How to Value a Stock like a Wall Street Analyst | Discounted Cash Flow and Comps

Wow! Do I have a special video for you today that will help you learn a ton about investing. This video is going to cover how to value a stock like the pros do to help you better identify stocks to buy. Let's jump right into the video.

There are two ways to value stocks that we will cover in this video: comps and discounted cash flow. These are the ways professional investors identify stocks to buy. Don't worry if these terms sound foreign to you right now because they will make a ton of sense once you have watched the video. And by no means are these concepts rocket science; all you need is to be able to do elementary school level addition and subtraction. By no means do you need a background in finance to use these methods.

In this video, I'm going to be joined by my friend Matt from the channel Peak Frameworks to help explain these concepts. Matt previously worked in investment banking and private equity. He has a ton of experience in the subject and has spent hundreds of hours putting these concepts to use in his career. Before I hand it off to Matt, make sure to like this video. It took a ton of time to put together, and I would really appreciate it. You guys are awesome!

Here is Matt explaining how to value a company using comparable companies, commonly referred to as comps. This is the practice of comparing a company to its peers and implying what it's worth based off of its relative trading metrics. When we're doing a comparable companies analysis, we're essentially looking for other publicly traded companies that have similar characteristics to ours so we can see potentially what ours will be worth. This is what's known as relative valuation because we are determining the value of a company relative to its peers.

So, in this video, we are going to explain what a multiple is and actually do comps by using online trading data in Excel. So, let's start by talking about what a multiple is. An evaluation multiple is simply just the ratio between the valuation of a company and the trading metric that we're looking at. What this valuation multiple essentially tells us is how expensive a company is. We're going to be contrasting the value of a company to however much revenue, profit, or EBITDA that the company generates.

Different companies are going to have dramatically different sizes and dramatically different revenues or EBITDAs. So, what we want to do is divide those two factors so we have a multiple that's much more easy to compare. So, if we're looking at a company that we value at 11 billion dollars, and the company generates one billion dollars of EBITDA, that means the company is valued at 11x EBITDA.

So, in order to do comps, I would break it out into these following steps. And for this exercise, let's try to determine the value of TikTok using comps. So, the first thing we want to do is try to find relevant peers. Now, what peers are similar to TikTok? When I think about TikTok, it really is a pure play social media player in my mind. And by pure play, I mean a company that has a relatively unified business model in one category.

I'll also include some of the larger consumer tech platforms like Facebook and Google because they also have social media components to them. So, when we look at these companies, we really want to make sure that they're all kind of adjacent, at least to social media, that they're growing quickly, and they have an international presence.

So, the next thing we have to do is aggregate the data, and this is actually a little bit more involved than you might think. So, here we are in Atom Finance. We're going to use this tool to pull the necessary data we need to do comps. As a retail investor, as an individual or student, I think this is probably the best sort of cheap option that exists.

So, what I'm going to do, I'm going to create a hub. This is essentially a group that I'm going to be using for my comps. I'm going to refer to the kind of broader list of companies that I had thought of that are similar to TikTok. So then, I'm going to save this as a hub. I'm just going to name this Social Media Comps, and now I have all these comps in front of me.

What I'm going to do is export these into Excel. I'm going to export these default columns and I've been through these. I also want to look at the returns data specifically. This is going to give me the week 52 low that gives me a rough sense for the percentage of the overall high that it's trading at.

So here we are in Excel. This is just the default formatting page that I use in all of my workbooks. What I'm going to do now, I'm gonna copy and paste the data from the two sheets that we just exported. Now I'm just taking the data from the other file so I'll have two sheets here. One I'm just gonna call comps data, and one is returns data.

Let's now create a new sheet which I'll call comps output, and I'll just quickly type in the title as well. Now, what we're going to do next is pull in the data from these sheets that we're looking for and put it off to the side. I'll take all of these for now, but I'm probably not going to use all of them.

So here we have all of the different multiples in front of us. Just to make things simpler, here we're only going to be looking at forward multiples. That's what a growth tech investor would primarily be focused on as well. So, I'm going to get rid of all the LTM—LTM meaning last 12 months. I'm also going to get rid of EPS growth; the reason is because for a lot of these companies they have very small earnings. They don't have a lot of net income yet, so it's not as relevant.

So, one thing off the bat, I actually don't think we're gonna include all of these. The one specifically that looks very strange is Match.com. First of all, they're already kind of a fringe candidate. They're more of a dating app which has its own set of valuation multiples now, but they also have much lower EBITDA and pretty much no earnings, so I'm not going to include this in our final set. I'm actually just going to delete it right here.

The other fringe one I would say is Amazon—mostly from a business model perspective. It's a lot more e-commerce which TikTok does not currently have, and unlike the other tech platforms, it does not really have a social media presence, so I'm just going to remove this one as well. Now, the final thing we're going to do is output this into a nice and clean fashion, and we're going to speed through this. But this is essentially the kind of format that you would actually show when you're in banking.

Now, this is pretty heavily sped up, but what I'm essentially doing here is retyping out all the titles, making sure that nothing overlaps with each other. Sometimes I'll put it into multiple rows and you want to make sure that you include the year that corresponds to the metric. So for here, it's FY1.

Now, there are two categories that we've kind of identified. I would say there's large cap tech platforms, so what I'm going to do here, I'm just going to copy and paste the links. For a percentage of 52 week, I'm going to take the price divided by that figure and make a percentage. We're going to do the same thing down here. Now, we're also going to add the median and average for all of these. These are really the rows we're going to be looking at when we're trying to understand quickly where the comps are trading at.

We're gonna speed through this as well, but I'm essentially just making sure that all the numbers are properly aligned and that they have the right format. I'm just copying and pasting from that master formatting tab to make sure that everything is right.

The last thing I'm going to do, I'm just going to add the total comps here. This is going to be instructive as we're thinking about the overall comp set. So, what I'm going to do here: median first set of numbers, second set of numbers, and then the average—same deal. So I would say that this is a relatively standard format you expect to do comps in investment banking.

I'm also going to select everything, then select Alt + P + R + S which sets a print area and makes it a little bit clearer to see. I'm also going to update this; it should actually be data in billions because these companies have billions of dollars of market cap. When I output it, I am going to do conditional formatting, making sure that everything turns black and I don't have this underlying font change. And to do that, you just have to go into conditional formatting right here.

So, the last thing for us to do is to come up with a set of reasonable financials for TikTok. Now that we have our constants in front of us, we have some multiples that we can start to use to determine evaluation, but in order to do so, we need to come up with the forward EBITDA estimate. Now, TikTok belongs to a private Chinese company, so they don't have very good data available.

What I had to do was go through a couple of articles in which it said they generated 17 billion dollars in 2019 on three billion dollars of profit. Then I saw in 2020 it was forecasted to generate 30 billion dollars. So, I use those numbers, which again is not too much to go off of, in order to come up with an estimate. I determine the profit margin based off that 3 and 17, and then I kind of use the 2020 figures as a basis for the growth rate.

I haircut the growth rate a little bit, but in 2021 I ended up with an estimate of about 8.5 billion dollars in profit. I'm using EBITDA as a proxy for profit here. Looking at our comps here, I decided to use large cap tech platforms. I'll probably use the median figure. I would have liked to use social media figures, but I think these companies are a little bit too small. Their EBITDA figures are a little bit too small, so I think these multiples are just way too high, and they won't provide a reasonable sense of valuation.

TikTok's revenue growth is going to be a lot larger than these large cap tech platforms, but their EBITDA presumably is going to be quite a bit smaller. So, I'm going to take this 15 times multiple and multiply it by the 8.5 billion dollars in EBITDA, and that arrives at an implied valuation of about 130 billion dollars. This is all quite rough math, but I think this is still a useful data point as we're thinking about TikTok's total valuation.

As another comparison point, it was reported that ByteDance is valued at 180 billion dollars, and that was in December 2020. Thanks for that great explanation, Matt! Make sure to check out Matt's website and courses where he goes over these concepts in more detail—link in the description. And if you're interested, use code IN investor for 10% off.

Now that Matt explained how to use comparable companies to value a stock, I'm going to explain the discounted cash flow, commonly referred to as a DCF. I use this method every day to value stocks at my job as an investment analyst at a large investment management firm. Now, don't get intimidated by this fancy term. All a DCF entails is using the cash flow a company produces to find the fair value for that company.

Using a DCF will help you identify what is referred to as a company's intrinsic value. The intrinsic value is simply the fair value of a business, or put another way, what the business is actually worth. A quote that Warren Buffett frequently uses is pulled from the book Theory of Investment Value by John Burr Williams: "The intrinsic value of any stock, bond, or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur over the remaining life of that asset."

So, put simply, the present value of a business is the present value of all future cash flows added together. Let's use Coca-Cola as an example to show you how to calculate cash flow. To calculate Coca-Cola or any company's cash flow, we need two numbers: a company's operating cash flow, also referred to as operating cash or net cash from operating activities, and capital expenditures.

Capital expenditures, or capex for short, is just a fancy way of saying the money used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment. Making capital expenditures on fixed assets can include repairing a roof, purchasing a piece of equipment, or building a new factory. You can easily find these numbers in a company's annual report and financial statements.

Here is Coca-Cola's cash flow statement from 2020. Keep in mind that Coca-Cola is a huge company, so these numbers are millions. For 2020, Coca-Cola had operating cash flow of 9.84 billion dollars. Coca-Cola also had capital expenditures of 1.17 billion dollars in 2020. This appears in the financials as purchases of property, plant, and equipment.

To calculate Coca-Cola's free cash flow, we would take the 9.84 billion dollars the company produced in operating cash flow and subtract out the 1.17 billion dollars the company spent on capex. The reason why you subtract out capital expenditures is that that money is essentially cash that needs to be reinvested in the business to either maintain the business's current size or to grow. Therefore, that cash is theoretically not available to be distributed to owners in the form of dividends or share repurchases.

Now that we understand the simple math behind calculating a company's cash flow, let's use an example of a pizza shop to walk through how you would use a discounted cash flow evaluation to determine the intrinsic value of a business. Let's say this pizza shop does one hundred thousand dollars in cash flow during the first year. To keep things simple, let's say this pizza shop is extremely consistent in its growth and is able to grow its cash flow ten percent a year as it sells more pizza and raises the price of each pizza by a little bit each year, and the shop's customers are more than happy to pay the price increase.

Then, at the end of year 10, you get an offer from a different investor to buy your pizza shop at such a high price you just can't refuse it. You are able to sell your pizza store for 15 times your ten's cash flow. Now, before we add together our cash flows to find the intrinsic value of the business, we need to take one more step. We now need to discount those cash flows back to the present day using a discount rate.

The reason you discount cash flows you receive in the future is that the dollar you receive today is more valuable than a dollar you receive in the future. This is for the same reason why if you have the choice between receiving one thousand dollars today right now or receiving one thousand dollars ten years from now, you would obviously pick the one thousand dollars today.

Going back to our example, the cash flows you will be receiving in years four, seven, or ten are less certain than the cash flows you will receive right now, and as a result, you need to discount those cash flows to account for the risk that you don't receive those cash flows. Additionally, you discount cash flows as a way to compare investments with each other. If you could put your money in an insured savings account at a bank and receive a five percent return on your money with no risk, you are going to need a return significantly higher on this investment to justify buying this pizza shop.

In this example, we are going to use eight percent as our discount rate. After you discount these cash flows, you can then add up the discounted values to determine the intrinsic or true value of the business. This is where another important concept of investing comes in: the margin of safety. In our example, we determined that the intrinsic value for our pizza shop is two million six hundred and forty-five thousand three hundred and two dollars. So, does that mean we should pay that amount to buy it? No way!

We ideally would want to buy this business at a significant discount to what we determined to be the intrinsic value. The difference between what the business is worth and what we pay is our margin of safety. This helps protect us if our projections of the cash flow turn out to be too high. Maybe another restaurant opens up directly next door and takes away some of our customers, or maybe the cost to make each pizza increases significantly.

So, as a result, we make less profit on each pizza. The margin of safety protects us from losing money if something unexpectedly bad happens. Additionally, the bigger the margin of safety or discount to intrinsic value we buy the business at, the higher our return will be if our projections turn out to be accurate.

Thanks again to Matt from Peak Frameworks for helping me put this video together! If you made it this far in the video, you are obviously serious about learning about investing. When I reached out to Matt about making this video, I asked him to provide you guys with the discount code to viewers who are interested in his course on valuation, which is a more advanced and detailed version of the material we covered in this video, as well as his course on landing a job in private equity.

Use the code investor to get 10% off. Make sure to check out Matt's YouTube channel and website, Peak Frameworks, to learn more about the concepts we talked about in this video. I put a link to both in the description. As always, thank you so much for watching this video! You guys are great! Make sure to hit the like button if you enjoyed the video. Talk to you soon!