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20. 7 ways to value stocks (deb sahoo)

20. 7 ways to value stocks (deb sahoo)






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    20. 7 ways to value stocks (deb sahoo) 20. 7 ways to value stocks (deb sahoo) Presentation Transcript

    • 7 WAYS TO VALUE STOCKS | Deb Sahoo | MBA, Finance, University of Michigan | MS, EE, University of Southern California | B-Tech, EE, IIT |
    • INTRODUCTION Why Valuation Matters? • One could purchase the best stock in the world, but if he/she buys it at a heavy premium, it could be a bad investment • But if one buys the stock of the worst company in the world cheap enough, it could be a profitable investment • Valuation is an art that involves assumptions that are difficult to formulate • But if one understands the assumptions and the disadvantages of each, he/she will be able to put an INTELLIGENT BET in the market !!!
    • 1.NETNETWORKINGCAPITALANDNETCURRENTASSET VALUE Method and Comments • Type: Balance sheet and tangible asset valuation • When to Use: When trying to determine where a company’s stock price is priced relative to its net assets. Don’t use for service or low asset companies such as SW • Net Current Asset Value (NCAV) = Current Assets – Total Liabilities • Net Net Working Capital (NNWC) = Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities
    • 1.NETNETWORKINGCAPITALANDNETCURRENTASSET VALUE Method and Comments • The formula states: • Cash and short term investments are worth 100% of its value • AR should be taken at 75% of its stated value because some might not be collectible • 50% off inventories if close outs occur • If the company is not burning cash, NNWC is higher than the current stock price, it could work out to be a fantastic investment • And if it has the following attributes it is definitely worth keeping an eye on • Company stock repurchases • Insider buying
    • 2.ASSETREPRODUCTIONVALUE Method and Comments • Type: Balance sheet valuation • When to Use: To find how much a competitor would to spend in order to replicate the company’s business • It is the minimum required level for free entry into an industry • Asset Reproduction Value = Adjusted Asset Value – Spontaneous & Circumstantial Liabilities – Excess Cash • Adjust CA, goodwill, PPE, add doubtful reserve to AR, LIFO adjustments to inventory. Cash and market securities will always be 100%. Cash is what it is, no more, no less
    • 2.ASSETREPRODUCTIONVALUE Method and Comments • Remove liabilities that are accumulated automatically as a result of the firm’s day-to-day business (COGS, AP, accrued expense, deferred taxes) and not required by a new entrant • Also remove liabilities incurred by circumstances in the past as a competitor is not required to pay for these circumstances to start a competing business • paying penalties for insider trading • lawsuits from former employees • inventory catching on fire • Remove extra cash not required to run the business as a competitor is not likely to invest more cash than what is needed to start a similar company • Assume 1% of sales can run 1 year of operations so the remaining 99% of cash can be removed
    • 2.ASSETREPRODUCTIONVALUE Method and Comments • If Net Reproduction Value > 0.5 Market Value of Equity • => Current stock price is well supported by the assets • => Remaining the stock price is made up of competitive advantage / growth expectations, which is SPECULATIVE • Go through each line in the balance sheet, see anything needs adjustments to find value that most investors would miss • Think about all aspects of the business, start with a broad view and then with each line item, try to break it up into smaller pieces
    • 2.ASSETREPRODUCTIONVALUE Method and Comments
    • 3.BENJAMINGRAHAMVALUATIONFORMULA Method and Comments • Type: Income statement based valuation method • When to Use: Cyclical companies, volatile cash flows, and young companies that does not have a lot of history Ex: EPS = $1.40 g = 12.6% Y = 6.05% ‫݁ݑ݈ܸܽ ܿ݅ݏ݊݅ݎݐ݊ܫ‬ = ‫ܵܲܧ‬ ∗ 8.5 + 2݃ ∗ 4.4 10 ܻ‫.ݎ‬ ‫݀݊݋ܤ ݁ݐܽݎ݋݌ݎ݋ܥ‬ ‫݁ݑ݈ܸܽ ܿ݅ݏ݊݅ݎݐ݊ܫ‬ = ‫ܵܲܧ‬ ∗ 8.5 + 2݃ ∗ 4.4 10 ܻ‫.ݎ‬ ‫݀݊݋ܤ ݁ݐܽݎ݋݌ݎ݋ܥ‬
    • 3.BENJAMINGRAHAMVALUATIONFORMULA Method and Comments • EPS is prone to manipulation as companies may follow accounting procedures which inflates earnings • Use earnings over a period of years (preferably normalized over a 5 Yr. or 10 Yr. period) and not just the previous or current year • 8.5 is the PE of a company with no growth • g is growth rate of the expected earnings. Use analyst 5 Yr. predictions from Yahoo or other sites
    • 4.EARNINGSPOWERVALUE(EPV) Method and Comments • Type: Income statement valuation method • When to Use: To find good companies and can be used for cyclical companies, volatile cash flows, and young companies with little history • First: Find Asset Reproduction Value or minimum required level for free entry into an industry the following way • Reproduce the assets that a competitor will need to compete with the company, this is called Adjusted Assets • To Adjusted Assets, add back 5% of sales as marketing effort and 80% of R&D expense, as any competitor will have to spend this to compete effectively
    • 4.EARNINGSPOWERVALUE(EPV) Method and Comments • Remove excess cash (2% of sales is the amount of cash needed for operation) not required to run the business • Subtract non interest bearing debt which is really spontaneous liabilities that are accumulated automatically as a result of the firm's day-to-day business, such as COGS, AP • Net Reproduction Cost = Adjusted Assets + Marketing Expense + R&D Expense – Excess Cash – Non Interest Bearing Debt • Second: Calculate Earnings Power Value • Start off with operating earnings, i.e. EBIT • Add back any one time charges
    • 4.EARNINGSPOWERVALUE(EPV) Method and Comments • Add 30% of SG&A and 30% of R&D back to earnings • Apply a tax rate to the adjusted EBIT to get to Adjusted Earnings After Tax • Subtract maintenance CapEx, add back 50% of D&A to arrive at adjusted income number • Divide by 9% WAAC to arrive at EPV, which is the value of the company based on current earnings without any growth • EPV of Business Operations = (EBIT + One Time Charges + 30% of SG&A and 30% of R&D )*(1-Tax Rate)* 1/WACC • EPV of Equity = EPV of Business Operations + Cash - Debt
    • 4.EARNINGSPOWERVALUE(EPV) Method and Comments • If Asset Reproduction Value > EPV => Company has no moat, no strategic advantage, bad management and is in a bad industry • If Asset Reproduction Value = EPV =>Company has no moat and is in a competitive industry where companies usually earn only their CoC • If Asset Reproduction Value < EPV ⇒Company has a moat, strong advantages, brand recognition and good management, is the type of company to look for
    • 5.ABSOLUTEPEVALUATION Method and Comments • Type: PE multiplier valuation • When to use: An absolute method that can be used for any company • Intrinsic value of the stock is based on the following five factors • Earnings growth rate • Dividend yield • Business risk • Financial risk • Earnings visibility
    • 5.ABSOLUTEPEVALUATION Method and Comments • For every percentage of projected 5 Yr. earnings growth from 0% to 16%, the PE increases by 0.65 points and if the growth rate reaches 17%, the PE value is increased by 0.5 points Expected Growth Rate (g) P/E 0% 7.00 1% 7.65 2% 8.30 3% 8.95 4% 9.60 5% 10.25 6% 10.90 7% 11.55 8% 12.20 9% 12.85 10% 13.50 11% 14.15 12% 14.80 13% 15.45 14% 16.10 15% 16.75 16% 17.40 17% 17.90 18% 18.40 19% 18.90 20% 19.40 21% 19.90 22% 20.40 23% 20.90 24% 21.40 25% 21.90 g vs. P/E vs. Table Dividend Yield (%) Additional P/E Points 0.0% 0.0 0.1% 0.5 0.5% 0.5 1.0% 1.0 1.5% 1.5 2.0% 2.0 2.5% 2.5 3.0% 3.0 3.5% 3.5 4.0% 4.0 4.5% 4.5 5.0% 5.0 5.5% 5.5 6.0% 6.0 6.5% 6.5 7.0% 7.0 7.5% 7.5 8.0% 8.0 8.5% 8.5 9.0% 9.0 9.5% 9.5 10.0% 10.0 Dividend vs. P/E Table
    • 5.ABSOLUTEPEVALUATION Method and Comments • Every dividend yield percentage receives an additional PE point. If the dividend yield is below 1%, use a PE factor of 0.5 according to the table above • Assign values for business risk, financial or leverage risk, and earnings visibility according to the following rule: • For an average company, assign a value of 1 • For a market leader, select a number less than 1. If a 15% premium is deserved, then 0.85 is the number to use • For a market lagged, select a number greater than 1. Poor companies should be discounted. A 30% discount requirement means a value of 1.3 will be used
    • 5.ABSOLUTEPEVALUATION Method and Comments • Based on the business risk, financial risk and earnings visibility, additional PE points are added to the basic PE from the table • If a company is expected to have 10% earnings growth with 0% dividend yield, according to the table above, assign it a PE of 13.5 • Limit the premium to the basic PE to no more than 30%. In other words, if the basic PE is 13.5, despite how good the company is, the final adjusted PE won’t be more than 17.55 (13.5 x 1.3=17.55) • Fair Value PE = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]
    • 5.ABSOLUTEPEVALUATION Method and Comments Factors P/E Projected 5 Yr. Earnings Growth 10.0% 13.5 + Dividend Yield 1.5% 1.5 Basic P/E 15.0 x Business Risk Factor 0.90 [1+(1-0.90)] x Financial Risk Factor 0.95 [1+(1-0.95)] x Earnings Predictability Factor 1.00 [1+(1-1.00)] Final P/E 17.33
    • 6.DISCOUNTEDCASHFLOW(DCF)VALUATION Method and Comments • Type: Cash flow valuation • When to Use: Consistent free cash flow, bigger/predictable business • Description: Finding intrinsic value involves two parts: • Finding the sum of the future cash flow • Calculating the excess cash (cash that is left over by the business that is not used for any operations) • Intrinsic Value = PV of Future Cash Flow + Excess Cash • Intrinsic Value = DCF + [Total Cash – MAX(0,Current Liabilities-Current Assets)]
    • 7.REVERSEDISCOUNTEDCASHFLOW Method and Comments • Type: Cash flow valuation • When to Use: Find out expectations embedded in stock price • Description: Reverse DCF attempts to eliminate the need to forecast. The purpose is not to find what the company is really worth, but whether the market expectations are reasonable • The three main assumptions of DCF are: • Projecting future cash flows • Figuring what discount rate to use • Predicting business growth rate
    • 7.REVERSEDISCOUNTEDCASHFLOW Method and Comments • Instead of starting with a given year’s FCF, and then projecting towards an unknown, the purpose of the reverse discounted cash flow is to calculate what growth rate the market is applying to the current stock price. • Purpose is to use the stock price as the starting point and identify expectations the market has for the stock • Calculate large caps discount rate as • Discount rate = risk free rate + risk premium • Discount rate = 3.5% + 5% = 8.5% (round up to 9%) • Now that you have the discount rate set to 9%, play around with the growth rate until you get a value that matches the current price of the stock