The Ultimate Guide to Stock Valuation

Table of Contents
03. How to Use and What to Expect 04. Introduction to Stock Valuation 05. Taking a Bird's Eye View 08. Benjamin Graham's "Net Net" Stocks 12. Graham's Formula Growth Formula for Value Stocks 18. Intrinsic Value of a Business 20. How to Value Stocks Using DCF 26. How to Value a Stock with Reverse DCF 28. Katsenelson's Absolute PE Model 35. Valuing Stocks with EBIT Multiples 38. What is Asset Reproduction Value? 45. The Full Earnings Power Value (EPV) 51. Your Valuation, Your Art, Your Way 52. Bonus: Top 7 Books on Valuation and Analysis 56. About the Author 57. Get Started with Old School Value

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The Ultimate Guide to Stock Valuation

Benjamin Graham's "Net Net" Stocks

In 1932 at the bottom of the Great Crash, Ben Graham's fund had lost 70% of its value. It was precisely at this time when he wrote a Forbes article stating how cheap the market was. In fact, Graham remarked about how the market was selling the United States for free. What made Graham make this claim?

Liquidation Value
Graham defined liquidating value very conservatively. The common definition used is Net Current Asset Value. NCAV = Current Assets - Total Liabilities You can see how conservative the above definition is. But the term current assets is rather broad. It consists of cash, accounts receivables, inventory, and other assets easily convertible to cash. A company with 100% cash is much better off than a company with 100% in prepaid assets. And so, to define it clearer, I use a variation of NCAV which is stricter, but makes more sense and offers extra security when valuing and selecting net net stocks. That variation is called Net Net Working Capital.

Deep Value Companies

It all came down to the way Graham looked at companies. Stocks were being quoted in the market for much less than its liquidating value, priced as if the company was destined to be doomed. This still happens today. But does it make sense to be quoted for less than the cash in your hand? Such deep value stocks are referred to as "net nets" and the idea is to calculate the liquidation value.

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The Ultimate Guide to Stock Valuation

Net Net Working Capital

The formula for NNWC is Net Net Working Capital = Cash and short-term investments + (75% x Accounts Receivable) + (50% x inventory) - Total Liabilities The formula states that cash and short term investments are worth 100% of its value accounts receivables should be taken at 75% of its stated value because some might not be collectible inventories should be discounted by 50% in the event a close out sale occurs

Let's look at a couple of examples. AEY is a net net with Cash and equivalents: $7.54m Accounts receivables: $3.42m Total inventory: $21.54m Total Current assets: $33.63m Total liabilities: $4.62m Shares outstanding: 10.03m

NCAV = $2.89 per share | NNWC = $1.62 per share

NNWC places importance on the main parts that make up current assets; cash, accounts receivables and inventory. When it comes to valuing net nets, you want to find high quality ones. This is an oxymoron because net nets are trading at deep value ranges for a reason, but out of the dump, you can find a few stocks that shines brighter than the rest.

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The Ultimate Guide to Stock Valuation

IGOI is a company that is extremely cheap. Cash and equivalents: $8.21m Accounts receivables: $3.53m Total inventory: $6.03m Total Current assets: $20.35m Total liabilities: $3.04m Shares outstanding: 2.91m

The key to valuing and investing in net nets is to purchase a basket of them. A few days after writing this, IGOI was bought out at a 50% premium to its stock price. This is the way net nets make you money. By buying a basket of them at dirt cheap prices, you protect the downside even though the company has a horrible business model and operational issues. There are always bigger companies who may see value in acquiring such companies. For bigger companies, it is easy because they can strip out money losing divisions and merge it into their existing lines or distribution networks. This will immediately return results whereas the acquired company may never have been able to achieve such returns. You can calculate the NNWC of any stock. Here is an example of Microsoft. NCAV = $4.32 per share | NNWC = $3.42 per share "Normal" companies like MIcrosoft have stock prices far higher than its NNWC. Compare the numbers for Microsoft on the next page with AEY or IGOI and you will get a good idea of how cheap a stock can really get.

NCAV = $5.95 per share | NNWC = $4.46 per share IGOI is a typical net net selling well below its net net value. Numbers look good, but always consider the history of losses and business model.

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The Ultimate Guide to Stock Valuation

Key Old School Value Subscriber Tips The Net Net section of the Stock Analyzer will import the necessary balance sheet items automatically to make it easy to calculate. Experiment with the percentage multipliers. You can increase or decrease the values depending on your situation. There is no hard rule that it has to be 75% of receivables and 50% of inventory.

Microsoft has a NNWC and NCAV of $3.24 and $4.32 respectively. The total stock price is always made up of two parts, the asset value and the growth value. $3.24 is the asset value which means that $31.57 of the stock price is attributable to growth and future returns. NCAV or NNWC is not a pure valuation. It is designed to be used as a measuring stick for cheapness and show you what the assets of a company is worth. http://www.oldschoolvalue.com

The Ultimate Guide to Stock Valuation

Graham's Growth Formula for Value Stocks

Benjamin Graham liked cheap net net stocks. What you may not have known is that Graham also came up with an intrinsic value formula to simulate growth investing valuation but applied a value investing twist.

The Corporate Bond Rate

The 4.4 was the average yield of high-grade corporate bonds in 1962 when this model was introduced. The entire formula is then divided by Y which is the current AAA corporate bond rate. You can find it on Bloomberg or Yahoo. Dividing by the AAA rate normalizes the 4.4% bond rate to today's environment. The reason for the inclusion is that Graham wanted a minimum required rate of return for investing in stocks. You see, Graham knew that intrinsic value was more than just growth rates and EPS estimates. He knew that intrinsic value was related to fixed income rates or bond rates and that stocks and bonds compete with each other and are therefore related. Graham wrote a lot about how the stock PE ratios were affected by the bond yield levels as well as the changes. Here is a quote from Graham that talks about this.

The Graham Growth Valuation Formula

This is the formula that Benjamin Graham published in The Intelligent Investor. V = EPS x (8.5 + 2g)

V is the intrinsic value EPS is the trailing 12 month (TTM) Earnings Per Share 8.5 is the PE ratio of a stock with 0% growth g is the expected growth rate for the next 710 years

The formula was later revised as Graham included a required rate of return.

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The Ultimate Guide to Stock Valuation

It seems logical to me that the earnings/price ratio of stocks generally should bear a relationship to bond interest rates. Viewing the matter from another angle, I should want the Dow or Standard & Poor's to return an earnings yield of at least four-thirds that on AAA bonds to give them competitive attractiveness with bond investments. - Ben Graham As you test the formula yourself, you will notice that bond rates affect valuation. The lower the yield the higher the price. This goes back to bond basics. If the yield is low, the price is high. If the yield is high, the price is low. Graham designed the formula to replicate this line of thought. Think of it as inflation adjusting. So it is important to understand the current bond environment as you value stocks with the Graham formula.

The common consensus is that you should use forward estimates of EPS. However, Graham did not intend the formula to be used in this way. Use a 5 to 7 year average of EPS to normalize the value. If the company is a high growth company, then the EPS should be calculated by using rolling averages. Remember that if you use analyst EPS estimates, it tends to be on the optimistic side and will result in a valuation at the upper range.

What To Do About Growth?

Growth for a value investor? Yes, and that is what Graham wanted to mimic. Although trying to estimate growth in general is a drawback, it is a big element of the whole valuation method. There are two parts that make up the growth variable.

Adjust Earnings Per Share

Further discussion on how to use the EPS value of the formula is required.

The PE of 8.5 and the growth rate, g

Graham defined 8.5 as the PE for a company with zero growth. There is no clear indication of how this number was derived, so I will have to take Graham's word and his research.

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The Ultimate Guide to Stock Valuation

But instead of using 8.5 as the no growth PE, I have reduced it to a PE of 7 in my version of the formula. Nowadays, even if a company has zero growth prospects, if it is able to maintain cash flows and distribute dividends, the PE is easily higher than 8.5. And I prefer to err on the side of conservatism. Choosing the growth rate is very much the same as what was discussed in how to find the EPS. Instead of using single forward estimate, calculate the average 5-6 years of growth experienced by the company. If a company has 3 years of operating history, then take the average of the three years. Next is the "2" multiplier, which I find to be too aggressive. This is understandable though if you take things into context. Graham never experienced companies with growth rates of 20-30% which are common today. Instead of 2, you can reduce the multiplier to 1.5 or 1. From all the valuations I have performed using the Graham formula, I have found that using 1 is completely satisfactory.

Final Adjusted Graham Formula

Here is what the final formula looks like.

Time for some examples.

The Graham Formula in Action

Let's run this formula through a couple of stocks. Microsoft (MSFT) is up first. I am going to be breaking the rules of what I wrote previously, but follow along to see why. First, here are the inputs that I will be using for the calculation.
EPS = $2.51 g = 13.9% Y = 4%

For a company like Microsoft with a huge moat and good predictability, you do not need to worry so much about using the past 5 - 7 year averages.

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The Ultimate Guide to Stock Valuation

Companies like MSFT do not change overnight. In this case, I like to average the past 2-3 years instead. That is how I get the EPS of $2.51. To find growth, I looked at the 5 year and 10 year rolling median. Surprisingly, the growth rate between the 5 year and 10 year rolling periods are identical at 13.9%, which is what I will stick with. Get the 20 year AAA corporate bond from Yahoo. It is currently 3.2%. About one to two years ago, the bond rate was in the 5% range. As discussed in the previous section on bond rates, the low yield is going to give a high valuation. So do you use the 3.2% yield or something else? Since the other inputs use averages and the bond rate is bound to go up, the long term bond rate comes out to be 4%, which is why I have chosen to use it for the basis of this valuation. Current Price: $33.49 Graham Formula @ 3.2%: $72.31 Graham Formula @ 4%: $57.70

Click to enlarge the screenshot and view in your browser

Applying it to Slow Growth Companies

Although the Graham formula is meant for growth stocks, it works even better for low growth stocks. Take a look at American States Water Company (AWR). It is a utility stock with low growth prospects but pays regular dividends. The inputs used are:

See the difference in the values when different bond rates are used?

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The Ultimate Guide to Stock Valuation

EPS = $2.63 g = 7.8% Y = 4%

Super Duper Growth Stocks

For a company to grow at rapid speeds, what does the Graham formula show? A hot stock is Netflix (NFLX) with an expected growth of 36%. Since Netflix has such high growth expectations, it is impossible to use an average. This is where you have no choice but to use the analyst estimates. The inputs are:
EPS = $1.41 g = 36.1% Y = 4%

Refer to the calculations in the screenshot below. Current Price: $53.05 Graham Formula @ 3.2%: $53.31 Graham Formula @ 4%: $42.65

If the valuation in today's environment was most important, then 3.2% bond rate shows that AWR is fairly valued at the moment. However, if you consider what bonds might do in the future, it is overpriced.

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The Ultimate Guide to Stock Valuation

Current Price: $223.52 Graham Formula @ 3.2%: $83.65 Graham Formula @ 4%: $66.92

Key Old School Value Subscriber Tips Practice makes perfect. Load different types of companies and look at how the valuation is affected based on the inputs you enter. Understanding the inputs is the key to valuation success.

Regardless of whether I value Netflix for the present or for the future, the Ben Graham model has decided that Netflix is extremely overvalued. Out of curiosity, I wanted to see what growth rate the market is expecting from Netflix. I will get into the details of this later, but by performing a reverse Graham valuation, using an EPS of $1.41 and bond rate of 3.2%, the expected growth comes out to be 108%! In other words, Netflix must be able to grow by 108% for the current stock price to be justified. Now go find three stocks. One that you believe is undervalued, fairly valued and over valued and test it out for yourself.

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