Hi @jcmleng

1. Yeah I discount back the calculated share price, and I do this at the desired return. So if I think the share price is going to be $10 in 5 years, and I want a 10% annual return, then I divide $10 by (1+10%), or 1.1, 5 times.ie. $6.21.

That way if I buy at $6.21, and it goes to $10 in 5 years, I'll get a 10% annual return.

2 & 3. Yes, use your estimate for what EPS will be at the end of your time period.

4. Yes, makes sense. My version just says enter the terminal PE and EPS, without giving you anything to calculate it from. But your approach will work well if you want to include an EPS growth rate.

I also made a html version of the valuation calculation which you can find on the blog (hit 'featured' and look for 'super simple.valuation tool'

Let us know if that doesn't make sense.

@Strawman @jcmleng

A more academic way of obtaining discount rate is perhaps calculating the cost of equity using the WACC formula.

I say academic because that is what was taught at University.

I'll need to consult my notes but i think WACC is used for discounting forward free cash flow while the cost of equity part in the formula could be used for discounting the forward estimate on the share price.

Or could even try using the market risk premium formulas such as sharpe ratio etc

Absolutely @edgescape -- lots of ways to arrive at a number.

I like to frame it as "what return would I like?" as that's really what you're trying to solve for. Of course, that rate will depend on what you can get elsewhere, your assessment of the risks and any margin of safety you might like to add.

In general:

WACC is a combination the individual cost of equity and cost of debt.

Equity side has the market risk premium in the calculation [Equity cost of capital = risk free rate + (Beta * Equity risk premium)]

WACC is used to discount back in a DCF.

If a company has no debt or debt isn't likely to be available of used (i.e. pre-profit company), then the prop to debt = 0% thus WACC = equity cost of capital.

@BkrDzn , @edgescape , mention of the WACC has triggered off bad memories of Uni Business Finance 1 from many moons ago! I realised that even from back then, and still true today, I never truly internalised the DCF, WACC, alpha, beta etc and how that all worked - I struggled with the maths! Which is probably why I have had this irrational phobia on valuations ever since ...

But I am now on the straight-er and narrow-er after @Strawman 's preso, where some basic valuation is infinitely better than none ...

Thanks for your responses @Strawman , all clear and fully understood, which is a huge mental hump, crossed!

I added the 2 extra fields to input the Trailing EPS and an annual EPS growth rate and the formula to calculate the Forecast EPS. It is a very small mod but what it does for me is to take away the focus from the math (which knots me), back to focusing on the key valuation input question of "at what per annum rate do I expect the company to grow between now and the terminal period".

I did all that at uni too. In fact of lot of my Eco&Fin degree proved not super useful and not sure it every really got me a job past my grad role. Problem I always had was textbooks say "assume everyone is rational decision makers". Real world "everyone might be really stupid and make random decisions".

Anyway.

Valuation is "sold" as a super mathematical and accurate construct but its as much art than science as there are may approaches to it as well as many inputs which are effectively subjective. The valuation can be right if you use the method properly but is also wrong if your estimate of EPS is garbage. Then how valuation is utilised is again subjective as there are many cases where cheap things stay cheap and buying some when its expensive is a good investment.

All I say is use a few different tools that are appropriate an use them as a guide.

I have always liked the line: All models are wrong, but some are useful.

For valuations, or prices in general, I'd adapt it to: All valuations are subjective, but some are better grounded than others. Not grounded in some philosophically preferred manner, but in what has shown strong empirical evidence of being a powerful attractor for share prices over the long term. EPS, basically (with the limitations recently discussed).

The PE model is really just a proxy for market sentiment combined with a guess about future EPS, worked backwards to a desired return. There is no way to consistently judge both variables with precision at a specific point in time, but at least this frames your thinking around the factors that matter, and for which a sensible rough guess can be made. Much better i reckon than trying to model dozens of interconnected and hypersensitive sub-variables.

Add a margin of safety for prudence and you have something you can actually work with. All of this is secondary to first deciding whether the business itself is worth owning. If it is, you at least have some safeguard against overpaying, and maybe tilting the risk/reward balance a little more in your favour.

My whole approach can essentially be summed up as:

1. Is this something I believe will be bigger in the future?
2. Can I own part of it at a price that is reasonable relative to its conservatively assessed potential?
3. Only sell if:
4. conviction in that potential materially fades
5. the price becomes way too optimistic relative to said potnetial
6. The position becomes way too large a part of the wider portfolio
7. A better high-conviction risk/reward opportunity comes along

@jcmleng , one thing i would point out is that there is an implicit assumption in the valuation process that the data you are using is actually forecastable. I have done valuation-based rankings since the late 1980's What you often see is that it does not adjust for risk properly, so the riskiest investments are at the top; (ie most attractive) it is just favouring risk, it's not risk-adjusted.

this is not a binary outcome but rather a certainty continuum where dcf's etc, are much more useful the more certainty there is around the future cash flows. success in part depends on your assessment of that.

if the cashflows are not able to be forecast with any real certainty, using a dcf is very, very tricky and can turn to custard very quickly.

i see feedback that "valuation tools" don't work and see that they are just being misused. The utility falls off with forecastability.

IMO for most of the SM most favoured list, i would approach the valuation task with trepidation, use scenario analysis, a margin of safety, and realise it is an estimation at best that could easily melt away.

horses for courses scenario