[Q&A] how to pitch and value a stock

Q: Pitch me a stock

A: Eaton is a great buy right now, because of its high growth potential and undervalued stock price. Eaton is an American power management company, which provides electric products as well as industrial solutions for its clients all over the world. Last year it achieved 20.4 billion revenue, a 3% increased compared to the previous year. The 19.4% ROE and 17 P/E ratio are both beyond industry average, and demonstrated the company's good profitability and positive investment outlook. Currently its stock price is 84 dollar. Based on DCF modeling we calculated its enterprises value (EV) to be 45 billion, and stock value is around 103 dollar. So currently Eaton's stock is undervalued, and it's a good time to buy in. 

Q: any risks involved?

A: yes. The industrial automation will be the key challenge/risk for Eaton as well as the manufacturing industry as a whole.

Q: So how you made the valuation

A: I use the DCF model for the valuation, because Eaton is a mature manufacturing company with stable and predictable cash flow. DCF values a company based on the PV of its cash flows and the PV of its terminal value. 

1. project the free cash flow. For the first 5 years we use data from financial statements. The net income in the income statement is the first line, then we add the non-cash expense D&A, less increase in working capital and capital expenditures to come to the free cash flow. 

2. estimate the free cash flow after year 5. From the 6th year, we assume there is a 5% growth on the cash flow, then use the gordon growth model to calculate the terminal value. 

Year 5 FCF*(1+growth rate)/(WACC-growth rate)

3. calculate the discount rate - WACC. We assume the cost of debt is 5%, and the cost of equity is 15%, and there is a 30% tax rate. From Yahoo finance we get the stock beta is 1.26, and considering the debt-equity-ratio, we can calculated WACC for each year, around 9% like this. 

WACC=cost of debt*debt proportion*(1-tax) + cost of equity*equity proportion

4. we add up the present value and the terminal value to get the enterprises value. It is around 45 billion.

Q: How you calculated the cost of equity?

A: I use the CAPM model to calculate cost of equity. It follows the formula that: 

cost of equity = risk-free rate + security beta * equity risk premium

equity risk premium = expected market return - risk-free rate

Q: explain beta?

A: beta measures the volatility of a stock compared to the market. If beta>1, the stock will be more volatile/risky than the market. 

beta=cov(ri,rm)/var(rm)=corr(ri,rm)*sd(i)/sd(m)

Q: so what's the difference between levered beta and un-levered beta?

A: un-levered beta does not consider debt/leverage, therefore include interest represent the money for all investors; levered considered/exclude interest, and therefore only available to equity investors. 

un-levered = levered/[1+(1-t)*(D/E)]

Q: how do you think about DCF result? higher or lower?

A: higher. because (1) DCF is always positive about the company's cash flow (2) variance in WACC estimation.

Q: tell me some other valuation model?

A: as below:
(1) comparable companies/multiple analysis: follow the apple to apple principle, eg: EV-sales/EBITDA-unlevered beta, market cap/earnings-price-levered beta
(2) market capitalization: stock price * outstanding shares 
(3) precedent transaction
(4) sum of the parts
(5) net assets value (for O&G)
(6) LBO (leverage buyout)

Q: ok, how you select comps?

A: for comparable companies: industry, geography, revenue/EBITDA; for precedent transactions: industry, within 1-2 years, similar market caps.

Q: then precedent transactions come up with a valuation higher or lower?

A: higher, it involves premium. 

Q: what about market capitalization?

A: lower, it is only the equity value, debt excluded.