In December 2012, I began ranking companies using a standardized discounted cash flow analysis.
The objective is to apply the same methodology to as many stocks as possible. Placing the same assumptions on every stock creates a level playing field and allows me to identify the companies that appear to be the most undervalued over the entire market. These elite companies, champions of value, can then be examined as potential investments.
This post just contains my methodology, and notes any changes.
- Run a screen on Finviz (Formerly Yahoo! Finance) for all companies with a positive projected forward P/E ratio, positive projected earnings per share for next year, and positive projected earings per share for the next five-years. The current price per share and beta values are also required for the calculation.
- Project next year's (Y2) earnings per share by taking the inverse of the forward P/E ratio and multiplying by the current share price.
- Project the current year (Y1) earnings per share by dividing the Y2 earnings per share by next year's projected earnings growth rate.
- Project earnings per share for each of the next five years by multiplying the Y2 by the estimated five-year growth rate. After the fifth year, project a perpetual earnings per share equal to the income level in the fifth year.
- Assume future earnings will equal future cash flows. The net present value of the future earnings is the intrinsic value. Calculate a valuation percentage for each stock by dividing the actual enterprise value by the intrinsic value.
- Find the discount rate that most evenly distributes the resulting valuations. This process is described in greater detail below.
- Calculate the net present value pf all future earnings per share of each ticker based on the beta-adjusted discount rate. This net present value is the price per share at which the company should theoretically trade.
- Calculate a valuation percentage for each ticker. This is the NPV divided by the actual price per share.
- Sort the companies in ascending order based on the valuation percentage.
It's as simple as that. I do not claim that the resulting valuations are the best or most comprehensive valuations possible. The objective is simply standardization.
Finding The Discount Rate
One of the advantages of running valuations in this manner is that the market discount rate can be calculated rather than assumed. This is done by making small iterative changes to the market discount rate until the number of overvalued companies (valuation ratio > 100%) is most nearly equal to the number of undervalued companies (valuation ratio <100%).
When the proper market discount rate is selected, the valuation ratios should form a normal distribution.
The market discount rate is not directly applied to each individual company. The discount rate utilized for individual tickers is the beta-adjusted discount rate found by multiplying the market discount rate by the beta of the specific ticker.
Change #1: 12-28-2012
There has been a significant change in the methodology since last week. While doing due diligence on Full House resorts, the previous week's quality estimate champion, I noticed that the valuation model was being thrown off by a 40.7 million one time gain. The one time gain was included in the net income number provided by Yahoo Finance! but not the earnings per share. Since the analyst estimated growth rate is based on the earnings per share this was inflating the projected earnings. The model now calculates income from continuing operations by multiplyingg the earnings per share by the number shares outstanding and uses it in place of the net income.
The change in methodology has changed the universe of ranked companies. There are 538 more ranked companies in this weeks' rankings than last weeks;, and a number of companies are no longer included in the rankings. This change is due to the deblanking of different fields.
Change #2: 1-18-2013
I have switched to Finviz from Yahoo! finance, and am now using the net present value of the future earnings per share to calculate a direct price. I had previously calculated the net present value of the whole company and adjusted based on the shares outstanding and enterprise value. As with the previous change, this has resulted in some deblanking changes to the universe of stocks.
Change #3: 1-25-2013
I am now incorporating a basic CAPM. The discount rate is multiplied by beta to produced a beta-adjusted discount rate unique to each ticker.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.