1. 7 WAYS TO VALUE STOCKS
| Deb Sahoo | MBA, Finance, University of Michigan | MS, EE, University of Southern California | B-Tech, EE, IIT |
2. 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 !!!
3. 1. NET NET WORKING CAPITAL AND NET CURRENT ASSET VALUE
4. 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
5. 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
7. 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
8. 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
9. 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
12. 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 ݁ݐܽݎݎܥ
݁ݑ݈ܸܽ ܿ݅ݏ݊݅ݎݐ݊ܫ =
ܵܲܧ ∗ 8.5 + 2݃ ∗ 4.4
10 ܻ.ݎ ݀݊ܤ ݁ݐܽݎݎܥ
13. 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
15. 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
16. 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
17. 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
18. 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
20. 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
21. 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
22. 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
23. 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)]
24. 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
26. 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)]
28. 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
29. 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
