Stock valuation…

Just because a company is fundamentally solid, it doesn’t mean you should jump in and purchase it without first asking yourself two very important semi-related questions:

  1. Is it too expensive at its current price?
  2. What price should I pay for it?

Now there are a number of methods available for determining a company’s intrinsic value, and I’ll discuss two of the better ones.

The one I use the most is based on Earnings per Share (EPS).

Note that there are a number of pitfalls in using this approach, the chief one being that it relies on estimating the EPS growth out into the future — usually for at least the next 5 years.

Be aware that not all companies have predictable EPS growth.

In fact, a large majority do not. However there is good news.

The fundamentally solid companies that value investors should be looking at generally have stable and predictable businesses and thus stable and predictable earnings.

And since we’re usually not interested in fundamentally weak businesses, the EPS method of determining a company’s intrinsic value generally works well.

But your mileage may vary and depends on the types of stocks that catch your attention.

Okay, so with that prologue out of the way, let’s dive in and find some intrinsic value.

The earnings per share method…

As an example, I’ll use Moody’s Corporation (MCO) since Warren Buffett holds a big chunk of it, through his various companies, and, in the past, has said it is a great company.

The thing is, he might be having second thoughts in today’s economic climate. 

During July of 2009, Buffett sold about 16% of his stake. Nonetheless, he still holds about 17% of the company even after his recent divestiture.

So Moody’s it is.

Before we can begin, we’ll need some data.

We’ll need the company’s current Earnings Per Share (EPS), its annual Dividend payment (if any) and the average analysts’ estimates of its Future EPS Growth to estimate what the stock will be worth in the future.

You can find all these data items at Microsoft’s Money Central site.

In MCO’s case, the numbers as of July 2009 are:

EPS = $1.68, Dividend = $0.40 and 5-year estimated growth rate = 12%

Next we’ll need to determine how long to hold the stock.

Longer periods are better, but the issue here is that the longer you project, the less accurate your EPS growth rate estimates might become.

But then again, if you’re dealing with a top-flight company, your estimates might end up being even more accurate.

In any event, we’ll use 5 years for our calculations. Using these data, we can calculate the future value of EPS for the 5-year time period using the following formula:

Future EPS = P(1 + r)^Y + c[ ((1 + r)^(Y + 1) – (1 + r)) / r ]

Where P = the current EPS; r = Est. EPS Growth; c = 1/2 the dividend rate; Y = Years to Hold.

Note that we use half of the dividend rate rather than the entire amount, because dividends are not guaranteed and they can be reduced or eliminated at any time.

So by using half the current dividend, we start building a very conservative estimate of the Future EPS value.

Therefore,

MCO’s Future EPS = 1.68 (1.12) ^5 + 0.20[ ((1.12)^ 6 – (1.12)) / 0.12] = 4.38

So Moody’s Future EPS is $4.38.

Once we have the future EPS value, we can now estimate the future price for the stock by using the Lowest Average P/E ratio for the past 5 years (17.80 for MCO).

Again, we want to build a conservative estimate and therefore we err on the side of caution whenever possible.

We can calculate the estimated future price using the following formula:

Estimated Future Price = Future EPS * Lowest Average P/E for past 5 Years

So,

MCO’s estimated future price = 4.38 x 17.80 = $77.96

Now discount the future price…

Once the Future Price has been estimated, the next step is to discount that price back to the present day. The formula to do this is:

Price = FP / (1 + r)^Y

Where FP = the Future Price; r = Discount Rate; Y = Years to Hold.

To determine the correct Discount Rate, we need to decide on the Margin of Safety and expected Worst Case Return we require.

The formula to calculate the Discount Rate is:

Discount Rate = Worst Case Return / (1 – Margin of Safety)

Plugging in all the numbers gives us the maximum price we should be willing to pay today in order to have the required Margin of Safety and worst case return.

If the stock’s current price is less than or equal to the maximum purchase price we calculated, then we should be happy to purchase the stock. Otherwise we should pass, as the stock is currently too expensive.

Note that the higher the Margin of Safety and the Worst Case Return we decide upon, the fewer stocks will meet these criteria. Lower settings will return more stocks.

You can use any Margin of Safety and Worst Case Return values, but the recommend values are 50% and 12% respectively.

You can interpret this to mean that if the stock’s return drops 50% from what you expect, your return will be 12% annually.

If the stock returns what you expect, you’ll see a 24% return.

The reason we use a worst-case return of 12% is because this is the average annual return of the S&P 500 over long periods of time.

If you’re going to spend the time and effort investing in individual stocks, you should expect to do MUCH better than the S&P 500 (the goal should be to at least double the S&P 500’s return).

If you can’t do that, then you’re better off investing in a low-cost S&P 500 index fund.

Plugging in the data based on our 50% Margin of Safety and 12% worst-case return, our discount rate becomes:

0.12 / (1 – 0.5) = 0.24

So our maximum buy price is:

77.96 / (1.24) ^5 = $26.59

Right now MCO is trading at $23.86. So it looks like the company is a buy (assuming its fundamentals are strong).

An easier way…

What you might have noticed is that there is an awful lot of calculating required in order to find the intrinsic value of ONE STOCK! And you’re right.

It’s also error prone.

But that’s how it was done for decades before computers came onto the scene.

Nowadays you can simply use an online Compound Interest calculator to determine the Future EPS value and use a Present Value calculator to determine the maximum purchase price. Or better yet, use a spreadsheet.

But I digress.

Back to the topic of valuation, let me say that there usually won’t be a very large number of high quality stocks trading at a discount with a sufficient Margin of Safety at any particular time.

However you can find a handful if you’re disciplined and patient. Using the Value Investing approach, you can actually pick up these bargains when others are jumping out of them for any number of short-term reasons.

And when you do, you position yourself to profit handsomely.

Nevertheless, the only way you can achieve these types of returns (and safety margins) is to be patient and pay less than what most people pay.

In other words,

the price you pay for a stock will determine the return you can expect on your investment.

The less you pay, the greater your return. The more you pay, the lower your return.

And that is what Benjamin Graham meant when he talked about the Margin of Safety.

Of course the valuation technique I’ve just described is not the only method, and Warren Buffett likes to use another method based on the Return on Equity (ROE).

The return on equity method…

To see Buffett’s method in action, let’s look at another example – we’ll use Marvel Entertainment (MVL) this time.

It’s close to rating Very Good on the fundamentals scale we discussed above — but it’s not quite there, it has a strong moat rating of 5, an average ROE over the past 5 years of 40.64% and it retains all of its earnings – that is, it pays no dividends.

Further MVL has a per share equity value of $5.08 and its lowest average P/E ratio over the past 5 years is 11.60.

Given these data, we can now estimate what the company should be worth 5 years from now.

First, we calculate the projected per share equity value 5 years hence.

The present value is $5.08, the 5-year average ROE is 40.64% and the number of years is 5.

Plugging these values into a Compound Interest calculator spits out a future value of $27.95.

In 5 years the company is projected to have a per share equity value of $27.95.

To estimate the per share earnings 5 years in the future, we simply multiply this $27.95 value by the 40.64% ROE to get a projected per share earnings value of $11.36.

To estimate the share price in 5 years, multiply $11.36 by 11.60 (MVL’s lowest 5-year average P/E) to get $131.78.

Now we can discount that future price back to the present using exactly the same method we used in the Moody’s example above.

Assuming our recommended discount rate of 24%, we can calculate our maximum buy price to be:

$131.78 / (1.24) ^5 = $44.95

Since MVL, as I write this, is currently trading at $39.01, it looks like a buy (at least from a valuation perspective, you still have to do your due diligence and ensure that you’re happy with the results).

Keep in mind that both of the valuation methods we’ve just seen rely on forecasts going out into the future.

If you’re looking at a company that has a spotty or volatile earnings or ROE history, these methods can end up being very inaccurate.

However, as I mentioned earlier, the companies you should be looking at (those with superior fundamentals and strong moats) should all have consistent earnings and ROE.

So these valuation strategies should work well with them (but as usual, don’t blindly follow formulas without injecting your own common sense).

For a stronger strategy, you can use both valuation methods and either average the results to find a maximum buy price or, for the more conservative investor, use the lower of the two as your maximum.

The point is to make your purchasing decision based on facts, logic and the numbers rather than on emotions, hype and the need to see action.

If you want to do well in the stock market, you need to take a page out of Buffett’s book and follow his lead.

So there you have it. A complete primer on how to invest successfully in the stock market.

If you follow these investing basics you’ll significantly increase the probability of not only outperforming the markets, but the professional mutual fund managers too, and you’ll most likely lower your risk as well.

 

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