I have a confession to make: I love valuation. It doesn't matter if it's discounted cash flow valuation, projected future valuation, or relative valuation against a firm's own history or against its competitors. I love 'em all.
First comes caution
There are pitfalls to valuation. You can get caught up in numbers and actually ignore the underlying business. You can make one or two systematic errors in your model, which, in turn, can give an erroneous buy or sell signal. Finally, valuation is largely dependent on future, unknown numbers that have varying degrees of uncertainty.
The future may not reflect the past, but then again, past records are all we have.
Still, I'm firmly in the valuation camp for the simple reason that it can help you avoid losing money foolishly. You might miss a few highfliers or a perpetually "overvalued" company , but you'll also avoid a lot of risky duds.
Yet while thumbnail valuations can be useful for projecting prospective annual returns, I contend that there is another "hidden" use.
If we turn the process around into what I call a "reverse thumbnail," we can predict the percentage a company must grow it's free cash flow (FCF) to justify a target return.
When to buy? When to sell?
The reverse thumbnail can also help investors determine good times to buy shares of a company -- and this is particularly helpful when analyzing small caps because they tend to be more volatile than the broader market. Buy decisions are even more difficult to make when a stock has been beaten down, even if we intellectually know that's precisely when we should be buying.
- Stock price
- Net cash and equivalents
- Free cash flow
- Shares outstanding
- Desired annual return 15.0% 20.0% 25.0%
- Price in five years to achieve desired return
- Total FCF in five years to achieve desired return
- Required FCF growth to achieve desired return
Getting into the habit of doing a reverse thumbnail can simplify buy or sell decisions and help you determine which stocks in your portfolio are best for new money now.
Remember Peter Lynch's words:
"The best stock to buy may be the one you already own."
But if your desired 15% annual return can only be accomplished through 30% or greater annual FCF growth, you should probably wait for a better price.
Nevertheless, it's always worthwhile to revisit your investments and their valuations.