How to value a stock

A business is worth the cash it will hand its owners, adjusted for the fact that cash arriving later is worth less than cash arriving now. A discounted cash flow model projects free cash flow forward for a handful of years, applies a terminal value to everything after that, and discounts the lot back at a rate representing what the money could earn elsewhere at similar risk.

Its strength is that it forces every assumption into the open. Its weakness is that the terminal value usually accounts for well over half the answer, which means the result is more sensitive to two numbers you guessed about the distant future than to anything you carefully estimated about next year.

• Best for businesses with predictable cash flows and a history long enough to extrapolate from.
• Worst for anything cyclical, pre-profit, or undergoing a change in what it does.
• Always run it three times, pessimistic, central and optimistic, and treat the spread as the actual output.

Because a discounted cash flow is so sensitive to assumptions, forecasting is often the wrong way to use it. Run it backwards instead: take the market price as given and solve for the growth rate that would justify it.

This converts an impossible question into a tractable one. Rather than predicting five years of cash flow, you are judging whether 12% a year is plausible for a business you understand. That is a question you can actually have an opinion about, and it is the question a reverse discounted cash flow puts in front of you.

Relative valuation asks what the market pays for comparable businesses and applies that to this one. Price to earnings, enterprise value to EBITDA, price to sales: each is a shorthand for a discounted cash flow that nobody wrote down.

It is quick, it is grounded in actual transactions rather than assumptions, and it inherits whatever the market currently believes. If an entire sector is overpriced, every company in it will look reasonably valued against its peers.

• Choose the multiple to match the metric. Enterprise value pairs with pre-interest profit; market capitalisation pairs with net income.
• Compare against the company's own history as well as its peers. A multiple far above its five-year average needs a reason.
• A low multiple on a business in structural decline is not cheap, it is correctly priced.

Where a company runs genuinely distinct businesses, valuing each separately and adding them can reveal value the market is missing, because a conglomerate is often priced on the least interesting thing it owns.

It is laborious, it depends entirely on segment disclosure being detailed enough to work with, and it only matters when the parts really are separable.

They will disagree. A discounted cash flow saying a business is worth double its price while it trades in line with every comparable company is not a contradiction to resolve by averaging. It is a question about which set of assumptions is wrong.

Usually the answer is that the growth or margin assumption in the cash flow model is more optimistic than the market's, and the useful next step is finding out what the market appears to be assuming instead.

Whatever number you arrive at, it is an estimate built on assumptions that will not all hold. The margin of safety is the gap between that estimate and what you pay, and it exists precisely because the estimate is uncertain.

How much margin is enough depends on how confident you are, not on a fixed threshold. A stable business you understand well justifies less than a cyclical one you do not.