This Is The Most Important Article About The Stock Market You'll Ever Read

by: Valuentum

At Valuentum, we take a different view on stocks than what may be widely held in the investment community. As many "play" the earnings game--anticipating whether a firm will beat or miss revenue/earnings estimates or guide above or below consensus for forward periods--we, on the other hand, like to view stocks as businesses. Over time, the best, value-creating (RONIC-WACC) businesses (purchased at the largest discount to their true intrinsic values) will ultimately see the most equity value appreciation in the future, in our opinion, regardless of what analyst expectations are on the stock in any given quarter. After all, should investors really care if a company misses earnings by a penny or two (or more), if the firm's competitive advantages, operational prowess, and earnings growth trajectory are still intact after the report? We tend not to care too much about quarterly earnings, and every day we seek to profit from the market's overreaction to both earnings misses and beats.

At the end of the day, we think valuation is the most important investment consideration (that's why a rigorous DCF and relative valuation process represent the first two pillars of our methodology, Valuentum Buying Index™ -- the third and final pillar is a technical and momentum assessment). The logic behind the earnings game just doesn't make sense to us. For example, if a company keeps missing earnings estimates into perpetuity, will its stock go to $0? Absolutely not. It just means the analysts are being too optimistic relative to what the company can reasonably achieve during a specific period. Is it the company's miss or the analyst's miss? What if the analysts are just bad?

But what if a company keeps beating estimates; will it keep going up forever? It shouldn't. We're disappointed so many mom-and-pop investors get lured into this way of near-term thinking, but it's quite understandable. For one, when market onlookers turn on the news, what they see is that a stock has popped on "better-than-expected" earnings, so it's easy to associate one with the other. But such moves are only temporary (it's mostly traders looking to anticipate value resets), as stocks will always (and we stress) always migrate toward their intrinsic value.

The problem investors face is that intrinsic value is difficult to measure. And for many, it's not all that fun to do extensive fundamental analysis to uncover investment gems. That's why many investors sometimes turn to technical analysis (chart reading) and trading/speculating; after all, it's much easier to look at a chart (or take a guess on a well-known product or firm) than assess the long-term competitive advantages, growth prospects, and profitability trajectory of a company. But we're not necessary against chart-reading either - our process embraces all investment methodologies in the true Keynesian sense (we'll have an expansive article about this later). And as long as chart-reading is combined with a robust fundamental and valuation process, we think it can certainly augment returns.

Our view is that the intrinsic value of a company is the sum of the present value of a firm's future free cash flow stream (adjusted for its balance sheet and other items, like its pension underfundedness, for example). Check out the basics of our valuation process here. In fact, we believe that many of the stock moves witnessed in the market can largely be explained through the levers of a DCF model. For one, what about global macroeconomic uncertainty? Well, investors might systematically use a higher discount rate in their DCF models, causing fair values to fall. Witnessing stock prices drop on poor news out of Europe shouldn't then be a surprise to the intelligent investor (investors are simply using higher discount rates or slower growth from the region in their valuation processes). Okay, what about stronger-than-expected forward earnings guidance? Well, this means the company will generate higher cash flows into the future, and therefore, investors will recognize it should have a higher fair value than before. It should then be no surprise that stocks increase on higher-than-expected outlooks, even if--dare we say--they miss the recently-reported quarter's consensus estimates. We can go on and on like this. For more information about how to use a DCF model to anticipate equity price moves on news, please see "Thinking About the P/E Ratio in a Different Light."

And you may hear some readers cite some of the potential pitfalls of DCF analysis, which interestingly (and importantly) all seem to center around the core concept of investing - making forecasts about the future -- let's think about the DCF for just a second. Would you (or should you?) pay anything more for a company than what you think you would receive as cash flows from it, discounted (adjusted) by the time value of money and maybe some risk premium? In this instance, shelling out extra cash above a firm's intrinsic value would be ludicrous, right? In fact, one would go broke if you kept handing out more money than you think you'd get back. Well, let us tell you, instances like this happen every day in the market. Look at the speculators buying LinkedIn (NYSE:LNKD), Chipotle (NYSE:CMG), Under Armour (NYSE:UA) and Groupon (NASDAQ:GRPN) as examples. And don't get us started about the banks and the recent housing crisis - did the banks really think they were gong to get their money back with the quality of loans they were making? Handing out money that you don't expect to get back only leads to insolvency.

So how do these bubble stories happen? Well, as it relates to stocks, it often comes down to the superficial earnings game that sell-side analysts play. Though innocently portrayed, sell-side analysts often purposely low-ball earnings estimates, so their favorite companies can beat them. The industry has even had to come up with a "whisper" number (combining buy-side thoughts) to combat this low-balling phenomenon, but even this "whisper" number is not estimable--regardless of what you've heard. The earnings game is then exacerbated because speculators, who often enter into overvalued positions after a company beats earnings, think they can eventually sell the overpriced stock at a higher price because

  1. they have done so before and
  2. many investors haven't yet learned the importance of intrinsic value (that companies are actually worth something).

Even though "that something" is not necessary a specific price, like $36.36 per share for example, due to the uncertainty of the future, and instead is a range like between, let's say, $30 and $40 per share, the company is still worth something. It's the job of the intelligent investor to figure what this range is. And we do our best to provide subscribers with the best estimate of a fair value range for all of the stocks in our coverage universe.

And please don't be fooled into buying overpriced stock after earnings. Think of overpriced stock as a hot potato, and someone at some point will be left burnt once the story unravels (and the price inevitably drops like a rock - haven't we learned anything from the dot-com or housing bubbles). Stick to the fundamentals and valuation! And only use technicals to augment such analysis - think high scores on our Valuentum Buying Index.

Ok, so you may say: I'm just a tiny individual investor, how can I view myself as being able to own an actual piece of a massive company? Don't I just own some piece of paper to trade whenever I want to? Well, let's put it this way. When private equity or another firm buys out a company you've invested in, you get paid out based on what a firm is willing to pay for the entire entity per share--not just your shares. So why should you analyze a firm (or its shares of stock) any differently that a private-equity firm or a competitor? In our view, when you buy stock, you truly are buying a piece of the company not just a piece of paper. This is often lost on investors because of the wild swings and market volatility that have become a part of our daily lives in the past few years (well, let's be honest--this has always been the case--1929, 1987, anyone?). Trust us, intrinsic values aren't moving around like that - the wild price swings are facilitated by the fact that little pieces of companies (shares) are extremely liquid (and can be sold on any news or rumor). If shares were not liquid, one might argue we'd see a better reflection of a firm's intrinsic value on a daily basis, but the negative trade-off of less-than-efficient price discovery and relatively inefficient markets may not be worth it.

So, as it relates to not just owning a piece of paper, you may counter with: Not every firm gets bought out or is on the auction block. Well, that's true to some extent, and we recognize that such an issue may be present with behemoths such as Apple (NASDAQ:AAPL) or Exxon (NYSE:XOM), which may never truly come to reflect their intrinsic value as very few other entities can afford to buy them (they just have become too big). However, as a side note, our fair value for Apple is $636 per share, and we wouldn't be surprised to see the iPad maker hit those levels soon. Full disclosure, we started picking up shares at about $320 in the portfolio of our newsletter. But for the most part, all firms are essentially "in play" or will be so in time--meaning that if a firm's stock price falls too low relative to its intrinsic value, it will find a way to get taken out or go private. There's a lot of money sloshing around, seeking out above-average returns.

We're not saying that investors should include a buyout premium in every valuation (in fact, we're not saying that at all). But we are saying there are legitimate market forces that ultimately drive a firm to reflect its intrinsic value. Whether it is private equity, a competitor, Warren Buffett, or the literally thousands of investors who assess the values of companies, market forces will find the way to drive the company to its intrinsic value. By definition, momentum investors and chartists will likely only have temporary implications on a company's stock price - unless of course in the event of Lehman or Bear Stearns. But bank stocks, in our opinion, are a whole different animal, as confidence remains integral to their functioning (unlike an operating firm that will never be exposed to the threat of a "bank run.")

By this point, you might be wondering what the best way is to determine a firm's intrinsic value. Well, it all comes down to free cash flow. The measure is not intimidating and simply represents the residual cash left over in the business after capital expenditures. In other words, it is the earnings of a firm +/- working capital changes less capital expenditures. Everyone knows that cash is king, and diluted earnings-per-share is just a shortcut. Don't fall into the trap of taking shortcuts. We use a discounted cash-flow model to calculate an intrinsic value for every firm in our coverage universe, and we make them completely available to our advisor and institutional clients.

And an extensive DCF process, the first component of our Valuentum Buying Index, has worked wonders for our subscribers. For starters, we told investors to steer clear of Netflix (NASDAQ:NFLX) and avoid AMR Corp (AMR)--two names that have absolutely been hammered in the past year. And on the long side, we uncovered a triple in EDAC Tech (NASDAQ:EDAC) and solid gains from a variety of other firms, namely Apple, Astronics (NASDAQ:ATRO), Buffalo Wild Wings (NASDAQ:BWLD). Give the discounted cash-flow model a try in your own investing arsenal. You really have nothing to lose, and everything to gain.

And please notice we didn't say dividends are the main driver behind the determination of a firm's intrinsic value. Though we are big advocates of dividend-growth investing, you, as an investor, have a claim on all of the free cash flows of the business (after interest, preferred), not only the dividend stream that is decided by the board of directors. Though we respect all views on the equity markets, we strongly believe that any investor who uses a simple dividend discount model (as the only tool) should re-evaluate his or her processes (a dividend discount model only works if dividends equal enterprise free cash flow, better known as free cash flow to the firm).

And investors should know that, after a firm pays the dividend, the price of a stock opens lower by approximately the amount of the dividend (adjusted for certain tax implications). That's because cash (value) is leaving the firm and ending up in your hands. That's right, we said cash. In other words, when a firm pays out a dividend, it is reducing its intrinsic value by the amount of the dividend. That's okay though, since you're getting the cash.

We think this concept is vitally important for investors to understand, as it opens the door to understanding equity valuation and is unfortunately not widely known. If it were well known, we wouldn't see so many investors seeking dividend payments (it's often a net-neutral action, excluding tax implications). Dividend payers and initiators have been the best performing stocks in certain historic periods because firms that pay or initiate dividends are often successful companies, not the other way around (let's not confuse cause and effect). And we like to invest in dividend-growth gems to generate a steady and growing income stream, while capitalizing both on a firm's future potential capital gains. In this respect, dividend-growth investing is still very much relevant for income investors.

And importantly, many investors will say that earnings drive a company's share price and value. And this is true, to a very large extent. Don't get us wrong, earnings are key, but the intelligent investor will say that cash flow drives stock prices. After all, if a firm has $100 million in cash and generates no earnings, it's still worth $100 million (all else equal-and assuming it won't throw away that cash). Earnings-based models fall apart in this light. Look at Apple as the most recent example. The market didn't start giving it credit for its near-$100 billion cash load until it could reasonably be assumed that it would deliver this cash-flow back to shareholders in a dividend or share buyback and not engage in future value-destroying acquisitions that would erode its cash load. Plus, we cannot forget the importance of assessing earnings quality when it comes to evaluating firms - not all earnings are created equal. It's the cash flow model that sorts out firms with strong earnings quality from those with weak. And our index puts all of this together.

All things considered, please don't play the earnings game. Focus on intrinsic value with a long-term perspective instead (using technical and momentum indicators to pick entry points on the most high-quality, undervalued stocks). Legitimate market forces will drive stock prices to reflect a firm's intrinsic value over time. Though it requires a strong stomach during any rolling short-term period, you'll thank us during retirement.

Disclosure: Some of the tickers mentioned in this article are included in our market-beating portfolios.