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 investment 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
Multiples Valuation
- 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)
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)
- cyclical
- no competitors
- growth
This is where I believe Bruce Greenwald’s 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 value 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.
Greenwald Earnings Power Value EPV lecture slides
June 3rd, 2009 at 4:38 pm
Hi Jae,
I just found your website from other sties. This looks great. Very useful info and resources.
By the way can you explain in details the difference b/w $15.95 spreadsheets and $21.95 spreadsheets? What financial statements are included?
Thanks
Ryan
June 3rd, 2009 at 6:00 pm
Ryan, is the email address you entered correct? ryan2041 (at) mail.com ?? The email is bouncing.
June 9th, 2009 at 12:58 pm
I have a question on one of the equation on slide #7, Maint. Inv = Depr + A, What is A ?
June 9th, 2009 at 2:55 pm
A = Amortization
June 9th, 2009 at 4:20 pm
Thanks for answering Anon.
August 27th, 2009 at 7:02 am
Not to split hairs, but I believe that Bruce Greenwald (in his book Value Investing: From Graham to Buffett and Beyond) actually describes his analysis as completely discounting any growth. That is, as a value investor, he’s unwilling to pay any premium for growth. EPV valuation simply assumes standardized earnings – “average” margins over “sustainable earnings” – multiplied by 1/WACC determines the Company’s current value. You’ll notice it’s very similar to a standard DCF analysis if you remove the growth rate and assume WACC as the discount rate. Just substitute “sustainable earnings” for “sustainable cash flow.”
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August 27th, 2009 at 12:19 pm
Yep. I just finished going over the book a second time but there are some substantial differences. Greenwald doesn’t like to use DCF because of the assumptions and projections required.
However, I ultimately see the intrinsic value of the business going up when the company is able to generate FCF. A company could have the highest sustainable earnings but could result in nothing if it never drops to the bottom line.
This is the biggest problem I have with using the EPV. Enron had high sustainable earnings but had people looked to see whether that number turned into FCF, it would have been a completely different story.
I’m still thinking hard about how I will implement this.