As value investors, we might have a value framework in mind where we finally understand that buying low, selling high is the best way to go. It’s the way Warren Buffett and other have done it for a long time and most importantly, have done it successfully. If you “get it” (value investing), you have climbed that six foot wall that many beginners and even veterans struggle to overcome. I will paraphrase Warren Buffett when he says in the Supers investors of Graham-Doddsville when he states that individuals get it or they don’t, some individuals will get in 5 minutes while others, you can explain to them all day and they still wont get it. Of course when I’m referring to “getting it”, I am referring to value investing. So now that we have climbed that mental barrier, the next question we ask is how do we determine if a company’s stock is undervalued.
How to Determine A Company’s Stock Is Undervalued
First and foremost, there are a tons of theories and models about calculating the fair value of a company. Some are simple and some are a bit more complicated but all have the same goal: helping is determine whether a company’s stock is undervalued. On a side note, from being in undergrad school, sometimes I sit there in awe and think about how academia has created something “complicated” but doesn’t make since. Beta? CAPM?Standard Deviation? From personal experience, I have used three valuation techniques. I have chosen these techniques for two reasons. First, they work. Secondly, they make sense.
Discounted Cash Flow
Introduction to Discounted Cash Flow- If you ever go to business school, you will do a discounted cash flow consistently. Its based on the concept of time value of money. Basically, you calculate trailing cash flow which will be your Year “zero” or starting point. From security and industry analysis you feel confident the company will grow at a certain growth rate in the near feature , usually 5 years. After those 5 years, growth would then slow. After the second stage of growth (another 5 years), you assume the company will growth at a certain rate until eternity. After projecting future cash flow you then discount those cash flows using an appropriate discount rate.
Wikipedia Cash Flow – Discounted Cash Flow
Discounted Cash Flow Calculator
Pretty basic introduction, but Wikipedia (link above) should do a better job of teaching you about discounted cash flows. There’s also a lot of resources online that will take the heavy lifting out of discounted cash flows. In the end, a discounted cash flow will give you an estimate of intrinsic value. But, its subject to a lot of errors and variables and thus I use them less and less. For one, your forecasting into the future. Can you imagine doing a discounted cash flow model on homebuilders sometime before 2007? Secondly, not all firms have positive cash flows. Thirdly, high growth companies will have wider range of growth rates. Finally, small changes such as changes in the discount rate can have big impacts on the whole model.
Earnings Yield
Magic Formula Investing system and other value investors use the earnings yield. Earnings yield is the inverse of the P/E but can be broken down further to take into account the effect of financing and accounting issues that net earnings. In other words, its a way to get a picture of what the company truly earned. To calculate earnings yield the formula is as follows.
EBIT/ EV
Where EBIT is earnings before interest and taxes and EV is equal to Market Capitalization + Interest Bearing Debt + Preferred Stock – Excess Cash.
Cash Flow Yield
I learned this metric from Bruce Berkowitz and has made a big difference. It’s similar to earnings yield but the focus is now on what counts, cash. Under current accounting rules, its simply a lot tougher to manipulate cash flow.
How to calculate free cash flow?
Free Cash Flow Per Share/ Current Market Price Per Share
Pretty basic right. For some it may be too basic but value investing is simple but not easy. So what do we do with earnings yield and cash flow yield?
Answer: you compare it against two things. First, we compare it against a risk free asset such as a t-bill. If the stock has a free cash flow yield of 15% versus government bills of 5%, it should and usually returns more than that. If Stock “A” has a free cash flow yield of 8% and Stock “B” has a free cash flow yield of 10%, Stock B is cheaper than Stock A. Put it this way:
- Stock A= P/E 12 (8.33%)
- Stock B = P/E 10 (10%)
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Sat, May 1, 2010
Bruce Berkowitz, Value Investing, Warren E. Buffett