How do you project what a stock price can go to?

Hi TIP'ers,

I had this argument over the weekend with my brothers regarding what the price of a stock can climb to, they bought Canadian cannabis companies Aurora Cannabis and Aphria in time before Canada federally legalizes recreational use this summer. They think that these companies can possibly go to $100 / share in 3 to 5 years.

I questioned their reasoning and there was no reasoning besides the fact that Canada is legalizing cannabis federally and this would make the early large players a lot bigger.

Can anyone give me some extra information as to how you can go about assessing the future share price from a value investing perspective?

Thanks

Adam

Best Answers

  • edited February 12 Answer ✓
    Hi AdamS,

    I'm probably not the best suited to answer your question, but I'll give it a go anyways ;-)

    I haven't looked into the stocks you mention here, but generally I believe you need some kind of track record in order to calculate a business' intrinsic value. Sure, you can make guesses as to what a newly found business might earn, say, 3-5 years forth. However, if you have some history in terms of what the revenues, earnings and free cash flow have grown at in the past, you can make estimates, or "qualified guesses", if you will. Cannabis stocks seem to be the new "hot topic", causing a huge influx of capital despite – often, I believe – an absence of intrinsic value calculations.

    Alright, that said, you can calculate the intrinsic value in multiple ways. The most common is probably a discounted cash flow analysis. You may have heard Warren Buffet say: “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” A DCF analysis aims to determine just that. The model seeks to estimate a company’s present value based on the future free cash flows of the business (into perpetuity). In essence, free cash flow (FCF) is the amount that is left after spending the money needed to maintain the operational assets (e.g. property, plant and equipment). Hence, the free cash flow is simply operating cash flow – capital expenditures. FCF is significant, as it represents 1) the cash you could pocket if you owned the entire business, and/or 2) the cash the company can allocate as it sees fit, e.g. reinvest in the business’ growth, pay dividends or share buyback programs. Once we’ve made our projections as to the growth of these free cash flows, we need to settle on an appropriate discount rate based on the investment’s risks. Finally, we subtract the business’ debts and add its cash position.

    I recently did a DCF of McKesson. I saw that it's FCF have grown at 2.3% during the past 5 years. I thus applied a 3% growth rate to the latest FCF figure, namely $2.8 billion. As I regard the investment as risky due to an industry price war and potential political involvement, I believed a discount rate of 12.5-15% to be suitable. Here's my calculations:



    As you can see, my intrinsic value estimate came out at $202-$229 per share. Compared to the current stock price of $148, I felt comfortable investing in the stock given the relatively fat margin of safety.

    There's other ways to calculate it as well, i.e. a business' liquidation value, dividend models and combined earnings and dividend models (for the latter, you can pick up a book called "Why are we so clueless about the stock market?"). I'm sure there are others, but I am only an aspiring value investor myself – lots to learn still, thankfully!

    I hope this helped a bit, AdamS!
  • edited February 14 Answer ✓
    @AdamS, I'm glad it was useful! Full transparency, I found it difficult to master. I've never been a math genius nor an Excel-prodigy, so when I read books on DCF and tried to construct spreadsheets based on these explanations, I failed.

    I then turned to Google, which led me to a few videos on YouTube. Now that helped! I watched the two-part video 'series' below. I divided my screen into two: the YouTube videos on one side, and a clean spreedsheet on the other. I then followed his instructions, and replicated the template step-by-step. It helped tremendously! The theory made sense, and I understood the 'mathematical mechanics'. Once the basic template was setup, I could start expanding it, i.e. by creating my discount rates columns so I didn't have to alter the variable a bunch of times to get the intrinsic value with this and that rate.

    By the way, there's an ocean of free DCF-templates out there, but for me, creating it myself really made the difference. I hope the approach will help you too, Adam!



  • Answer ✓
    Hi guys,

    are you aware that all of what you just discussed - intrinisc value, DCF,how to investigate a stock - is in detail explained on this very same webpage from Preston and Stig? and all for free- you do not even have to sign up.
    Under
    http://buffettsbooks.com/
    you find 40+ videos explaining all you need to know about investing in stocks and bonds.
    And when you scroll down a little bit, you find on the right hand side "Your tools", which has links to the intrinsic value calculator, a Discounted Cash flow calculator and many more. All of these are also explained with videos.

    This is how I got started.

    Hope that might help a little.

    Christoph
  • Answer ✓
    Thanks for pitching in, @christoph! How could I forget Buffett's Books – indeed, it's a fantastic ressource! It's not just a great point of entry to the concept/calculation of intrinsic value, but also an awesome introduction to the value investing philosophy, and it outlines a ton of healthy investment principles. You gotta check that out too if you haven't already, @AdamS.
  • edited February 18 Answer ✓
    While I can't give much input on DCF calculation, I can give a little input on the complete euphoria in Canada right now over marijuana stocks. I had recently bought several marijuana stocks speculatively and then realized after that I was insane. The stocks are extremely volatile, the companies don't even have good earnings yet (P/E ratios are in the hundred's) and people are going crazy trying to buy into the sector before the government legalizes MJ in the summer. When people are saying things like, "Aphria is at 20$ and I think its going to hit 65$", they have no idea what will happen. That being said, I've exited most of my marijuana stocks and I'm trying to learn as much as possible about value investing.

Answers

  • @obruhndk Wow. That was an awesome and thorough explanation
  • Thanks @michaeljperry, appreciate the kind feedback! Hope it was useful!
  • edited February 14
    Amazing feedback and stellar explanation!!! I'm going to grab that book you mentioned.

    Where did you learn how to do the DCF analysis? Did you take the TIP courses or just google it?

    Thanks again for taking the time to help me understand.
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