THE BASICS OF STOCK VALUATION

Over time, the stock market’s returns come from two key components: investment return and speculative return. As Vanguard founder John Bogle has pointed out, the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio

Price Multiples

A. Price-to-Sales (P/S)

P/S ratio = current price of the stock / sales per share

The good thing about P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings. In addition, sales are not as volatile as earnings. Thus, P/S ratio useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios. Also the P/S ratio can be used when earnings are negative (P/E ratios cannot be calculated - indicated as N/A).

Biggest flaw: Sales may worth a little or a lot, depending on a company profitability. A company may post billions in sales, but still losing money.

B. Price-to-Book (P/B)

P/B ratio = stock’s market value / book value (also known as shareholder’s equity or net worth).

The main weakness for P/B is that there is increasing trend in intangible assets worth, which may limit the usefulness of P/B ratio. For service firms which depends on brand, dedicated employees, strong customer relationship, efficient internal process, P/B has little meaning.

P/B is tied to ROE (equal to net income / book value), in the same way that P/S is tied to net margin (equal to net income / sales). Given two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio. Therefore, when you are looking at P/B, make sure you relate it to ROE. A firm with a low P/B relative to its peers or to the market and a high ROE might be a potential bargain, but you’ll want to do some digging before making that assessment based solely on the P/B.

P/B is useful for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets. Financial firms trading below book value (a P/B lower than 1.0) are often experiencing some kind of trouble.

C. Price-to-Earnings (P/E)

The Good: accounting earnings are a much better proxy for cash flow than sales, and they’re more up-to-date than book value. Moreover, it is readily available.

The easiest way to use a P/E ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, or the same company at a different point in time.

The Bad: Relative P/E has one drawback, a P/E of 12, for example, is neither good nor bad in a vacuum. Using P/E ratios only on relative basis means that your analysis can be skewed by the benchmark you’re using.

Risk, growth, and capital needs are all fundamental determinants of a stock’s P/E ratio:

* higher growth firms should have higher P/E ratios,
* higher risk firms should have lower P/E ratios,
* and firms with higher capital needs should have lower P/E ratios.

When you’re using the P/E ratio, remember that firms with an abundance of free cash flow are likely to have low reinvestment needs, which means higher P/E. Also:

* If a firm has recently sold off a business or perhaps a stake in another firm, it’s going to have an artificially inflated E, and thus lower P/E.
* If a firm is restructuring or closing down plants, earnings could be artificially depressed, which would push the P/E up. For valuation purposes, it’s useful to add back the charge to get a sense of the firm’s normalized P/E.
* If the firm cyclical? Firms that go through boom and bust cycles - semiconductor companies and auto manufacturers are good examples - require a bit more care. Your best bet is to look at the most recent cyclical peak, make a judgment whether the next peak is likely to be lower or higher than the last one, and calculate a P/E based on the current price relative to what you think earnings per share will be at the next peak.
* Does the firm capitalize or expense its cash-flow generating assets? A firm that makes money by building factories and making products gets to spread the expense of those factories over many years by depreciating them bit by bit. On the other hand, a firm that makes money by inventing new products like drug, has to expense all of its spending on R&D every year. Arguably, it’s that spending on R&D that’s really create value for shareholders. Thus, the firm that expenses assets will have lower earnings - and therefore a higher P/E - in any given year than a firm that capitalizes assets.
* Which type of P/E? There are two kinds of P/Es-a trailing P/E, which uses the past four quarters’ worth of earnings to calculate the ratio, and a forward P/E, which uses analysts’ estimates of next year earnings to calculate ratio. In general, forward P/E < peg =" P/E" yield =" 1" return =" Free">

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Discounted Cash Flow:STOCK VALUATIONS

What is the Discounted Cash Flow Model

DCF analysis calculates the present value of a company’s future earnings. In other words, what is the value of a company’s stock assuming their earnings grow at a certain rate over a given time period. We can figure out what an investment is worth to us today by entering 4 parameters into our model.

Four DCF Parameters

• Earnings Per Share over the past 12 months - we enter the latest EPS as our earnings starting point.
• Earnings Growth Rate over next 5 years - we use the earnings growth rate to calculate a company’s forward EPS for the next 5 years. Also known as the analyst’s projected earnings growth estimates.
• Growth Rate after 5 years- In order to generate an rational stock price, we enter a conservative growth rate after the initial 5 years. I usually enter 0% as the leveling off growth rate because you should never assume EPS growth for more than 5 years in advance. Companies produce negative earnings all the time, so we must enter a conservative value to make our discounted stock price more precise.
• Discount Rate - This is the most difficult number to derive because it differs between small, mid, and large-cap stocks. The discount rate is the expected return on your investment in 5 years time if purchased during present times. I use annual index returns as my discount rates because these indices represent a large number of securities which produce actionable average return values. An index return will keep your discounted cash formula from returning outliers. I use 15%+ for small-caps, 11% to 15% for mid-caps, and 8% to 11% for large-cap stocks.

When we enter these 4 factors into our discounted cash flow calculator, it returns a present day value of future earnings. Anytime investors like Benjamin Graham highlight the importance of evaluation formulas, we pay attention. Now that you know about discounted cash flow, you can add another useful model to your arsenal of investing tools.

Take Discounted Cash Flow With A Grain of Salt

DCF analysis is a tool and should not be the sole reasoning for a particular investment. Formulas and metrics are only as good as the numbers and values we enter into them. If you find an investment that’s highly discounted, try to figure out why the stock is so discounted and look over your values again. It’s easy to make a mistake and compute an irrational number as well.

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VALUE INVESTING IS ASSET BUILDING

value investing s all about asset building and long term capital appreciation...WARREN BUFFET the legendary investor and one of the wealthiest person on earth is having worth more than $45 billion only due to value investing...now i think there is no need to give more examples about value investing

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Understanding Value Investing

Shouldn’t we all be value investors? After all, who wants to buy crummy stocks? However, in this case, value investing refers to a particular philosophy that drives the way an investor approaches selecting stocks.

I should say up front that value investing is not junk investing. Value investing is not shopping the bargain bin for seconds and discontinued models. It is not about buying anything less than $3 per share.

Value investing is about finding stocks that the market has not correctly priced. In other words, a stock that is worth more than is reflected in the current price.

VALUE INVESTOR
The value investor, perhaps more than any other type of investor, is more concerned with the business and its fundamentals than other influences on the stock’s price.

Fundamentals, such as earnings growth, dividends, cash flow, and book value are more important than market factors on the stock’s price. Value investors are also buy and hold investors who are with a company for the long term.

If the fundamentals are sound, but the stock’s price is below its obvious value, the value investor knows this is a likely investment candidate. The market has incorrectly valued the stock. When the market corrects that mistake, the stock’s price should experience a nice rise.

Stock XYZ is down 25% from its high of six months ago. Is it a candidate for a value investor? Maybe, but probably not. Value investors aren’t usually interested in beaten up stocks unless there is no fundamental reason for the drop in price.

THE MARKET'S RIGHT

This happens; however most of the time the market is right and a stock gets hammered because of any number of sound fundamental reasons (declining earnings, declining revenues, are good examples) or something fundamental changes in their market or product line. A pharmaceutical company has a top seller yanked off the market by the government - that fundamentally changes the company.

On the other hand, other pharmaceutical companies may see their stock clipped also even though they are not part of the recall. That may make them worth a look by a value investor.

VALUE INVESTING GUIDLINES

What do value investors look for in a potential investment? Here are some guidelines gathered from a variety of value investors. Investors should settle on a formula that works for them, but it will probably include as a minimum these elements:

* A Price Earnings Ratio (P/E) in the bottom 10 percent of its sector.
* A PEG of less than one. (The link will take you to an article that explains how to calculate PEG.) A PEG of less than one may indicate the stock is undervalued.
* A Debt to Equity Ratio of less than one.
* Strong earnings growth over an extended period. A realistic number might be in the 6% - 8% range over 7 to 10 years.
* A Price to Book ratio of one or less.
* Don’t pay more that 60% to 70% of the stock’s intrinsic per share price (see below for more on intrinsic price).

A big challenge for the value investor, and all investors for that matter, is reconciling market value and book value.

INTRINSIC VALUE

Current accounting standards are adequate for measuring buildings and equipment (book value), but as our economy has moved to a more technology/knowledge-base, many of these intellectual assets never show up on financial statements.

Value investors acknowledge that their target investment company is much more valuable as an ongoing business (expected cash flows, etc.) than its assets (market value). In many cases, it is the intangibles – patents, trademarks, research and development, brand, and so on – that drives the expectations of future growth, not hard assets.

How do you calculate the value of intangible assets? An article from Investopedia.com offers a step-by-step process to come up with a number.

Coming up with the intrinsic value of a stock is a complicated process and there are a number of ways to get to the number.

FINDING INTRINSIC VALUE

Fortunately, there are several places you can go on the Web to find the number. MorningStar.com calculates the number, which it calls “fair value,” on its site, however you need to be a member. Take the two-week free trial to see if you like their service. Another good source is Reuters, which also requires a registration, but it is free.

However you arrive at the intrinsic or fair value, give yourself a margin of error with the thought that if the calculation is wrong you might over pay. If you use one of the services mentioned above or another source to find the intrinsic value, determine if they have already factored in a margin of error.

For example, if you believe the intrinsic value is $40 per share, give yourself a margin of safety and lower the target to $36 per share.

CONCLUSION
Many people have made fortunes using a value-based approach to investing. This overview suggests a philosophy that works over time if you buy carefully and hold for the long term.

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BENJAMIN GRAHAM FORMULA FOR VALUE INVESTORS

In The Intelligent Investor, Benjamin Graham describes a formula he used to value stocks. He disregarded complicated calculations and kept his formula simple. In his words: “Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the evaluation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.”

The formula as described by Graham in the 1962 edition of Security Analysis, is as follows:

V'= EPS * (8.5 + 2g)

V = Intrinsic Value
EPS = Trailing Twelve Months Earnings Per Share
8.5 = P/E base for a no-growth company
g = reasonably expected 7 to 10 year growth rate

Where the expected annual growth rate “should be that expected over the next seven to ten years.” Graham’s formula took no account of prevailing interest rates.

This highly simplistic formula has little practical value to most value investors. A company with an expected growth rate of 10% in EPS could have a P/E (Price/Earnings) of 28.5 to be considered a buy. Most value investors would reject it. At least half of the stocks in the S&P 500 meet this criteria and most value investors wouldn't buy them at a P/E of 28.5 or anything close. On the other hand, if it could grow earnings at that rate for 30 years, it would be a bargain.

However, Graham also preached Margin of Safety. Therefore, taking this formula and allowing a 50% Margin of Safety you arrive at a P/E of 14.25 in the above example. Many value investors would take a hard look at a company with a 14.5 P/E growing earnings at 10% a year.

Then, he revised his formula in 1974 (Benjamin Graham, “The Decade 1965-1974: Its significance for Financial Analysts,” The Renaissance of Value) as follows:

Graham suggested a straight forward practical tool for evaluating a stock’s intrinsic value. His model represents a down-to-earth valuation approach that focuses on the key market-related and company-specific variables.

The Graham formula proposes to calculate a company’s intrinsic value V' as:

V' =EPS*(8.5 + 2g)* 4.4/Y

V: Intrinsic Value
EPS: the company’s last 12-month earnings per share
8.5: the constant represents the appropriate P-E ratio for a no-growth company as proposed by Graham
g: the company’s long-term (five years) earnings growth estimate
4.4: the average yield of high-grade corporate bonds in 1962, when this model was introduced
Y: the current yield on AAA corporate bonds

To apply this approach to a buy-sell decision, each company’s relative Graham value (RGV) can be determined by dividing the stock’s intrinsic value V' by its current price P:

RGV =V'/P

An RGV of less than one indicates an overvalued stock and should not be bought, while an RGV of greater than one indicates an undervalued stock and should be bought.

Because of the measures it uses, difficulties may be encountered in evaluating both new and small company stocks using this model as well as any stock with inconsistent EPS growth. It is efficient because of its simplicity but it also limits it: the model doesn’t work well for every stock.

Thus, the calculation is subjective when considered on its own. It should never be used in isolation; the investor must take into account other factors such as:

* Net Current Asset Value in order to determine the financial viability of the firm in question
* Current Asset Value in order to determine short-term financial viability of the firm
* Debt to equity ratio
* Quality of the Current Assets.

It's noteworthy that 1974 was the crash of the Nifty Fifty and it would be interesting to see how Graham's original and revised formula would have performed with this group of Wall Street darlings.

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