The Secret Of Financial Statement Modeling
When it comes to getting filthy rich overnight, folks usually find the key to success to be investing in stock markets. The good news is that today in the era of tremendous technological advancement investing in stocks is now possible with one and only one condition: Have all the data available to make the best decision.
The first thing that must be learned towards gaining enough knowledge about investing in the stock market is to have a deep understanding of companies’ financial statements which are the most reliable data, audited by third-party firms.
Understand Company Financial Statements
A company has 3 financial statements: Income statement, Balance sheet statement and Cash flow statement. It publishes them every year.
Each of the Financial Statements Have a Purpose:
Statement of Profit & Loss Income Statement
Often, the first place an investor or analyst will look at is the income statement. The income statement shows the performance of the business in terms of Revenue, Cost of sales and Profit (Both Gross and Net Profit).
- Shows the revenues and expenses of a business
- Expressed over a period of time (i.e., 1 year, 1 quarter, Year-to-Date, etc.)
Balance Sheet Statement:
The balance sheet displays the company’s assets, liabilities, and shareholder’s equity.
- Shows the financial position of a business
- Expressed as a “snapshot” or financial picture of the company at a specified point in time (i.e., as of December 12, 2017)
- Has three sections: assets, liabilities, and shareholders equity
Statement of Cash Flow
A cash flow statement is a financial statement that provides aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources.
- Shows the increases and decreases in cash
- Expressed over a period of time, an accounting period (i.e., 1 year, 1 quarter, Year-to-Date, etc.)
- Shows the net change in the cash balance from start to end of the period
These three statements allow us to have a clear picture of a company's financial health at any given time frame.
For example for Apple Inc. 2018 Net Income is 59.53 billion USD, Total Assets represents 365.7 billion USD and its free cash flow 5.624 Billion.
Similarly, for Microsoft Inc, 2018 Net Income is 16.561 billion USD, Total Assets represents 258.848 billion USD and its free cash flow of 4.283 Billion USD.
All these figures are a positive and good indication for establishing a reputable trust on investors but there are also other aspects like key financial Ratios that must be taken into consideration while decision making about a particular stock.
These financial ratios are like ROI (Return On investment), Current Ratio, Debt/Equity Ratio, etc.
Hey Folks! Don’t be afraid of these jargons. These data are easily available for almost all listed stocks. You can find them as reported in the U.S. Securities and Exchange Commission (SEC) website.
Other than that we encounter many new methodologies in the market and we will discuss today the DCF Methodology.
I will explain to you in a few lines to give you a better understanding and will save your time roaming around.
What is the DCF Model?
A basic DCF model involves projecting future cash flows and discounting them back to the present using a discount rate (weighted average cost of capital) that reflects the riskiness of the capital you then add up all those discounted cash flows and the sum is really the intrinsic value of the company (equity Value).
In this method we try to compare the Market Value of the Share price with the intrinsic value of the share price which is calculated under the DCF methodology through this formula:
Share Price = ((PV of Free Cash Flow) - Net debt ) / Shares Outstanding
Present Value: The values in the presence of a sum of money, in contrast to some future value it will have when it has been invested at compound interest.
Free Cash Flow: Free cash flow (FCF) is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, dividends, reducing debt, or other purposes.
Net Debt: The overall debt situation of a company by netting the value of the liabilities and debts of a company along with its cash and other similar liquid assets.
Shares Outstanding: Are all the shares of a corporation or financial asset that have been authorized, issued and purchased by investors and are held by them.
If you calculate it's discounted cash flow value called DCF. In simple terms, we want to project the company financial statements that we just analyzed for the next five years to determine if its value today is more or less than the company’s current share price.
Apple has the Following Information Furnished with Us
- PV of Free Cash Flow: $1,091,589
- Net debt = $8,749 . Number of outstanding shares: $4,617
- WACC: 11%
- Growth Rate: 4% .
Let’s look deeper at Apple DCF:
Let's look at the formula for the DCF method
Share Price = ((PV of FCF) - Net debt )/Shares Outstanding.
Now we will put the figures of the example into the above formula. For more details of the above formula, please have a look at this Apple Terminal Value. You will see the whole breakdown of the calculation.
So if we use the formula we get:
Share Price = [1,091,589 - $8 , 749 ] / 4,617. Share Price = $238.28.
Is Apple Inc. overvalued or undervalued?
We see the intrinsic value as 2019 of Apple Inc. to be $238.28 which is below the current market price of $267.25, so clearly, Apple Inc. is overvalued.
In conclusion, based on this DCF value, we should only take a short position on this particular stock. Following the same reasoning, we can find good buying opportunities such as Facebook or Google. You can find all the details of the valuation and DCF rankings based on the best opportunities available on the market.
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