds it to the already discounted cash flows to arrive at the value of the company. It is enough to subtract its debt and its possible cash flow to arrive at the valuation of its equity. Then divide it by the number of shares outstanding to determine the theoretical share price.

The “sums of the parts” method

This method is used for conglomerates which have quite diverse activities. The investor or analyst will simply use one of the methods described above to value, separately, each of the activities of this conglomerate.

It will then add them together (hence the term “sums of the parts”) to arrive at a business value. A conglomerate discount is then applied to this sum. This is due to the fact that the market (generally) values ​​pure players better than companies with diversified activities. This less good perception has multiple explanations, such as limited synergies, investments dispersed within activities and not concentrated on the most promising, or even a lack of readability.

In December, Vivendi cited its “very high conglomerate discount” to justify its plan to split into three companies (then four since January) in order to reduce this discount.

Simplified example of DCF

Let’s take the example of a fast-growing company, with one billion euros of net debt, 156 million shares outstanding and a share price of 52 euros.

This company plans to generate 100 million euros in free cash flow in one year, 150 million in two years, 200 million in three years, 250 million in four years. From the fifth year, the analyst estimates that the company should see the growth of this cash flow slow down to reach an increase of 10% per year on average. Also assume that the weighted average cost of capital is 12%.

The DCF method implies that the sum of the discounted free cash flows is: 100 /(1.15) + 150/(1.12)^2 + 200/(1.12)^3 + 250/(1.12) )^4 + 275/ (1.12)^5 = which gives 666 million euros.

It is now necessary to calculate the terminal value of the company in year 5. To do this, the Gordon-Shapiro formula involves dividing the last cash flow by the difference between the WACC (12%) and the “normative” growth rate of free cash. -flow (10%).

Or: 275/ (12%-10%) = 13.75 billion euros

This terminal value should be discounted and added to the discounted free cash flow. Which give:

Enterprise Value = 100/(1.15) + 150/(1.12)^2 + 200/(1.12)^3 + 250/(1.12)^4 + 275/(1.12) ^5 + 1375 (+1.12)^5

We arrive at an enterprise value of 8.46 billion euros. By subtracting net debt, this corresponds to a market capitalization of 7.46 billion euros. With 156 million shares in circulation we arrive at a theoretical price of 47.82 euros. The stock is therefore slightly overvalued.

Let us point out that we have taken an ultra-simplified and purely illustrative example with certain generous parameters, such as cash flow growth.