But how, you will ask, does one decide what [stocks are] "attractive"? Most analysts feel they must choose between two approaches customarily thought to be in opposition: "Value" and "growth" ... We view that as fuzzy thinking ... Growth is always a component of value [and] the very term "value investing" is redundant. -- Warren Buffett, Berkshire Hathaway (BRK.B) annual report, 1993
We take Buffett's thoughts one step further. We think the best opportunities arise from a complete understanding of all investing disciplines in order to identify the most attractive stocks at any given time. We therefore analyze each stock across a wide spectrum of philosophies, from deep value through momentum investing.
This involves performing significant valuation analysis, both on a DCF and relative value basis, as well as a assessing the firm's fundamentals (cash flow, risk, etc.), technicals and momentum indicators. The best stocks, we believe, will be attractive from a number of investment perspectives -- from value through momentum (hence our name, Valuentum). On the other hand, the worst stocks will be shunned by most investment disciplines and display expensive valuations and poor technicals and momentum indicators. We don't believe valuation analysis and technical analysis are mutually exclusive, and we are the only firm that actually considers opportunity cost as an expense. We don't think it makes sense to hold an undervalued equity forever -- eventually, we would expect it to converge to our fair value estimate.
As part of our process, we employ a discounted cash-flow model to arrive at a fair value estimate for every company within our equity coverage universe. In Kohl's (KSS) case, we think the shares look undervalued at today's prices. Our fair value estimate for the retailer is $64 per share, roughly 25% higher than where it is currently trading. In the spirit of transparency, we make available our fully-populated DCF valuation models for all firms in our coverage universe here. Check them out -- you won't be able to get professional-quality DCF models anywhere else.
For Kohl's, we assume revenue growth will average in the low-single-digits over the next five years. We also assume that Kohl's will grow earnings at a high-single-digit pace during our discrete five-year horizon. We expect the firm's excess returns on invested capital will fade to our estimate of its cost of capital (about 9.9%) by Year 20 in our model. Kohl's registers a 6 on our innovative Valuentum Buying Index methodology (click here), besting all industry peers except Macy's (M). As it relates to peer analysis, JC Penny's (JCP) is overvalued on a DCF basis in our view.
Our estimated fair value range (the spread between our downside case and our upside case) for Kohl's falls between $48 per share and $80 per share (as determined by a firm-specific margin of safety). Though this is large range, it considers the risks inherent to Kohl's business as well as the future potential variability in the company's free cash flow stream. With the retailer trading at the lower end of our fair value range, we're strongly considering adding it to the portfolio of our market-beating Best Ideas Newsletter.