You could purchase the best stock in the world, but if you buy it at a lofty premium, it is a bad investment. Vice versa, the stock could be the worst company in the world, but if bought it cheap enough, it could work out to be an excellent and profitable investment. Valuation matters.
To help you figure out the value of your stock, here is a compilation of seven valuation methods I have written about to refresh your memory. The problem I fell into as I began valuing stocks was trying to use a single valuation method for every company. But that is wrong. A gold miner cannot be valued the same way as a tech company, just as how you cannot use the same valuation technique to value a capex-heavy company and free cash flow (FCF) cow.
Valuation is an Art
Most important of all is to remember that valuation is an art. Anything that involves assumptions will be difficult to formulate, but provided you understand the assumptions and the disadvantages of each, you will be able to utilize each tool to great effect.
- Net Net Working Capital and Net Current Asset Value
Type: Balance sheet and tangible asset valuation
When to Use: Net net stocks, when trying to determine where a company’s stock price is priced relative to its net assets. Can’t be used for service or low asset companies such as software.
Description: When Graham was around, the only types of companies that existed were industrial businesses. Mainly factories, manufacturers and retailers. There were no consulting, software, or high tech companies you see today. This made analyzing the balance sheet very easy and worthwhile because mostly all companies fit into this mold.
Because there were no computers, stock market radio, tv shows, news etc, information was slower in circulating and more inefficiencies existed which Graham could take advantage of and allowed Graham to buy companies at or below liquidation value. For you and me, knowing the liquidation value of a company is advantageous because it gives you a reference point for a floor value of the stock. Companies where the stock price is below this floor value are called net nets. There are two ways to calculate this.
Net Current Asset Value
NCAV = Current Assets – Total Liabilities
Net Net Working Capital
A stricter version of the NCAV because it discounts certain items from the balance sheet.
NNWC = Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities
Provided the company has a decent business model and not burning cash, a net net stock could work out to be a fantastic investment. Read the original article: Graham Net Net Asset Valuation.
- Asset Reproduction Value
Type: Balance sheet valuation
When to Use: To figure out how much a competitor would have to spend in order to replicate the company’s business. Sort of like a moat test.
Description: To rephrase “asset reproduction value”, it is to find how much it would cost a competitor to replicate the assets of the business.
This method is really part 1 of the Earnings Power Value (EPV) explained further down.
To calculate the reproduction value of the assets, you need to go through each line in the balance sheet and see whether anything needs adjustment. This method involves quite a bit of work, because you need to understand the industry in order to adjust the balance sheet appropriately.
Unlike Graham, where he just slapped a discount percentage of 50% to inventory and ignored things such as goodwill, the asset reproduction value requires you to include goodwill because it is something that a brand new competitor will not have and will therefore be required to spend money in order to acquire such things as brand recognition, partnership agreements, and patents.
- Benjamin Graham Valuation Formula
Type: Earnings stock valuation method
When to Use: Cyclical companies, volatile cash flows, and young companies where there is not much history.
Description: Graham has always been a balance sheet analysis investor who wanted to buy a basket of companies at a cheap price. However, he offered a formula in his book The Intelligent Investor which uses earnings to value a company.
The formula he introduced is
where V is the intrinsic value, EPS is the trailing 12 month EPS, 8.5 is the PE ratio of a stock with 0% growth and g being the growth rate for the next 7-10 years.
However, this formula was later revised as Graham included a required rate of return.
The formula is essentially the same, except the number 4.4 is what Graham determined to be his minimum required rate of return. At the time of around 1962 when Graham was publicizing his works, the risk free interest rate was 4.4%. But to adjust to the present, we divide this number by today’s AAA corporate bond rate, represented by Y in the formula above.
But after using this formula, I found that the valuation numbers were far too optimistic. Back in Graham’s days, all companies were industrial and so growth was limited. Back then, 20% to 30% growth was unrealistic whereas you see many companies able to achieve this standard in today’s era.
With that, I further modified Ben Graham’s formula to:
For a deeper look at how this formula is read the original article below: How to value a stock with Benjamin Graham Formula
- Earnings Power Value (EPV) by Bruce Greenwald
Type: Earnings stock valuation method
When to Use: To find good companies. Also can be used for cyclical companies, volatile cash flows, and young companies where there is not much history.
Description: It is best to use EPV in conjunction with the Asset Reproduction Value above. Although the formula for EPV is quite simple, arriving at the adjusted earnings number is a little more difficult. You saw how the balance sheet had to be adjusted to make Asset Reproduction Value work. For EPV, you need to do it for the income statement which will give you a no growth value of the company.
Again, go through the article below to get the detailed step by step instructions of how this works. But see below for a quick idea of how how Asset Reproduction Value and EPV come together.
With just the asset reproduction value alone, you see that it is the minimum required level for free entry into an industry. The middle bar shows that having a competitive advantage will create an EPV that is higher than the asset reproduction value with zero growth assumption. If you include growth, you get the total value, but since growth is so difficult to predict, sticking with the EPV alone is good enough.
However, there are different cases which could break the model above. See below.
In case A, you have a company where the asset value is much higher than the EPV. In this case, the company has no moat, no strategic advantage, bad management and is in a bad industry.
In case B, asset reproduction value is equal to EPV. Such a company has no moat and is in a competitive industry where companies usually earn only their cost of capital.
Case C is the type of company to look for, where asset value is less than EPV which means that the business has a moat, strong advantages, brand recognition and good management. Think Coca-Cola (NYSE:KO), Microsoft (NASDAQ:MSFT) or Apple (NASDAQ:AAPL).
- PE Model for Stock Valuation
Type: PE multiplier stock valuation method
When to Use: Robust method that can be used for any company.
Description: An absolute, instead of relative, PE valuation model that Vitaliy Katsenelson created and explains in his book Active Value Investing.
There are subjective inputs required in this model with the intrinsic value of the stock based on the following five conditions.
Earnings growth rate
For each of the five points above, the idea is to assign it a value and then to calculate the fair value PE with the following formula.
Fair Value PE = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]
- Discounted Cash Flow (DCF) Stock Valuation
Type: Cash flow valuation
When to Use: Consistent free cash flow, bigger companies, predictable companies.
Description: Many people dislike the DCF method of valuing stocks. But many people also like it, and I am one of them.
The weakness is that you have to project future cash flows, calculate a discount rate and predict the growth rate, but with realistic assumptions instead of inputting numbers to match what you want it to be, it is a valuable tool. Just don’t abuse it.
Think of it like golf. If regular guys like me try to play with pro clubs, the ball will go anywhere. I first have to understand the mechanics of the golf swing as well as the characteristics of the club. Blindly swinging a pro golf club will result in shots that are way off the mark. That’s how it is with DCF. It is very useful as long as you know what you are doing. Thankfully, it isn’t difficult. The version of DCF is not the standard method that Wall Street or business school teaches. I learned investing through Joe Ponzio’s F Wall Street and so my DCF is also based on his and has been tweaked over the years. Joe’s DCF is a very practical, real world business like version.
- Reverse Discounted Cash Flow
Type: Cash flow valuation
When to Use: Figure out market expectations embedded in stock price
Description: If you dislike DCF, then maybe reverse DCF is for you as the purpose is to identify what expectations the market has for the stock.
As mentioned above, the three main weaknesses of a DCF are;
Projecting future cash flows
Figuring out what discount rate to use
Predicting the business growth rate
All three involve assumptions. With the reverse DCF however, you use the stock price as the starting point to figure out what the market expects. The purpose then becomes not on what the company is worth, but whether the expectations are reasonable.
On May 16, 2011, with Cisco (NASDAQ:CSCO) priced at $16.88, the stock price was reflecting a growth rate of -9.6%. The stock price did go down another 12% or so, but with such low expectations, CSCO managed to beat Wall Street’s expectations and has outperformed the market since.