What You Will Learn
- How to Analyze Businesses Using 3 Easy Valuation Methods
- What are the Best Valuation Methods and When Should You Use Them
- What is Intrinsic Value and Why it is Important in Valaue Investing
One of the questions I have frequently been asked lately is, “How do you analyze businesses?” I usually respond by noting that determining a company’s intrinsic value is a subjective operation. It is nearly impossible to determine a company’s precise value but it is not hard to determine its approximate value and that is the aim, to be approximately right and not precisely wrong.
With that in mind, I think the following will be helpful to anyone that is interested in learning how to properly analyze potential investments from a value perspective.
How to value stocks series
For other posts in the series, follow the links below.
- How to value a stock with DCF Method
- How to value a stock with Benjamin Graham Formula
- How to value a stock with Reverse DCF
- How to value a stock with EPV
- 3 Quick and Easy Valuation Methods
What is Value Investing?
Value investing in the manner initially defined by Benjamin Graham & David Dodd entails the strategy of purchasing securities only when their market prices are significantly below the calculated intrinsic value.
This difference between value and price is thought of as buying with a “margin of safety”. The objective is to purchase a proverbial dollar for 50 cents or less.
While the objective is simple, the actual task is anything but. The goal of this article is to show one how they can assess with reasonable certainty the approximate intrinsic value of potential investment targets.
Here are a few of the simplest and most accurate methods which I have personally utilized for the past five and half years to get one started in determining a company’s intrinsic value:
Asset Based Valuation using NCAV
NCAV (Net Current Asset Value) shows how to calculate the classic “Net-Net” as utilized by the father of value investing Benjamin Graham himself.
Current Assets – Total Liabilities = NCAV
This is both the simplest and most conservative estimate of a company’s intrinsic asset value. As a rule, Benjamin Graham only looked to purchase company’s which were valued at a discount to their net current asset value by 33% or more.
Today, value investors are hard pressed to find company’s valued at such a significant discount and would be happy to pay 100% net current asset value for a company and acquire both its earnings and any potential growth for free. This equates to essentially paying only liquidation value for a company and nothing more.
Asset Based Valuation using Reproduction Costs
This type of analysis requires much more specialized knowledge about both the business and the industry in which it participates.
In this instance we attempt to assign a value to each asset on the company’s balance sheet to determine what the inherent reproduction cost of all the asset is.
As you can plainly see from the example above, the liquidation value or reproduction costs of assets is usually far below what is stated on a corporate balance sheet. It is from the reproduction value figure that investors must deduct all liabilities to ascertain a company’s true asset value.
Again, when it comes to asserting reproduction values to assets the better one understands the company and the industry in which it operates the better (and more accurate) the estimate they can place on its assets.
Earnings Based Valuation using EPV
EPV (Earnings Power Value) is the most conservative earnings based valuation and hence why I utilize it as it falls in line with my foremost investment objective which is to maintain the safety of my principal.
Adjusted Earnings x 1/Cost of Capital = EPV
Earnings Power Value is what I believe to be the second most reliable measure of asserting a firm’s intrinsic value, behind estimates based on assets.
The simple goal of EPV is to accurately estimate the currently distributable cash flow of the company. To do this we analyze the earnings data and make adjustments where necessary.
After making adequate adjustments to the cost of goods sold, selling, general & admin, as well as depreciation & amortization which takes into account amounts actually spent on increasing sales and brand awareness while determining actual business expenses and costs more accurately, we arrive at the above stated figures.
After making these necessary adjustments and arriving at a more accurate earnings figure, all that remains to be done is simply assume that these cash flow figures will be sustained and experience no growth whatsoever.
We then divide this figure by a reasonably determined cost of capital (rate of interest at which the company can reasonably borrow money) to arrive at our EPV for the firm and thus its earnings based valuation.
By dealing only in current facts and figures and not relying whatsoever on future growth or cost of capital projections like a discounted cash flow analysis or the like would we arrive at a much safer valuation figure.
Growth Based Valuation
Like any value investor I would advise not paying anything for even the rosiest projections of future growth unless they have some basis in current and past figures.
If one does see stable growth then they must first, determine if the growth is taking place within the franchise and if the firm does indeed enjoy a competitive advantage in the marketplace. If this is found to be the case only then can a growth based valuation be estimated.
One such method is the Benjamin Graham Valuation method.
Benjamin Graham Valuation
EPS x 8.5 + 1.5G x 4.4/4.60 = V
(In depth look at Benjamin Graham Valuation)
EPS is the trailing 12 month’s earnings per share, 8.5 is the PE ratio of a stock with zero growth, G is the estimated growth rate for the next 5 years, 4.4 is the minimum required rate of return when investing, 4.60 is the current 20 year AAA corporate bond yield, V is the intrinsic value of the company.
This is the original growth valuation formula employed by Graham as described in Security Analysis.
However, be forewarned as this method of valuation is much riskier than both an asset or current earnings based valuation simply because of the fact that we are making projections about the future which are always extremely imprecise.
As always there is much more to be said about business analysis than contained in a brief article such as this, many more things to be considered and much more expertise to be imparted by those with much greater knowledge than myself.
However, I would like to add a few further words for consideration. Namely, that many insights can be gleaned from performing and then comparing asset, earnings and growth based valuations to one another.
Doing this will enable one to better understand certain qualitative aspects of the business in question, such as if the reproduction cost of the assets is greater than the EPV then in all likelihood, that implies that current management is not earning an adequate return on its current assets or it can also be that the industry in which the business is involved in is operating with excess capacity.
Further analysis can determine which of these scenarios is factual. Another very important thing to remember is to always perform a follow up analysis on companies held in your portfolio to ascertain if the initial reason you made your purchase is still valid. I usually do this on a half yearly basis.
This article was written by guest author, Theodor Tonca. If you would like to have an original article featured, please contact me via one of the methods below.