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My first CAPS post - My use of the capital asset pricing model for the valuation of equities.

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February 01, 2008 – Comments (15)

This is my first CAPS posting. I have been posting on Yahoo for 10 years, and I must be honest - I have become quite upset with the overall quality of other Yahoo posters. The Yahoo message boards is now just a free for all of nasty, illiterate, bashers, or dumb permabulls, or spammers...I started my CAPs about a week ago, and have blogged a bit. I am impressed with the overall quality of CAPS, and fool.  If anyone out there can give me advice on CAPS game, that would be appreciated. The questions I have are: How many equities should I manage?, When should I close out positions - Are the gains of more the 5% significant? Can I close out losers if they are less then 5%, and not get my rating dinged??  Just a quick blurb about me. I am an economist and software developer. I spent many years developing econometric models, while getting my masters in economic and finance. My focus was on linear modeling using matrix algebra, probability theory, and simulation programming. I used APL, & SAS as the main programming languages(this dates me). My actual thesis was a proof of the Efficient Market Hypothesis, using the equities market, and interest rate movements..Then for about 10 years I was a portfolio manager for large leasing firms - I manage large portfolio of computer equipment, and large commercial aircraft's..I currently manage my own hedge fund, and use my proprietary DCF model to help analyze equities.  For many of you, the use of DCF's to value equities is old news, so if I coma across preachy, it just that I am very enthusiastic about this topic. I use various types of cash flow in my model - free cash flow, operating cash flow, clean cash flow(NI + depr + adj), etc...This model has been very good at predicting performance. over the past 3 years, 4 out of the top ten in my list have been bought out at huge premiums...DCF is a tricky metric though. I break all the numbers into current and future cash flow yields, so when stocks crash there yields soar. So you have to be careful your not just catching falling knives.  My goal is to come up with a spreadsheet of about 100 equities for evaluation. I have personally not found a good cash flow screener on the net - If anyone has, please provide a link. So my first step is to perform a stock screener based on low PE stocks. You can filter these low PE stocks with other variables. Then you will get a more manageable list.. I had to analyze about 500 equities after my filters... Some variables to consider for additional filtering:

1)P/B below 2
2)OP margin above 10%
3)ROE above 15%
4)Market cap above 500M
5)D/E below 50%
6)NI growth rate above 10% Of course you could be filtering out some very good stocks, but you need a manageable number to start with. Keep in mind, as well, that discounted cash flow analysis is just the beginning of the due diligence process. Creating a DCF list of equities does take some time. I massage the data also.  Here are some steps I use.

1) Cleanse the cash flow data. I look for large one time gains that may inflate the cash flows. This is important since I add back in the NI adj's for some of my cash flow data. but I weight Maintenance cash flows more. This is (NI + depr + NI adj's) - maintenance capex(minimum capex to keep the firm running). Then I just divide by the market cap of the equity to get the current cash yield for the equity.

2)I analyze the net asset value of the equity. If the cash flow is growing, but the NAV is not, I get very suspicious. NAV must be growing with cash flow growth, for me to buy..

3)Research the industry. This is difficult work. I like to read and listen to the CC's of the firm, and its competition. I like to do this for current Q and up to one year back. I am trying to glean the next 12 months of future cash flow...My models heavily weight the next 12 months of cash flows.

4)Set benchmark metrics. P/B under 2, OP margins > 10, ROE > 20, D/E < 50, NAV growth > 8%, cash on hand > 10% of NAV, etc... These metrics are helpful when comparing firms within the same industry. Comparing OP margins in different industries can be difficult. As an example, the food industry has very low OP margins, while energy equipment(drillers) firms have very high OP margins. This does not mean that NBR's is better than let say SAFM just because NBR's op margin is much higher...

5)Go to the equities web site. Read all the investor presentations for the past 3 years, and see how accurate these past report were. Is the firm always overly optimistic in it presentations? Read the past Q reports with the same critical eye.

After this due diligence the list of 100 top DCF stocks should to trimmed to about 50..From here I sort this cash flow yield spreadsheet  by current, and future yields, with obviously the highest yield at the top. Then I research the top 20 for my purchase decisions.

Any thoughts, comments on this process is welcomed...I will be posting my top 20 for 2008, once I have all the Q4 data for my equities...

 

 

 

15 Comments – Post Your Own

#1) On February 01, 2008 at 10:16 AM, floridabuilder2 (99.26) wrote:

bellard..... keep your picks under 50 or otherwise you will become a day trader... in a bull market you could probably go to 100 on a lot of buy and holds

red thumbs.... are limited to 100% gain, unless you are riding it down... then you could close a red thumb at a 10% gain, then reopen the red thumb at a lower price and close it again as it falls, etc.... you build up accuracy here, but it becomes a job more than fun.... it is best just to red thumb what you don't like and close the position when you feel you are totally screwed... the thing is flying or when you feel the stock has hit a bottom

green thumbs... buy and hold .... again you can trade these just like anything to gain accuracy, but again do you really want to continuously open and close a position to gain accuracy... especially when if there is a reversal it could actually hurt you....

i have found that the people who open a position a stick with their conviction perform better than the people that are trying to build accuracy by closing everytime they have a 5% gain... your ended picks are all over winners and then like me you have 140 not ended picks in the red

go to quick stats and there is a link that says how caps rating is calculated or something like that... there is also a little help link............... whatever you do.................. do not I repeat do not close any picks until you read the rules......................

you will find that CAPS is 200% better than yahoo... there is so much quality content, cool people and blogs, the star ranking system, and so on that you will never go back to yahoo message boards for anything......

this site is brilliant and i would study all the features carefully so that you maximize the sites use... additionally, reach out to other bloggers.. when you see a blog hit the recommend button and the ask the blogger a question about whatever his topic is.....  you will find the quality of CAPS friends here you meet to be way more sophisticated and helpful...........

It is rare that people attack each other here, it is very friendly... obviously my blog was to entertain and act like an idiot, but I neer attacked people..... we don't want to turn this into a yahoo message board......

also, when getting advice you can see how that person picks stocks (audit trail) and whether or not the advice is good.. .unlike yahoo

if you want someone as a favorite, click on my favorites... i just clicked you on ............... then each day there is a link on your main caps page that gives you emails and shows you what picks your favorites opened or closed.. so you can follow people you really respect instantly

welcome

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#2) On February 01, 2008 at 10:27 AM, bellard (99.33) wrote:

"also, when getting advice you can see how that person picks stocks (audit trail) and whether or not the advice is good.. .unlike yahoo "

This is huge for me - much better than yahoo. I have always been interested in investor psycology, and by blogging with serious people such as you - and then check your picks - I gain very valuable insight to this complex dynamic... 

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#3) On February 01, 2008 at 10:45 AM, floridabuilder2 (99.26) wrote:

i see you have 4 favorites... if you have too many it can be confusing... but if you go through enough of the caps top 100 players you will find some guys who are just stellar at making picks, they just aren't in the top 20..... and I am not talking red thumb picks, i am talking green thumb picks....

the guys with 50 picks such as yourself that have 1,000 points and 80% accuracy are the guys you want as favorites... especially if they are doing all green thumbs.... you can sort caps players by accuracy too..... so again, don't open to many more picks.... learn more about the site and take full advantage

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#4) On February 01, 2008 at 11:05 AM, bellard (99.33) wrote:

FB;

I am going to go thru the top 200 players, and research. It seems logical that as of now, with the recent huge market declines over the past 3 months - the top players may just be shorties, or perma-bears... I don't want these as mentors, every dog has his/her day....

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#5) On February 01, 2008 at 11:45 AM, floridabuilder2 (99.26) wrote:

bellard..... exactly..... you will find that a significant portion of the top 100 are shorts or red thumbers....  you can sort out all their scores and see a lot of their scores are from blanket shorts of builders, banks, mortgage, etc............. first i must say that these were terrific calls because most were made early in 2007.....  however, are they one trick ponies or can they repeat the magic with green thumb bets... because at the end of the day a green thumb can be worth 1,000 plus points for one pick.... if you go to top 10 you can see the highest individual scores achieved on single stocks....  you need a lot of red thumbs to accumulate those points

you will also find a lot of industry investors... people who will make 30 long gold stock picks... if they are right they go through the roof and if they are wrong they go through the floor.....

if you look at my past picks they are all over the map green and red thumb... but 35% of my points came from builders.........

going forward I am going to take a laser sharp focus vs.. an industry focus............

a lot of people in caps follow the leaders blindly without understanding that they are making wholesale picks on industries... nothing wrong with that, but you have to understand that is how they got there.... over the course of 5 years we will see who really knows stocks.... CAPS has only been around for 1 1/2 years... that is not a long track record especially when you consider how easy it was to short 5 industries in 2007 and walk away with a boatload of cash..... 2008 is going to be more challenging to be a bear or bull

finally hit your own recommendation button....  a lot of times I won't even check out a blog unless it has at least one recommendation... gets the blog rolling.....  the key to blogging you will find is that the more you blog the more comments you will get... if you blog once and nothing really happens it is because no one knows you and there are a lot of mindless random blogs... or two, your subject title sucks for instance "great stock ideas".............. WTF?  that is why I try to put in catchy subject titles...

so don't be discouraged if you don't get 100 hits on this blog, because you have to build up credibility... part of that credibility is going to other blogs and commenting about their subjects... once people realize your bright which you are and they see your stock picks and you are showing success, they will engage you...

that is what makes caps great, over time the cream always rises to the top............ i will be watching your picks and your score good luck

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#6) On February 01, 2008 at 2:14 PM, zygnoda (27.20) wrote:

Wow, florida you're on a roll!    Welcome to caps bellard

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#7) On February 01, 2008 at 3:12 PM, zygnoda (27.20) wrote:

Wow, florida you're on a roll!    Welcome to caps bellard

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#8) On February 01, 2008 at 4:03 PM, zygnoda (27.20) wrote:

Wow, florida you're on a roll!    Welcome to caps bellard

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#9) On February 01, 2008 at 6:54 PM, bert111 (82.88) wrote:

Bill,

Delighted that you are here and posting.  I may be wrong, but I suspect that you’re going to make a significant mark in CAPS, based on my understanding of you from the Yahoo AEO forum and, of course, this tremendously well-written first CAPS blog contribution.

Thanks,

Robert Crawford

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#10) On February 03, 2008 at 1:20 AM, zygnoda (27.20) wrote:

doh! sorry about the multiple posts...

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#11) On February 03, 2008 at 10:07 AM, marlonious (< 20) wrote:

what is DCF? i'm FB blog follower. i'm new to investing. I work hard job in the military, get payed very little. i tryed investing on my own, but that did't workout, now i'm reading "investing for dummies" and i got investools.com to reseach stocks.

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#12) On February 03, 2008 at 3:53 PM, bellard (99.33) wrote:

Hi Marion;

DCF - is discounted cash flow. An asset like a company is worth all its future cash flows - discouted back into todays dollar. My advice for individuals who do not have the time to research individual stocks, is just buy ETF's or mutual index funds...SnP 500,  a small cap index fund - IWS. Keep reading, and add some more picks for you CAPS!, Looks like your picks are doing a lot better than mine! good luck..

 Do some research on Ben Graham. Below is a simple formula you can use instead of the more complex DCF models:

 

The formula as described by Graham in the 1962 edition of Security Analysis, is as follows:

V = Intrinsic Value
EPS = Trailing Twelve Months Earnings Per Share
8.5 = P/E base for a no-growth company
g = reasonably expected 7 to 10 year growth rate

 

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#13) On February 06, 2008 at 9:02 PM, alstry (35.44) wrote:

I myself prefer the 1932 Edition of Security Analysis.  The examples are much more entertaining.  However, for the casual reader, they may prefer the newest anotated version of The Intelligent Investor which is a much easier read providing the necessary substance.  Buffet's are comments are a hoot.

 As for DCF, there are a bunch of free calculators available on the internet if you just Google DCF calculator.

 Nice job on your blog.  Kick some booty on your picks.

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#14) On February 07, 2008 at 8:00 PM, bellard (99.33) wrote:

Al;

Thanks for the book picks - I like Buffet - I will try and read Intelligent Investor...

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#15) On June 11, 2008 at 7:09 PM, TheGarcipian (62.61) wrote:

Hi Bill,

Welcome to CAPS. I love your blogs and only wish I'd discovered them sooner. I have a lot of your writing to catch up on now. Thanks for all the insight you've given us from your economist's eye as well as your mathematical modeling.

Good luck to you in CAPS and in the RW,

--Gar 

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