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I am often asked how I determine the value of a stock to know whether or not I want to invest. Below are several methods picked up over the past two years that I have found effective if used correctly and when an individual knows the limitations of the measurement.

Price-to-Earnings Ratio

Often stocks are valued on their P/E ratio. This is calculated by dividing the current price by the sum of the past 4 quarters of earnings. This ratio essentially tells you how much you are paying for a company’s earnings, so it allows you to compare very different companies using the same measurement.

On average, companies in the US trade at a P/E ratio of 15 (that is, on average investors are willing to pay $15 for every $1 in annual earnings that a company has for that year). Companies that display high growth rates of earnings may command premium multiples over 15. It is not uncommon for fast growing tech companies to have P/E ratios that are in the 30s and 40s if they have been able to consistently deliver high growth. Slower growth companies, or companies with uncertain earnings, may trade under the historic average of 15 due to this lack of growth and uncertainty.

For example: Safe Bulkers, Inc. (SB) has earnings of $1.77 over the past year. It currently trades at $8.27 a share. This is a P/E ratio of 4.67, well below the historical average. This means that I pay $4.67 for every $1 in earnings that this company delivers. The reason its multiple is so low is because of the uncertainty of future earnings in the dry bulk sector. There is the potential for oversupply and falling rates, meaning that the market is expecting that this company will not be able to continue to deliver $1.77 in earnings in the near future; thus, its depressed share price.

There are a lot of limitations to this metric:

  1. The P/E ratio does not explicitly take into account the future growth of a company. It only tells you how expensive/inexpensive a company is against its past earnings, not its future earnings. A forward P/E has been developed to help address this problem. This ratio simply uses the expected earnings for the next year; however, this is still a very short term forecast and tells nothing of the year after that.
  2. Similar to the first limitation, the P/E ratio does not speak of how stable or consistent a company’s earnings are. A company may have earnings that are temporarily deflated/inflated and the P/E ratio will not be an effective measure of value in these cases.
  3. Earnings are inherently a poor way to value companies because they are so easily manipulated by savvy accounting. Often they do not represent the actual earnings of a company, thus, any metric based on them may overvalue or undervalue a company.

PEG Ratio

The PEG ratio is an improvement upon the Price-to-Earnings ratio in that it does account for future growth. To calculate the PEG ratio, one simply takes the P/E ratio and divides it by the % growth expected from the company. Typically, PEG ratios of less than 1 are desirable and ratios over 2 are considered to be an indicator of an overvalued company.

We will continue to use SB from our example above.

  • P/E ratio: 4.67
  • Growth Rate: ?

It is often difficult to determine what the growth rates of a company might be. In our example, SB is a relatively new publicly traded company and recent years earnings are tainted by a global slowdown and a collapse in the dry shipping sector. This data is hardly “normal operating conditions” and thus past growth and earnings may not reflect true earnings potential. Also complicating the issue is the oversupply in the system.

The thing that’s nice about the PEG ratio is that you do not necessarily need a fixed number. In this instance it is obvious that as long as SB can obtain earnings growth rates over 4.67% then its PEG ratio would be less than 1. All I need to do is come up with a growth scenario that could achieve these results. I think this possible given that SB has plans of growing their fleet by 50% its fleet by 2013. Even in an environment of falling rates and oversupply, as long as SB is able to operate these new vessels at a very minor profit its growth should be more than 5%.

The limitation of the PEG ratio are identical to those listed above for the P/E ratio with the exception that it does take into account long-term growth rates.

Book-Value/Price-to-Book Ratio

Book Value is the equivalent of equity in a company. It is all of the assets minus the liabilities. Anything you have left over is called the company’s book value. In simpler terms, it is the amount of money you would receive if you bought the entire company, sold everything, and paid off all of its debts with the proceeds. Anything left over is your profit, or loss, on the company. Typically, companies trade at multiples of their book value because it would rarely make sense for the company to trade for less than its liquidation value.

The multiple for book value will change with industries: If the company is in a capital intensive industry that requires a lot of machines, buildings, or any other hard-assets, then the multiple to book value will most likely be lower as a large part of the value of the company is in these assets. Thus, it would not make sense for the value to be too much greater than the amount of the assets that make up the company.

If the company is a consulting company that does not rely on machinery, factories, and assets other than its employees, it is likely the company will demand a higher multiple of its book value because of the lack of importance that fixed assets have in its money making potential. Thus, the importance of book value fluctuates with the industry you are looking into.

The problems with using book value are:

  1. It is unlikely that you will be able to buy the company in its entirety, or even a large enough piece, to be able to force this liquidation in order to profit from the differential. Often you will have to wait for another company to buy it for you.
  2. Even if a company does decide to liquidate, it may not receive the full value for the assets that it sells. This will eat into any profits that an investor may expect to earn.
  3. A company who is trading for less than its book value may continue to operate at a loss for many years before filing for bankruptcy or liquidating which will eat into the value an investor expected to receive upon the liquidation.
  4. If the company is no longer operating, it is likely due to hardships that may lead to bankruptcy or Ch. 11 bankruptcy protection. In the latter case, shareholders are likely to lose any claims they have on the assets.

To help alleviate some of the negative consequences due to these problems investors often demand a company to trade at a discount to book value, often 33%-50%, before they consider buying into it.

Another way to discount book value is by using its NET CURRENT ASSET VALUE instead. This is calculated by adding together all of the company’s cash and cash equivalents and short term investments and subtract the value of all of the liabilities it has (both short and long term). Investors try to find companies selling for less than this Net Current Asset value. If a company has a net current asset value $10.00 a share is trading or $7.50, for every $7.50 that you invest, you are getting $10.00 back in cash equivalents and are essentially getting the entire amount of long term assets and a share in the future profits for free.

Example: KHD Humboldt-Wedag

In November 2009, KHD Humboldt-Wedag ((KHD) was trading at $11.85 a share, less than its book value. Soon after, the company announced that it would change its name to Terra Nova Royalty Co. (TTT) and that it would split into two companies: the aforementioned royalty company and that it would spin off its cement engineering operation, KHD (OTC:KHDHF).

In early 2010 the management estimated the book value of the entire company (both entities) to be $13.48 per share. At the time the company was trading right around this value; however, not long after the price per share fell substantially below this $13.48 a share. As the company had $13 a share in cash, it’s book value of $13.48 could be considered pretty reliable because a large amount of it is cash. Now the company has separated into two entities and, when combined, are trading above their combined book value now that the markets are more certain in the company’s performance. Currently the company is trading 20%-30% higher than prices that it was trading at earlier and it looks like the shares may have further to go.

If you are interested in reading more about this special situation George Fisher has done some great articles following these developments here.

Discounted Cash Flows (DCF Analysis)

Many investors encourage the use of discounting cash flows from a company to determine its value. Warren Buffett is a large supporter and adopter of this technique. With this metric, you are essentially treating the entire company as ownership of a bond, and valuing it just like a bond; its value is the summation of all future cash flows discounted to their value today. The difficulty with this method is that there is no clear end to a company like there is with the maturity date on a bond.

Warren Buffett advises using a metric called “owner’s earnings” instead of just the cash flows with this valuation. Owner’s earnings are defined as: Net Income + Non-Cash Expenses – Necessary Capital Expenditures. Non-Cash expenses are items like depreciation, amortization, and depletion. This is the amount of cash that you would have in your pocket at the end of each year if you owned the company in its entirety. This value would then be applied to a discounted cash flow formula that should give us the present value of all future cash flows.

Let us take Google (GOOG) over the past four quarters for our example:

  • Net Income: $7.936 billion
  • Non-Cash Expenses: + $1.380 billion
  • Capital Expenditures: - $1.694 billion
  • Owner’s Earnings: $ 7.622 billion

Google has displayed annualized growth of 50+% in their owner’s earnings over the past five years. Growth rates of this size will be hard to continuously achieve but I think Google can achieve growth rates of 18% for the next three years. I think it will continue to grow at least 10% a year for the three years following that. I think that it can carry a growth rate of 5% into perpetuity. Lastly, we need a discount rate. Some individuals use the cost of capital for their discount rate, others use the rate on 3 month treasury yields, and others use the average return on similar investments. I do not limit myself to any specific asset class so I consider al investments comparable investments and demand at least a 10% return. Thus, 10% will be the discount rate applied.

  • Owner’s Earnings: $7.622 billion
  • Growth: 18%, 10%, 5% into perpetuity
  • Discount Rate: 10%

The first term is the present value of the earnings growth at 18%, the second term is the present value of the earnings growth at 10%, and the third term is the value to perpetuity.

Assuming that Google can compound owner’s earnings at 18%, then again at 10%, and perpetually at 5%, it should have a present value near $400 billion dollars. Keep in mind this would be about a 33% premium to the largest company (by market capitalization) in the US. (Either an unreasonable answer or an unreasonable current valuation).

The negatives of using this metric is that it is completely reliant upon input which is estimated. If you put garbage in you will get garbage out. If Google’s growth for the first three years isn’t 18% my estimated value will be off. If it can’t achieve growth of 10% for the following three years my estimate will be off. If it cannot continue growth at 5% into perpetuity there will most certainly be changes in the final answer. This is why several individuals can use this approach and receive answers that are vastly different from one another’s.

Return-on-Equity

Another way to value companies based on their book value is based on their return on equity. This is similar to using the book value because equity is book value. One can use earnings or cash flows to approximate the term “return”, whichever you feel is better. I typically opt for using owner’s earnings again.

The way this metric works is described well here.

If we assume, as in the attached article, that a company should earn at a minimum of 6-8% on their assets than a price-to-book value ratio of 1 would be required for a company making cash flows (or earnings) equivalent to 8% of their equity. If a company as returning 16% on their equity they would deserve a price-to-book multiple of 2, or in other words, should trade at twice its book value per share.

Let’s Look at an Insurance Company: Fairfax Financial (OTC:FRFHF)

When valuing an insurance company, especially one in a soft market, its underwriting performance is of less importance than the value of investments. Currently, insurers are in a soft market where they are underwriting for a loss. Fairfax is no exception and it has been cutting its market share to prevent the hemorrhaging of cash to non-profitable insurance. So, as long as this soft market persists it will write less insurance and its earnings are more dependent on its investment portfolio. Fairfax has an investment portfolio outlined below:

  • Bonds: $12,492.6 million
  • Preferred Socks: $537.5 million
  • Common Stocks: $3,504.6 million
  • Ownership stakes: $888.2 million
  • Derivatives: $586.7 million

Fairfax has an average return on common stocks of 12.2% over the past 5 years and an average return of 16.1% over the past 15 years. We’ll use the 12.2% to remain conservative.

This suggests a return from stocks that is worth $427.5 million.

Its average return over the past five years from bonds has been 9.6%. Its average over ten years is 9.4% We’ll use the 9.4% to remain conservative.

A 9.4% return would equate to $1174.3 million.

I’m going to assume that Fairfax can pull 5% gains from its preferred stocks and its ownership stakes in other insurance companies. This 5% return would equate to $71.29 million.

All this leaves left is their hedging derivatives. I know that these derivatives are largely bearish options taken out on the market to hedge the company’s equity holdings. I think given the recent run-up it is likely that they have lost value, but how much is anybody’s guess; they were purchased for a value of $364.9 million so they were clearly a savvy investment if they are worth 586.7 million as of September. I think that the management has shown their investment ability for me to be comfortable with their derivative investments. Thus, I’m going to assume that the loss will be limited and will assign a value of -58.67 million to as a 10% loss.

This results in a return on owner’s earnings of $1614.42 million on equity of $8.224 billion. This is a 19.6% return suggesting the company should carry a book value multiple of about just over 2. This seems a little high, as far as I know most insurers do not trade at multiples of 2x book value; however, it does suggest that FRFHF should trade higher than it does right now which as just over 1x book value.

The shortcomings of this metric are similar to some of the others listed above.

  1. Inputs are estimated and so the outcome is only as good as the estimate. This makes the metric similar to the Discounted Cash Flow method.
  2. Even if one decided to use past earnings, or past cash flows, to avoid any estimation then it does not account for any growth.
  3. If one uses earnings as an estimate than the metric is limited by the accuracy of earnings.
  4. This input does not consider the safety that some investments may offer investors. In the example above, Fairfax Financial has $582 a share in cash while it is only trading at $400 a share. This cash can be used to cushion against any significant insurance loss or used to drive valuable purchases like its most recent one: purchasing an insurance company at book value and at only 3x cash flows. This would represent a 30% cash return.
  5. Lastly, this metric does not take into account how a company is capitalized. A company can take on a lot of debt that will lower its equity and potentially drive earnings gains which would make suggest it should trade at greater multiples of book value; however, the more debt a company takes on the more exposed it is to risk.

I have presented these metrics and their limitations in hopes of educating you on several different approaches to valuing companies. No one measure is more “right” than the other and often it depends on the type of company as well as its business to determine which one is best. If you are like me, you might pick a couple to blend and get an idea of how much the company is worth by weighting and averaging several of these metric outputs.

It is my hope that individuals realize the limitations of such valuations and do not follow them blindly; rather, these metrics should be used as a screen for companies that deserve a closer look. None of the examples were intended to be accurate; however, they were provided to give real world examples of their applications in companies that I am familiar with.

Disclosure: Author is long SB, FRFHF.PK, KHDHF.PK, and GOOG

Source: My Methods for Valuing Stocks