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By Brian Nelson, CFA

Intrinsic value represents the conclusion to any and all stock research: What is the company worth? DCF valuation captures the expectations of a firm's competitive advantages, growth prospects, strategic endeavors, and any other qualitative factor. No other process does this. Putting to numbers a plethora of advanced fundamental items in arriving at a fair value estimate is the cornerstone -- and the most critical component -- of any stock research analysis. Without an in-depth intrinsic-value assessment, research is but a story that has no ending.

-- Valuentum Securities, 2011 slide deck

Sometimes I have to remind myself that I was once a youngster, too. I remember pitching stocks to my portfolio manager and the chief investment officer. It was fun.

I remember the buyside firm I worked at back then had a methodology that didn't require calculating the intrinsic value of a firm. I remember a number of my colleagues at that firm used to get flat-out disgusted when valuation was brought up. I remember it well.

A lot of investors -- and intelligent ones -- don't apply valuation techniques in earnest. They may say a firm is trading at 10 times EBITDA or that it's trading at 10 times earnings, but they really have no idea what the same company they are talking about is worth.

Yet, our team religiously and rigorously calculates the intrinsic value of every firm in our coverage universe.

Why do we do this?

Let's answer this question by starting with a simple example.

You have four buckets: the first is filled with $100 worth of ice, the second is filled with $100 worth of worms, the third is filled with $100 worth of shampoo, and the fourth is filled with $100 worth of water. Which one is worth more, assuming each bucket is identical?

I have to say that 99.9% of people will say that each bucket is worth the same. This isn't a trick question. We're hoping you'd say they are worth the same.

No matter how cold the ice is, or how good the worms can be used to catch fish, or how refreshing the shampoo is, or how thirst-quenching the water might be, the buckets still are worth the same. We've already determined the value of these buckets based on their respective intrinsic qualities, and no matter how well one talks up the attributes of each, the value is not going to change.

But what does this example have to do with investing? Well, when it comes to investing, the ability to reason through comparisons like this, and the application of common sense to answer obvious questions like this breaks down.

Why? Because investors start focusing and talking about the composition of a firm's value, instead of focusing on the firm's value itself. Think of value as what something is worth because of its qualities (future free cash flows), not in addition to its qualities.

Let's now try this example for illustration.

You have four companies. One continues to exceed earnings estimates, but its discounted future free cash flows suggest it is worth $70. Warren Buffett classifies the second company as having an ultra-wide economic moat, but its discounted future free cash flows suggest it is worth $70. The third company has an awesome chart, but its discounted free cash flows suggest it is worth $70. And the fourth company pays a hefty dividend, but its shares, too, are worth $70 each.

Which company is more valuable?

You'll start hearing comments like the company that exceeds earnings estimates is the better idea, or you'll hear others say that Warren Buffett's moat makes the second pick better. There will be a third group that says the chart is all that matters. And the fourth group won't even know that the first three companies exist because they don't pay a dividend.

Can you start to see how investors get confused in this day and age? The whole ability to compare stocks somehow breaks down when they start talking about them.

No matter how wide Warren Buffett thinks the firm's economic moat may be or how frequently the company has beaten earnings estimates or how fancy the chart looks or how high the dividend payment is, each company in the above example is still worth $70. The composition of the value is not a reason to own a company. The value of a company is the reason to own it.

Any day of the week, I will gladly pay less than the present value of a company's future free cash flows for that company (the bigger the discount the better). Notice how I didn't say anything with respect to earnings estimates, valuation multiples, or Warren Buffett's economic moat.

After all, how can you pay less than the value of "exceeding earnings estimates" or less than the value of an "economic moat"? And how do you determine the value based on a chart? It just doesn't make any sense. Earnings, competitive advantages, etc. are just factors that roll up to calculate the intrinsic value of a company.

The value of a company is not a consideration to own a company; it is THE consideration. It embodies a firm's expected growth rate, its competitive prowess, and every other intrinsic factor. So the next time you read about a discounted cash-flow valuation analysis, it is not a robotic output or just some financial metrics, it represents and embeds the conclusion to any and all fundamental analysis. It is not missing something. It is the answer, the conclusion, the result of any and all research.

Of course, it's fine to talk about the qualities of ice, worms, shampoo and water (as in the above example), but at the end of the day, the only thing that matters is what something is worth (what does it weigh). Legendary investor Benjamin Graham was well-known for calling the market a weighing machine in the long run, and to a large extent, the value (the weight) of a firm is what he was referring to in this particular instance.

If Benjamin Graham or Warren Buffett could buy a no-moat stock for pennies on the $1, they'd do it. After all, Buffett did do it with US Airways (LCC). And do most investors that follow earnings estimates actually think the best companies of all time always beat estimates every quarter? They must know that there was something else supporting the stock -- its valuation. And for the pure technicians, what happens when a chart rolls over? Is the company then doomed forever? Absolutely not. We love combining valuation and technical/momentum indicators in our stock-selection process, the Valuentum Buying Index.

Understanding business models is important. After all, it helped save many readers a ton of money on our call on American Capital Agency (AGNC) and other highly-leveraged mREITs both at the top in September 2012 (here) and right before the recent collapse (here). I strongly encourage taking a read of these two pieces, as we certainly went against the crowd in our independent analysis (look at the comments, for example -- there was some fierce opposition). We were spot on.

But valuation is ever-more powerful. Just look at our inaugural Best Ideas portfolio in July 2011. We documented the inaugural portfolio on July 15, 2011 in the public domain on Seeking Alpha because we know you can't just take our word for how good our stock picks have been. The portfolio, as of July 15, is right here. Our longs were Apple (AAPL), Altria (MO), Ancestry.com (which was bought out), Astronics (ATRO), Buffalo Wild Wings (BWLD), Collective Brands (which was bought out), EDAC Tech (which was bought out), Precision Castparts (PCP), and Republic Services (RSG). We also held a put option on now-bankrupt AMR Corp (AAMRQ.PK).

The July 2011 edition that had our Best Ideas portfolio documented within it was certainly a valuable edition. You'd think this would put a stop to some of the outrageous comments we get on our valuation articles. Nope. Even some of our great calls on identifying dividend cuts (click here) haven't done much to win fanfare in these parts. We think it's just a matter of time.

When you read our research, it's important to note that we're not just providing financial metrics -- Valuentum is providing an answer to the only question that matters in investing: what is a company worth? Though there are varying opinions about which underlying factor is the most important investment consideration, at the end of the day, valuation is the only thing that really matters.

Three Top Stock Ideas

If you've made it this far through the article, I'd like to congratulate you. How about a reward in the form of three of the most undervalued companies in our coverage as of today? I hope you enjoy!

Baidu (BIDU)

Baidu will benefit from the ongoing boom in China's Internet space. The country has the world's largest Internet user population--and a long way to go to reach penetration levels of developed countries. We think Baidu will remain at the forefront of such secular expansion for many years to come. Baidu will likely successfully mimic several of Google's (GOOG) strategies since Google mostly doesn't compete in China, but also because Google has done tremendously well building a powerful brand and company. Baidu recently reported strong second quarter results and scored a rare 10 on the Valuentum Buying Index, our stock selection methodology. The firm remains a position in the portfolio of our Best Ideas Newsletter. We think shares are worth roughly $180 each (at the time of this writing).

Teva Pharma (TEVA)

Teva's global generic opportunity is arguably the best within our coverage universe, and we're excited about its new therapeutic entity (NTE) pipeline, which we're expecting to be a multi-billion dollar revenue stream in coming years. Teva is uniquely positioned to capture the NTE opportunity because of the firm's ability to combine its generic and branded-drug expertise across indications. Still, we continue to be mindful of patent expiration of its current large profit-driver Copaxone in May 2014, roughly a year earlier than we had been expecting prior to initiating our position in the firm in our Best Ideas portfolio. We fully expect the next 12-24 months to be difficult for the company with respect to year-over-year comparisons, but we still feel comfortable holding shares in the portfolio of our Best Ideas Newsletter. The long-term opportunity for lower-cost generics in an environment where governments across the globe are looking to cut expenses and become more efficient is just too great to pass up, in our view. We think shares are worth $55 each at the time of this writing.

Microsoft (MSFT)

As much as we'd hate to say it, the market is probably right to cheer CEO Steve Ballmer's departure, if not simply for pumping some new lifeblood atop the organization. Ballmer's financial performance was by no means terrible, but he'll never be lumped in with other famous tech CEOs like Steve Jobs, Bill Gates, Larry Ellison, or Mark Zuckerberg. Regardless, Xbox One should provide a nice catalyst in fiscal year 2014, and we think the company's Windows 8.1 refresh will be a bit better for classic Microsoft customers. Dividend growth at the tech giant should remain fantastic, and we think shares present a compelling risk/reward idea for long-term investors. We're happy to keep holding shares of this cash cow in the portfolio of our Dividend Growth Newsletter. We think the company is worth $46 each.

Source: Why Some Investors Fail And 3 Top Stock Ideas

Additional disclosure: Some of the firms mentioned in this article are included in our actively-managed portfolios.