Choosing the right financial tool to evaluate a company can be a daunting task, especially when different models are giving you drastically different conclusions. For instance, while my relative valuation model tells me TAL Education Group’s (NYSE:TAL) is undervalued by 71.26%, my discounted cash flow (DCF) model signals a 13.97% overvaluation instead. So, which model is more reliable and why?
A closer look at intrinsic valuation
At the heart of the DCF is the basic assumption that a firm’s intrinsic valuation is equivalent to the sum of all its future free cash flows (FCF). As those familiar with the DCF will know, forecasting FCFs reliably past 5 years is often a difficult and subjective task, which is why I’ve used analyst FCF forecasts as a starting point for my model. To obtain the per share intrinsic value of TAL, we must first discount the sum of TAL’s future FCFs by 9.9%, which gives us an equity value of $US$15.2b, then 567.29k shares outstanding are divided through. This results in an intrinsic value of $26.87. Check out the source of my intrinsic value here.,
Before we move on, let’s evaluate whether this number is accurate. To ensure our conclusion is robust, let’s take a look at how many analyst forecasts are being used in the last year of TAL’s 5-year forecast horizon. With only 2 analyst forecasts for TAL’s FCF in the fifth year, our DCF demonstrates that even broker analysts struggle to reliably forecast future cash flows for TAL after a few years. The lack of analyst forecasts undermines the conclusion we made earlier, which is a legitimate justification for attributing less weight to our DCF.
Deep-dive into relative valuation
The assumption behind relative valuation is that two companies with similar risk-return characteristics should have the same price since investors theoretically would be indifferent to purchasing either company. Unfortunately, the hardest part is finding companies that are similar enough to TAL to compare it against. As such, I’ve used the overall Consumer Services industry as TAL’s proxy. Obtaining the fair value of TAL through relative valuation is quite straightforward. We simply multiply TAL’s earnings by the industry’s P/E ratio, which gives us a share price of $6.65 that implies TAL is currently overvalued. However, is this conclusion robust enough for us to use?
One quick way of finding out is to see if TAL shares a similar growth profile to the overall Consumer Services industry we are comparing it to. With a projected earnings growth rate of 26.45% for next year, TAL has a significantly different growth profile when compared with the Consumer Services industry, which is projected to grow at 14.94%. Unfortunately, this check shows that the Consumer Services industry is a poor proxy for TAL, which weakens our relative valuation analysis. Instead, we could dramatically improve our analysis by hand-picking companies that share similar growth profiles with TAL. I’d encourage you to do this by taking a look at TAL’s competitors.
Which Model Is Superior?
Both are somewhat weakened by assumptions we have used to fill in the gaps. While intrinsic valuation is immune from market irrationality and mispricing, it is highly exposed to forecasting error. On the other hand, relative valuation is easy to calculate but affected by overall market mispricing. For example, relative valuation would not have been an effective tool to value a technology company at the height of the dotcom bubble in 2000. Given the pros and cons that I have laid out, I encourage you to derive a valuation by calculating a weighted average share price by using both models.
For TAL, I’ve compiled three essential aspects you should further research:
- Financial Health: Does TAL have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does TAL’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of TAL? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.