What You Will Learn
- The Disadvantages of Several Stock Valuation Methods and Why Knowing it Will Help You as an Investor
- How to Know if the Stock You are Buying is Cheap and Worth the Buy
Stock Valuation Methods
Buffett and other respected investors mention that if you need a spreadsheet to determine a fair value of a company, the investment idea should be thrown into the pass pile. I only agree to some degree on this comment. It’s true that we should concentrating on no brainer investments rather than deworsifying into extra positions just for the sake of being invested, and while most people can read the financial statements to some degree, I’m sure many have trouble grasping all the numbers and coming up with a single dollar value as a fair intrinsic value number.
For me, as I run through companies, I always look at the free cash flow and cash flow statement first to determine whether the business is worth investigating. I can’t immediately come up with a number but I can determine whether the business is a good one. The stock valuation spreadsheets you find on this site was created to determine whether these stock ideas are cheap and to determine the buy and sell price range.
So far I use the following stock valuation methods:
- Discounted Cash Flow (DCF)
- Ben Graham Formula using normalized earnings
- Ben Graham Net Net Working Capital
- Multiple methods based on industry and competitors (used occasionally)
Disadvantages of Stock Valuation Methods
Discounted Cash Flow
- Need to estimate a growth rate. (Be conservative)
- Need to project into the future
- Does not work well for young, growth or cyclical businesses
Ben Graham Formula
- Uses earnings which can always be inflated even if it is normalized
- Projects using a EPS growth rate
- Back tests have shown that the value is the upper range and overly optimistic
Ben Graham Net Net Formula
- Calculates the value of assets only
- Does not provide an upper range indicator
- A snapshot valuation method
- Useless if business has no direct competitors (e.g. Mead Johnson Nutritionals. I’m having quite a difficult time trying to determine the fair value of the business.)
Earnings Power Value (EPV)
The GreenWald EPV Method
So even with 4 analysis tools in my toolkit, there is a hole that needs to be filled. Currently, I am still unable to value companies that are:
- young (<5 year old)
- no competitors
This is where I believe Bruce Greenwald’s EPV (or the Greenwwald EPV) method will come in handy. The stock valuation method allows the investor to value all of the above points.
A full detailed explanation of earnings power valuation in a practical step by step guide is available for Microsoft. The stock investment spreadsheet also allows you to perform a fully automated earnings power value stock analysis.
I was able to find Greenwald’s lecture notes from Columbia business school on the investment process and valuation which I’m sure you will all benefit from.
The EPV section starts from slide 16.