What you will Learn
- How to differentiate between price and value
- How to use the Cash Flow Analysis, a simple tool for estimating a company’s value
- To what Warren Buffett attributes his investing success
My wife raised her eyebrows as I walked into the living room with the embarrassingly large Nintendo box under my arm.
“How much did you pay for that?” she asked skeptically.
“I paid what it cost.”
This was my way of hiding the price of the Nintendo. Perhaps a better way to address this would be to extol the Nintendo’s value – the fun and fellowship we will get by playing together as a family.
Price is what you pay; value is what you get.
Warren Buffett
Mr. Buffett frequently emphasizes the difference between price and value when investing. This implies two things; first, price and value are not the same, and second, you CAN place a value on a company. So let’s go hunting for value!
One way to value a company is to determine the profits that it will generate in the future, and what you would be willing to pay today for those profits.
Consider this simple example. A local coffee shop that makes $10,000 in profit every year is for sale. Let’s say that it is self-sufficient and is likely to continue making that $10,000 annually with little effort. How much would you be willing to pay for that coffee shop?
Now consider it from the other direction. If you were the business owner, at what price would you consider selling?
If you’re like most people, you’d be unlikely to sell it for $10,000, as you could make that in one year anyway with little effort. You might be willing to sell for $70,000 (7 years profit) or $140,000 (14 years profit).
The point is, there IS something of value here which we can haggle over – the intrinsic value of the coffee shop.
By having an idea of intrinsic value, we can stop Bigger Fool investing. Bigger fool investing is when you buy a stock today, hoping a bigger fool will eventually come to pay you even more for it. The problem is, of course, that you just made yourself someone else’s bigger fool.
The Discounted Cash Flow Analysis
Here is one method to calculate the intrinsic value of a company. It is called a Discounted Cash Flow Analysis. This works best for a company that is profitable and consistent, just like the coffee shop. Unlike the coffee shop, the businesses we invest in will most likely be growing. Fortunately, the Cash Flow Analysis also accounts for growth over time!
Briefly, our goal here is to determine what a company’s future earnings will be over the next 10 years. We will then extrapolate back to today and determine what we’re willing to pay for those earnings today.
Step 1: Write down the current Earnings Per Share (EPS)
EPS is simply the company’s profit divided by its total number of shares. This is a commonly reported metric and is freely available on any financial website or company’s annual report.
Step 2: Determine the company’s growth rate
As the company grows, its EPS should also grow. We’ll need to account for this increase in earnings over time.
This is the step that takes the most work and the one most likely to lead you astray. The growth rate that you choose to give the company will have a large effect on the calculation. Fortunately, there is a safety mechanism in place as financial analysts also publish growth rates for most public companies.
Find these numbers for your company over the last 10 years:
a) EPS
b) Sales
c) Cash
d) Equity
– Equity may be listed as book value, and this is the most important number. That is because as the company earns a surplus of cash, it will show up in equity growth.
These values can be found on financial websites and are freely available in the company’s annual reports.
I find it works best to put them in a table like this.
Take a moment and look at the numbers in general. Are they going up, going down, or staying the same? Do they move in tandem or opposed to each other?
If a company has not been growing over the last 10 years, that may suggest it is not competitive in its industry.
If things look good and the company growing, keep going with the analysis.
We’ll need to pick a representative growth figure for our calculation. You don’t need to be exact here, but the growth should be reasonable based on what the company has done recently.
The formula to calculate growth is:
This may look complicated, but it is simple in practice. Once you’ve done one, you’ve done them all.
Here is how to do this on your calculator step by step:
1) Type in the present value and hit divide.
2) Type in the past value and hit equal.
3) Hit the xy button.
– This skip can be stepped on your one-year calculation.
4) Type in (1/n) and hit equals.If your present value is in 2020 and your initial value is from 2010, n is Nine – not 10.
5) Subtract 1.
6) To convert to percent, multiply by 100.
Why 10 years?
Because the typical business cycle is 8-10 years. If you look at 10 years of data, you should catch at least one down cycle in your calculations. This protects you from over-estimating growth, such as what happened with Yahoo! heading into the dot-com crash.
Determine the growth rates for EPS for the last 1, 3, 5, and 10 years. Your chart will look like this.
This company has grown EPS by 15-19% over the last 10 years, but declined by 9% in the last year!
Then do the same for Sales, Cash, and Equity. It takes time, but it is worth it! You are well on your way to being an informed investor, not someone else’s “bigger fool.”
Which growth rate do you choose?
After you’ve determined the growth rates take a step back and look at the numbers you’ve calculated. Are they similar and consistent? Are they growing or shrinking? Does anything stand out or look off to you?
Your job will be to choose a growth rate that represents the overall growth over the next 10 years.
Fortunately, professional analysts forecase growth rates for most large companies, and these can be found on the internet. You can compare their guesses with your own (I purposefully chose the term ‘guess’).
Choose the lesser between yours and the analyst’s prediction. Because the future is wrought with uncertainty, you want to underestimate actual growth. Don’t fall into the trap of expecting best-case scenarios.
Step 3: Estimate the future Price to Earnings (PE).
The price to earnings is a commonly used metric in investing. It is used to convert EPS to a price-per-share.
Think back to our coffee shop that earned $10,000 per year. If there is one owner, he owns the whole “share,” and EPS is $10,000. If he sells the company for $100,000, the PE is 10 ($100,000/$10,000).
We have two ways to estimate the future PE of our company.
First, you can double the growth rate you estimated in Step 2. If you think this company is going to grow at 10%, it’s future PE is going to be 20.
Second, you can use the company’s historical PE. Just search any financial website to find your company’s representative PE over the last 10 years. Be sure not to use a single point in time (such as today’s PE) – you want to choose a PE that is typical of the company over time.
Choose the lower of these two PE values. For example, if the growth rate is 10%, and the historical PE is 12, you choose the future PE of 12 rather than twice the growth rate (10%x2=20).
4) Choose your desired rate of return
This is a number you choose based on your own needs. I recommend choosing 15%. This means that you’re targeting investments that return 15% compounded annually.
The average return of the S&P 500 is 7-8%, about half of our target. Choosing 15% pays you for the increased risk you’re taking by investing in single companies (and means you get richer a LOT faster).
The Crystal Ball
Now that we have everything we need to perform the Cash Flow Analysis let’s see what this company is worth!
First, extrapolate the future EPS by growing the current EPS by their future growth rate. Because this is compounded growth, the formula is like this:
Here’s how you do it in practice:
1) Enter 1 + your growth rate and hit enter.
– This is in decimals, so a 24% growth rate should be 1.24 by the end of this step.
2) Hit the xy button.
3) Enter 10 and press equal.
– This is because we’re projecting 10 years into the future.
5) Multiply by today’s EPS and hit equal.
Next, we convert the company’s earnings per share in 10 years to their future share price. Easy, just multiply the future EPS by the PE ratio you found in step 3 above.
Finally, we determine what price we could pay today to reach our targetted return. This part is also easy if you take my advice and demand a 15% return – simply divide the future stock price by four.
* Only if your targeted return is 15%
Why four?
We divide by four because an investment that grows at 15% compounded for 10 years will always double twice in that time*. In other words, a $20 investment will double to $40 and then to $80 in 10 years.
* Ok, it may not double twice exactly, but it is incredibly close.
Margin of Safety
Now that you know the company’s value, I also recommend you demand a margin of safety before you buy. This comes directly from the Ben Graham/Warren Buffett/Charlie Munger style of investing. Here is a quote from the Berkshire Hathaway Shareholder letter in 1992:
“We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin of safety principle, emphasised [sic] by Ben Graham, to be the cornerstone of investment success.”
Warren Buffett (emphasis my own).
Conclusion
My hope is that I’ve convinced you that:
– Companies do have an intrinsic value.- As individual investors, we can estimate intrinsic value.
– A discounted cash flow analysis is a simple, fast, and powerful method for determining intrinsic value.
Did you have trouble with this exercise? In future posts, I will walk through an example using a real company!
All the information in this article is for your entertainment and education. I am not a financial advisor, nor have I considered your financial situation, and thus this is not investment advice.
