What is my method?

There's hundreds of ways that talented equity research analysts try to price assets. So, what is my ideology when trying to find the true price of a security? Well, this generally starts with your standard discounted cash flow analysis. However, unlike so many models, I understand my shortcomings when it comes to finding future projections that are actually accurate. But I am a believer in markets and the market pricing model as a whole, so I find out a lot about a company based on its share price.

This brings me to my assumptions-driven model, where we can look at an example corporation and relevant concrete assumptions. These assumptions are pieces of information about our "Dummy Corporation" that are usually easy calculated using industry standards, taken from financial statements, or industry comparable averages. We'll assume that this data is in millions, besides "per share" information (although this assumptions isn't really necessary).

I chose a relatively low Exit Multiple to put some more emphasis on Free Cash Flows, but this is not necessary. With this data, I'll now project out future cash flows like any given DCF, starting with the 2022 FCFF, assuming that the firm's calendarized fiscal year has come to a close for 2022.

Now that I have begun plotting future cash flows, there is a lot I can learn about the value of the company. The first thing that I'd like to note is the two various methods used to calculate implied share price, either the Terminal Growth Model (TGM) or the Exit Multiple Method (EMM). For the most part, industries use the EMM, so that will be my main focus in this case. Usually, this happens because a "terminal growth rate" is often incredibly hard to predict, highly variable, and rarely accurate. So, for the sake of this model, EMM will used primarily.

Given my "reasonable" assumptions for the future growth rate of FCFFs (Free Cash Flow to the Firm), I can see that I have arrived at an implied share price that is less than the current share price. Many analysts would point to their ability to predict cash flows so accurately, classify the stock as "overweight" or "sell", and finish their report. I think this is an incredibly shallow, assumptions-driven way of pricing assets or securities. Yes, there are some very talented equity research analysts that can predict these cash flows generally accurate, but my assumption is that even the "best" equity research analyst will fail, in most cases, to predict future cash flows as precisely as the market as a whole. This is not to say that markets don't "make mistakes", but the starting point of any deductive analysis should not be one's own future assumptions, but those of the market.

So, getting back to "My Method", I think its best to try my projections again. I'm not so happy with finding a share price that is over $11.00 away from the current price. Therefore, its time to alter those key growth assumptions (focused mainly on the EMM).

So, now a separate analyst has contacted me, telling me that analyst 1's assumptions are far too grim. The "Dummy Corporation" will produce incredibly high free cash flows in the future. The year 2022 was a "dud" and non-indicative of future performance in the realm of standard measurements. I am yet again incredibly unsure of how accurate these statements are, especially considering a nearly 20% difference from the current trading price. So, in what is a bit of a "Goldilocks" process, I realter the future assumptions and come up with my own set of cash flows and implied share price.

Okay, so I've finally come up with a set of assumptions in the future that solved for the current share price. I can see that assuming the concrete figures are market-adopted, the market expects "Dummy Corporation" to have FCFFs growth in the high double digits for the next few years, with a Year 5 rate of 10.50%. Now, "My Method" comes into play finally. Of these three models, which do I think will be most indicative of the future? Keeping in mind what the market expects is an incredibly important facet of this analysis, since, at least in my opinion, markets tend to be more accurate than a single set of a assumptions that come from an analyst.

Now that I know what the market may expect of my company, I can do a number of things. For most equities, I'll look at 10-K/10-Q data, combined with finding comparable companies and listening to the conference call, to determine if I think that the assumptions are optimistic, conservative, or somewhere in the middle. This is the basis for making my decision on the security, where I usually produce a final verdict: either underweight, overweight, or fairly valued.

However, "My Method" is contingent on many factors, as are most forward-looking forms of quantitative analysis. This is why I like to look at the market expectations of future cash flow in terms of modern day macroeconomic activity, along with treasury rates, global conflict, and inflation. Using this secondary form of analysis, I will add a certain time scale to my "verdict", which helps to bring my macroeconomic views into play. It is important to note that these are simply predictions at the end of the day, and there is still a lot of analyst-side subjectivity. I've just done my best to push this to the very last stage, making this otherwise incredibly subjective process a bit more objective.

I have included a copy of the Excel file I used to complete these example calculations, so feel free to download the file and play around a bit with the assumptions. In the case of more sensitive data, I will often include a sensitivity analysis to aid in my determinations and final verdict regarding a company or asset.