You have touched upon a very interesting topic my friend, so brace yourself for a lengthy answer!
You need to think about this in two parts - understanding the Business and estimating a good price (valuation)
Part 1 - Understanding the Business
When a company files for an IPO, the company is bound to give you a prospectus with the following details..
- Background of the company, its promoters, directors, early investors, bankers, auditors etc
- Plant or service delivery location
- Description of products and services
- How much money the company targets to raise?
- Why are they raising money and the timeline during which they will utilize the proceeds
- At least last 5 year balance sheet, profit and loss and cash flow statements with the respective notes (schedule) to the statements
- The company needs to explain their business model in a convincing manner ( you may be interested to know that one of the reasons why Just dial IPO was delayed was because SEBI did not understand their business model)
- Threats and opportunities they foresee in their business environment
- Forward looking statements – how they see their business growing over the next few years
Now, with all this information, you will obviously get a good understanding on what, why and how of the company. You should also be able to figure out who their competitors are and what advantage or disadvantage they have over others.
Part 2 - Estimating the fair value of the company (valuation)
Assuming you have done a thorough analysis you should have a fair sense on the business model and the growth prospects of the business.
If you feel the business is too good and you want invest in it, you now need to know the fair price of the stock.
To evaluate the price and check if the price is right, you need a valuation model. There are two types of valuation model that you can build - DCF (discounted cash flow) using Free cash Flow to Firm (FCFF) and comparable valuation.
I’ll give you the steps for a DCF model because thats the tougher model to build…
Step 1) Input the Historical Balance Sheet and PL numbers
Step 2) Build an assumption sheet on which you have drivers for the BS and PL line items
Step 3) Build a schedule for assets, reserves and debt of the firm
Step 4) Using the schedules and assumptions project the BS and PL for next 5 years
Step 5) Derive the cashflow using indirect method. Note: Cash flow has to be derived using BS and PL. You will know you have derived the cashflow numbers right by cross checking with what the company has published. This also marks a milestone in your valuation model. Using the projected cashflow numbers, proceed to build a DCF model.
Step 7) Start the DCF model by calculating the free cash flow by subtracting the net current assets, investments, contingent liabilities from the net cash flow of the firm
Step 8) Estimate the terminal value of the firm by growing the last year cash flow by a terminal growth rate
Step 9) Calculate the net present value of the free cash flow to the firm and the terminal growth rate by discounting at a weighted average cost of carry (WACC)
Step 10) Calculate the enterprise value (EV) of the firm by adding the discounted FCFF and terminal growth value
Step 11) To the EV add cash and deduct the debt value to calculate the free cash flow to equity (FCFE) holder
Step 12) Divide the FCFE by the share capital to estimate the fair price of per stock!
Step 13) Check the IPO price or for that matter the market price of the stock with the fair value. If the market (or IPO) price is more than what you have calculated then it means the stock is overvalued. However if the fair price is higher than what is being offered in the IPO/market then you have an opportunity, therefore go ahead and buy the stock!
Step 14) There is always a room for error when you are building a financial model, always remember this and therefore make room for model errors.
So if ever you plan to invest in stocks, these are the things you need to do. If you can do this, perhaps you are setting yourself on the most flawless way to make money in the stock market (according to me of course). If not for anything…you can assure yourself a job of a good quality Equity Analyst :-)
Good luck and stay invested!