### How Do I, And How Can You, Value Company's?

Recs

### 6

**INTRODUCTION **

I'm a value investor and all of my CAPS picks are underpriced value stocks. But how do I, and how can you, value what a stock is worth? Well, there are several ways to approach this. You can use EPS, average P/E ratio and expected growth rates to make a simple little formula to come to a fair value/intrinsic value estimate. But you can also use a discounted cash flow (DCF) model, which takes a bit more time. I'll discuss them both later on.

**WHERE DO I START?**

There are thousands of company's listed and it would simply take far too long to analyse them all and then look at which one is best. No, you got to filter the *possibly better company's* out of the rest. There are several ways you can do this: You can use Yahoo!'s screener or MSN's deluxe stock screener, you can use the stocks talked about in Motley Fool articles as starting points for your search for value, or use the CAPS system to locate interesting stocks. You can also look for stocks near 52-week lows or use the Magic Formula for stock idea's. Morningstars Free Cash Flow statements can be used to look for company's with positive free cash flow.

Look for company's with stong balance sheets. Some things you can look for are: ROE>15, ROA>10, Debt/Equity<0,5, does the company pays a dividend? Positive (growing) free cash flow, increasing profit margins, low P/E ratio, high earning yield, growth potential, does the company has a durable economic moat? Is the company simple and predictable? Does the company has trustable management?

A great company has all of the above, if your company hasn't it can still be a good company and to be sure you could use a larger margin of safety to compensate.

**I FOUND A CANDIDATE, NOW WHAT?**

Now comes the fun part: coming to a conservative intrinsic value estimate. First I'll explain the fast and simple way, using EPS ttm, average P/E ratio and expected growth rates.

I have a little Excel sheet which can make this a bit easier for you guys, here it is. That is my standard sheet I fill in for every company I analyse, just to give me a neat and quick overview of the company. I get the data from the following places: The 5 year average ROE and ROA, the Debt/Equity ratio and the profit margin I get from Reuters ratio page. The EPS ratio I get from Reuters too, but you can also check out http://www.cnbc.com or http://finance.yahoo.com for that. The expected growth rates I get from Yahoo!'s analyst estimates page. (Next 5 Years (per annum) somewhere around the bottom). I get the average P/E ratio by looking at Reuters performance page: just add the high and low P/E ratio's and then devide by the number of P/E's you added up to get an average P/E ratio. (NutriSystem (NTRI) isn't a good example for this, because it has very different P/E ratio's every year. For this I just took an extremely conservative P/E of 14, lower than the low P/E of 2006.)

Just look up the same data for any company you are intersted in, fill them in on the Excel sheet and you got yourself an intrinsic value estimate!

**NOTE:** the only necessary things you need to fill in in order to get an intrinsic value estimate are: EPS and Price in the top blue/white table and the average P/E ratio and expected growth rate under the Debt/Equity table.

**THE DCF METHOD**

This one might take a bit more time, but that doesn't mean it's harder to do than the previous method. I have 2 Excel sheets you could use for this, which are both not created by me but very helpful. First we have a simple one from warrenbuffett.tk and the second one is made by fwallstreet.com.

I recommend you use Morningstars 10-year free cash flow and balance sheet data to fill in the needed data into the DCF calculators.

In the first one, from warrenbuffett.tk, you need to calculate the cash on hand per share, than the free cash flow per share. You then look up the expected growth rates of that company, apply a margin of safety and fill in the growth cells. (The best thing is letting the growth rates go down as time passes. So growth in year 1-5 is higher than growth year 6-10). As a discount rate I always use 9% (average market return).

Now an intrinsic value estimate comes rolling out of the equation!

The second DCF calculator from fwallstreet.com works a bit different and is much more accurate and complete than the one from warrenbuffett.tk. Morningstars cash flow and balance sheet page are highly recommended when using this sheet.

Fill in current liabilities, total liabilities, shareholders equity, and free cash flow in the upper part of the sheet. Now under *Company Valuation *you fill in the total shares outstanding and the current price. Now you got yourself a nice and complete overview of the company's value.

If you might be wondering what CROIC means: it means Cash Return On Invested Capital. For the full explaination and some extremely interesting articles, I advise you to visit the fwallstreet website.

**SOME FINAL WORDS**

I really hope this was an informative blog and that it helps some people out.

Happy investing to all of you and remember to only buy company's at a *big discount* to your most conservative intrinsic value estimates! I recommend using both the methods described to get a good image of a company's value, before you start buying stocks like crazy!

Disclaimer: I am not responsible for any losses of money or the like because of the usage of the above mentioned methods and tips. You hold full responsibility over your own actions.

## 1 Comments – Post Your Own

#1)On February 26, 2008 at 10:17 PM,bellard (97.51)wrote:Value_dude;

Nice post. Its good to see some value investors here on CAPS. One difference we have is ROE. I have found over time this metric not to be of much use. An example is a firm doing a levered buyout with the firm just gettting goodwill packed on the BS - shareholder equity decreases(bad), but the ROE goes up??

CROIC seems a bit more interesting. My models always focuses on cash flow. Read my first blog for my methods. Also I just published my top 20 DCF stocks for 2008.

Report this comment