An interesting engine....
They also seem to do a pretty good job of describing what they do and how they calculate it.
I had all kinds of things written -- mostly critical -- of the model they use, but the more I looked at it and the more I understood, and when I stopped making mistakes in the way I changed data, the criticisms all went away and the questions all answered themselves. I have left some of what I wrote set out below on the off chance that it might help someone else work through an understanding.
It also has a better -- or at least more thorough -- discussion of beta, which dovetails into the beta discussion I started a week or so ago. It is set out below in their words, but basically it includes debt-to-value as a component of risk and thus beta, which is as it should be. It may also explain why different places report different betas for the same stock.
One caveat to this valuation tool, which applies to all such tools, the ultimate value is only as reliable as the assumptions one uses and some of their default values are unrealistic in most cases (for example, the 10 years excess valuation period). Plus, given that it imports raw data without any consideration of the quality of that data, one needs to be careful about just accepting the financial data at face value. Financial results caused by one-time events are treated as though they are normal.
It is a nice tool so long as one understands how it works and thus, its inherent (though not necessarily bad) limitations.
Troy
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One thing, however, does not make sense to me -- maybe someone can explain it to me.
The third measure of return versus risk (beta) should be related to the specific stock being purchased-how risky is the type of business the firm does and how risky is the financial structure or leverage of the firm. Beta measures the risk of the company relative to the risk of the stock market in general. With greater risk, as measured by a larger variability of returns (business or operating risk), the company's should have a larger beta. And with greater leverage (higher debt to value ratio) increasing financial risk, the company's stock should also have a larger beta. And with a larger beta, an investor should expect a greater return. The beta of an average risk firm in the stock market is 1.00.
The financial risk model that uses beta as its sole measure of risk (a single factor model) is called the Capital Asset Pricing Model (CAPM) and is used by many market analysts in their valuation process. The relationship between risk and return that comes out of that model and the one that is incorporated into our FCFF analysis and spreadsheet software is:
Exp.(Rs) = (Rf) + beta(Rerp)
which in English translates to "The expected return on a stock (e.g. McDonald's) is equal to the risk free rate (e.g. 5%) plus the specific stock's beta (e.g. 0.97) times the equity risk premium (e.g. 3.0%)." In numbers it looks like this: Expected Return on McDonald's Stock = 5% + 0.97(3.0%) = 7.91%
I understand the theory of the CAPM as far as using it to calculate whether a stock is likely to produce the return required by the risk, but how can an expected rate of return on a stock, based on risk, be part of the intrinsic value, at least as far as quantifying the present value?
Conversely, in running some various companies and variable changes through it, I noticed that as the equity risk premium goes up, the intrinsic value goes down. This seems to be as it should be since the current intrinsic value would have to be lower as its expected cash flow returns diverged from the risk required return, but this is inconsistent with a rising beta producing a higher intrinsic value.
After I wrote the stuff above, I ran some more numbers and realized that it actually decreases intrinsic value as beta increases -- just as it should. My confusion stemmed not from the theory of how beta changes should affect price, but from my own poor quality and mistaken assumptions. I have included this because it truly demonstrates the garbage-in (mine) garbage-out reality.
Troy
Those who shoot from the hip usually end up just shooting themselves.
Plan the grub and grub the plan.
Where is the party tonight? Who is bringng the drinks?
