I believe valuation is an integral part of successful stock picking.
Unfortunately, it's not an easy thing to do – especially when you're new to financial statements.
However, regardless of which valuation technique you to use value shares, the rule remains the same…
The rule is this: It's all about cold hard cash.
Indeed, once you feel confident in determining the expected free cash flow or dividends of a business, the rest is simple data entry.
It's this data entry that makes valuation subjective. That's because two analysts could get entirely different estimates of the true worth of a stock even though the process for doing so is identical.
For example, it's easy to say Telstra Corporation Ltd (ASX: TLS) will grow free cash flow at 20% per year from here on, but it likely won't.
Conversely, I could say its free cash flow may fall 10% every year for the next five years, but it probably won't.
That's where a prudent analysis of the business, risks, expected product launches, and capital expenditures become vital to stock analysis and investing.
Are Telstra, Westpac and ANZ shares a BUY?
Bearing that in mind, here are some of my basic assumptions used to value shares of Telstra, Westpac Banking Corp (ASX: WBC) and Australia and New Zealand Banking Group (ASX: ANZ).
| Forecast FCF Growth | Historical FCF Growth | Implied value Per Share | Current Price | |||
| Telstra | approx. 2.25% | 2% | $6.12 | $6.42 | ||
| Forecast Asset Growth | Historical Asset Growth | Historical ROA | Forecast ROA | Implied value Per Share | Current Price | |
| Westpac | 3.50% | 5.7% | 0.98% | 0.90% | $25.81 | $34.90 |
| ANZ | 5.00% | 9.7% | 0.92% | 0.92% | $25.49 | $33.02 |
Source: Annual Reports and my calculations.
To value Telstra, I've used a standard discounted cash flow valuation. My free cash flow assumption is for slightly above trend forecasts of free cash flow over the next seven years, after adjusting for the divestments of CSL and Sensis. Given the growth prospects of Telstra, I may have been a little too conservative.
As can be seen above, my theoretical or intrinsic value estimate of Telstra shares is $6.12.
To calculate the worth of Westpac and ANZ shares in the table above, I've used a dividend discount model. To get to dividends, I've used asset growth as the defining growth indicator – remember a bank makes money from its loans (aka assets). From assets, I've adjusted for movements in profits using its return on assets (ROA) and included the effect of regulatory capital, known as common equity.
As can be seen in the table, I'm more bullish on ANZ. It has achieved strong average asset growth over the past five years (9.8%). Along with the broader economy, my expectations of 5% are below trend.
I'm not as confident Westpac will achieve as strong asset growth as its counterpart. It is less diversified than ANZ, which may be able to offset a slowing Australian economy by growing its Asian businesses.
Are these stocks a sell?
As can be seen in the table, I do not believe Telstra, Westpac or ANZ shares are a good buy at today's prices. However, contrary to many value investors' beliefs, I don't find it concerning to have an expensive share in my portfolio.
Personally, I'd rate Telstra as a hold. However, I wouldn't want to hold either ANZ or Westpac shares at this point because the downside appears too great. Indeed, in a slowing economy, the big banks may not grow their loan portfolios at all – let alone at 3.5%!
If the banks failed to grow their loan books to keep bolstering record profits, it should go without saying that the implied valuations of ANZ and Westpac become even more alarming…
