Peter Larson's  Instablog

I haven't updated my DCF Championship in a while and I apologize for that if anyone is following this.

I am still running numbers weekly, and I'll get everyone caught up when I catch myself up.

But I figured I'd give a quick update about what's going on:

First, and I realize this is a lame excuse, but I've been very busy at my day job and caring for my kids, so blogging time is at a premium.

Second, I have made several significant changes to the methodology (I am now using Finviz instead of Yahoo! finance, for one), and I feel obligated to get the methodology section updated before posting any more results. Otherwise the numbers would be misleading.

Third, since I have been doing this a couple of months, I am able to look at actual performance relative to the valuations. I'm finding something interesting, but it is not exactly what I expected.

Basically, investing in stocks that are priced lower than their calculated DCF fair valuation has not been a particularly effective strategy. -BUT- investing in stocks whose DCF valuation has increased in the previous week has shown some promise as a strategy.

So, I'm (slowly) working on reconfiguring the presentation to reflect this.

Plus, I'm not sure anyone is reading this.

When I get things figured out, I'm working on putting everything on a Google site.

The valuations and rankings of all companies analyzed this week are available in a Google spreadsheet here.

Feel free to go ahead and search for your favorite company. There's a good chance it has been valued.

Data on 1,4219 ranked companies was obtained from Finviz at the market close on January 18, 2013.

The methodology.

Discount

The current discount rate is 8.5%. At this rate, 713 companies included in the analysis were undervalued and 707 companies included in the analysis were overvalued.

Here are the distributions of different valuation percentages:

(click to enlarge)

Yes Virginia, valuation does matter

There has been a signigicant change in the methodology this week- I switched from Yahoo! Finance to Finviz for the initial data. Additionally, I am now modeling the net present value of future earnings per share instead of simply future earnings. This eliminates the need to include enterprise value in the calculation.

These changes have drawn the bulk of the curve closer to fair value. This is a positive sign for a valuation ratio. Here is the curve from two weeks ago for comparison:

(click to enlarge)

(click to enlarge)

There are three reasons a company may be an outlier on this valuation curve; the market has mispriced them, the analysts have overestimated them, or the valuation calculation just doesn't fit them.

In other words; either the market is wrong, the analysts are wrong, or I'm wrong.

Obviously, I'm hoping that the cause of the undervaluation is that the market is wrong; that is when there's a big payoff. What's less obvious is that my second preference is actually for me to be wrong, because at least in that case I can expect the stock to simply market perform. When the analysts are wrong, the company ends up missing earnings and losses mount.

The Champion And Runners Up

According to the model, the following companies are trading at the absolute greatest discount to their intrinsic value:

5 Most Undervalued Companies

Quite frankly, I wouldn't invest in any of these tickers.

With the exception of MANU, they are all Chinese reverse mergers that are categorically suspected of fraudulent accounting. So it makes sense that they are undervalued by the numbers.

Suspected frauds and database errors are some of the reasons that I do not consider the raw list of the most undervalued companies to be the DCF champions. These companies are outliers- a company with an error in the database or encountering any sort of accounting oddity will shoot straight to the top or the bottom of the valuation list along with the more genuine market overeactions.

Because I want to avoid companies that only appear undervalued due to overexuberant analysts I employ a simple estimate quality factor as an additional screen. The following five companies are the most undervalued companies whose projected growth rate is no more than twice the return on assets.

5 Most Undervalued Companies, Conservative Growth Estimates

Unfortunately, as the quality factor does not screen out frauds or suspected frauds, China Electric and FUQI are still on the list. ZX also appears to be a Chinese reverse merger.

Manchester United and British American Tobacco are worthy of further consideration.

There is less upside for these five companies than for the pure picks, but the valuation should be a bit more dependable. Although due diligence is still warranted.

In the past I referred to all five of these companies as champions. I did this because I believe that a basket of all five picks would outperform an investment in just one company. I still believe that, but on second thought five champions is just plain un-American. From now on, only the top ranked company is the champion.

Although I do NOT intend to buy this stock or think that it is a good buy, I must award the championship to China Electric Motor Company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours..

The valuations and rankings of all companies analyzed this week are available in a Google spreadsheet here.

Feel free to go ahead and search for your favorite company. There's a good chance it has been valued.

Data on 2,180 ranked companies was obtained from Yahoo! finance at the market close on January 11, 2013.

The methodology.

Discount

The current discount rate is 9.1%. At this rate, 1,089 companies included in the analysis were undervalued and 1,079 companies included in the analysis were overvalued.

Here are the distributions of different valuation percentages:

(click to enlarge)

Yes Virginia, valuation does matter

(click to enlarge)

There are three reasons a company may be an outlier on this valuation curve; the market has mispriced them, the analysts have overestimated them, or the valuation calculation just doesn't fit them.

In other words; either the market is wrong, the analysts are wrong, or I'm wrong.

Obviously, I'm hoping that the cause of the undervaluation is that the market is wrong; that is when there's a big payoff. What's less obvious is that my second preference is actually for me to be wrong, because at least in that case I can expect the stock to simply market perform. When the analysts are wrong, the company ends up missing earnings and losses mount.

The Champion And Runners Up

According to the model, the following companies are trading at the absolute greatest discount to their intrinsic value:

5 Most Undervalued Companies

I did allow one minor correction this week- AU, AngloGold Ashanti- originally showed up in the number 3 spot as the raw data showed the analyst one year growth estimate where the five year estimate should have been. Because AngloGold is one of the world's largest companies- and I've noticed oddities with the data from AngloGold before- this stuck out like a sore thumb. I generally avoid making corrections of this nature, not because they aren't waranted, but rather because the resulting valuation for AU is now not a blind valuation - i.e. it required me to look at the name and price of the ticker and make a judgement call. But I couldn't resist, it was too obvious.

Database errors such as this are part of the reason that I do not consider the raw list of the most undervalued companies to be the DCF champions. These companies are outliers- a company with an error in the database or encountering any sort of accounting oddity will shoot straight to the top or the bottom of the valuation list.

Another big name on the list this week, JPM, is an example of why price targets are sometimes more reasonable than target returns. I rank companies based on enterprise value rather than market capitalization, and JPM's extreme undervaluation is due largely to the amount of cash on the balance sheet. So while the target return rate is unrealistically high, the price target is actually just 116 compared to a current price of 46. Usually with these outlier companies it is the other way around.

The most undervalued companies are not the champions. Because I want to avoid companies that only appear undervalued due to overexuberant analysts I employ a simple estimate quality factor as an additional screen. The following five companies are the most undervalued companies whose projected growth rate is no more than twice the return on assets.

5 Most Undervalued Companies, Conservative Growth Estimates

There is less upside for these five companies than for the pure picks, but the valuation should be a bit more dependable. Although due diligence is still warranted.

Humana, HUM had appeared in the previous two iterations of this list. It is now in the number 34 position for conservative growth estimate companies, and is now 40.69% undervalued. I'll have to look into this.

In the past I referred to all five of these companies as champions. I did this because I believe that a basket of all five picks would outperform an investment in just one company. I still believe that, but on second thought five champions is just plain un-American. From now on, only the top ranked company is the champion.

And for the second list in a row, that champion is Perfect World.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.