To complement the valuation post with multiples some time ago, its also important to take a look at the discounted cash flow (DCF), since multiples like roe, roic, cagr provides data based on the past and that compares the stock's market value to financial metrics such as earnings, sales, or book value. However, DCF valuation is an intrinsic valuation method that estimates the present value of a company's future cash flows. The DCF takes into account a company's specific financial situation and future growth prospects, as it considers a company's cash flows over a long period of time and discount them back to their present value using an appropriate discount rate (normally the interests rates), that would be the cost of opportunity of money in that time in a bond. So both models are used together, past data and future projections.
An interesting comparision is from Warren Buffett to his tutor, Benjamin Graham, they have different methods for determining valuations and intrinsic value. Graham was known for using a quantitative approach (multiples), focusing on a stock's book value and earnings, while Buffett uses a more qualitative approach that emphasizes the future cash flows of a business, more similar to DCF.
Graham believed that the market is often inefficient and that stock prices can deviate significantly from a company's intrinsic value in the short term. He used various metrics, including price-to-book ratio, to determine a company's intrinsic value. He believed that by buying stocks at a significant discount to their intrinsic value, investors could protect themselves from the downside risk of investing in the stock market (margin of safety).
Buffett, on the other hand, defines intrinsic value as the present value of the future cash flows expected to be generated by a business. He emphasizes that the intrinsic value of a business is not determined by its current stock price or the book value of its assets, but by the cash flows that it can generate over the long term.
So how Buffett determines the margin of safety? The risk associated with the cash flows that Buffett uses in his discounted cash flow analysis is linked to the uncertainty of future events that may affect the business, such as changes in the competitive landscape, technological disruption, regulatory changes, or macroeconomic conditions. These risks can impact a company's ability to generate cash flows over the long term, and therefore affect its intrinsic value. To mitigate these risks, Buffett often looks for companies with a sustainable competitive advantage or "economic moat". A company with an economic moat has a unique and durable advantage over its competitors, which allows it to generate consistently high returns on capital and protect its market share over the long term. Examples of economic moats include brands, patents, network effects, economies of scale, and switching costs. By investing in companies with a strong economic moat, Buffett believes that he can reduce the risk associated with the uncertainty of future cash flows. In addition, he also looks for companies with a strong balance sheet and a history of generating high returns on capital to further reduce the risk of investing in a particular company.
So here we can see that the net margin and current ratio liquidity of a company matters a lot, otherwise the company can have a high burn ratio and turn capital hungry, needing to keep raising money to sustain itself, not by its operational health... And the stock price tends to be reflected on that health.
Also important to notice how macro factors affects it and how the market will precify next. When interest rates are low, the cost of borrowing is lower, which can encourage more investment and spending. This can lead to higher cash flows and higher valuations for companies. Conversely, when interest rates are high, the cost of borrowing is higher, which can lead to lower investment and spending, and lower cash flows and valuations for companies. Therefore, when interest rates change, the DCF valuations of companies is also impacted.