A Beginners Guide: Value Investing

One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway from $12 a share in 1967 to an astonishing $70,900 in 2002. Although Mr. Buffett does not hold himself only to value investing, most of his investments were made on the basis of value investing principles.

A value investor looks for stocks with strong fundamentals or strong earnings, dividends, growth, and cash flow. The basic principal of value investors is that you should first find out what the true price of a share of stock is and then determine if it is undervalued. After you have determined its stock price is below what it should be you would then buy and hold it until it gets back in equilibrium. There are several ways to find out exactly how much a certain stock is worth. The most basic way to do this is determining the company's book value. Book value is calculated by subtracting total liabilities from total assets. If a company has a history that you can go back and check to see what it's average market value to book value ratio this method would prove to be a key factor in your valuation. We can't stop with just book value though we must dive deeper.

The next major indicator I would look at is price to earnings ratio. The P/E ratio determines how the market feels relative to the earnings that the company is making. You would want to look at the stocks historical P/E ratio and determine where their current P/E ratio relative to historical. If it is below the historical average, we could say that the stock is undervalued.

A lot of the time when I'm picking a stock with this method I will also look at the major stock holders and try to determine if any hedge funds or other big institutions have picked up this stock recently. If they have then I will just move on to another stock because it has already been discovered.

Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:

• Share price should be no more than two-thirds of intrinsic worth.

• Look at companies with P/E ratios at the lowest 10% of all equity securities.

• PEG should be less than one.

• Stock price should be no more than tangible book value.

• There should be no more debt than equity (i.e. D/E ratio < 1).

• Current assets should be two times current liabilities.

• Earnings growth should be at least 7% per year compounded over the last 10 years.

Remember these are rough guides. You can always try out some new stuff and see how it works for you. Value investing may not seem as sexy as some other styles of trading or investing but it relies on a strict screening process that helps you get to know the company you are buying in order to make the best decision.

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Value Investing the Warren Buffett Way

There are almost as many definitions for the term, "Value Investing," as there are people using it. No wonder it can be confusing. However the quintessential definition belongs to the way Warren Buffett does it.

After all, he's made over $50 Billion doing it his way. So if you're going down the Value Investing road, you may as well follow the man who is most successful.

Now most people think that Value Investing is simply buying cheap stocks. Unfortunately there are some serious downsides to simply finding cheap stocks, even fundamentally solid ones, and buying them.

First, the market could take a very long time to realize these stocks are undervalued. At the end of the day, it doesn't matter whether you own excellent value if nobody is willing to pay you for that value. This is called the realization-of-value-problem and is a very real concern, for anyone who invests money in the stock market, because the longer it takes the market to realize the true value of a company, the lower the compounded annual returns will be.

To see why, let's look at an example where a stock that has an intrinsic value of $10 a share is selling at a discounted $5 per share. If the market realizes the stock's true value in a year, the annualized return will be 100%. If it takes two years, the return will be 41.42%. Three years? 25.99%. Five years will return 14.87% and ten years will give a 7.18% return.

As you can see, the differences in annualized returns are significant, and we really don't know when the market will fully value the shares.

Another problem is that a company might look attractive at a particular point in time, but a host of intangibles, such as management integrity or government regulation, that weren't reflected in the numbers could cause an excellent business to decline in the future.

To guard against this occurrence, Benjamin Graham, Warren Buffett's mentor, would widely diversify, sometimes holding hundreds of stocks in his portfolio. He expected some would not perform well, but believed that the ones that did perform would more than offset the ones that didn't. And he was usually right, as his results often showed.

However Buffett soon tired of this way of thinking and started searching for a more efficient way to invest. He famously said that, "wide diversification is only required when investors do not understand what they are doing." This was not a slight at his mentor Graham, who would have agreed with Buffett, because Graham himself had to admit that he did not understand all of the companies he held. There were just too many of them.

Buffett eventually found what he was looking for in the works of John Maynard Keynes, Lawrence Bloomberg and Philip Fisher. When he combined their philosophies with Graham's, he arrived at an investment strategy that has served him well over the past five decades.

Buffett used Keynes' concept of the concentrated portfolio to focus his investment analysis on areas that he knew very well, and no others. During the Internet technology boom of the late 90s, Buffett refused to participate and was ridiculed by many for missing out on huge profits. However Buffett had the last laugh when the crash inevitably came. To this day Buffett does not invest in technology firms because he says that he doesn't understand their business models.

Bloomberg contributed the idea of the consumer monopoly (or economic moat). This is a business that has an extraordinarily high barrier to entry. It could be because of lucrative patents (think pharmaceutical companies), brand (for example, Coke) or a real monopoly (such as Microsoft Windows).

Bloomberg determined that such companies should be able to grow their earnings faster, which would lead to higher returns on equity and, eventually, higher share prices. By filtering on this criterion, Buffett was able to eliminate a large number of companies that had higher risks of failing. This one idea allowed Buffett to remove the need to diversify as widely as Graham had because he was relatively certain that the companies he chose had a far greater chance of success.

Coupled with Keynes' notion of intimately understanding a company's business model, Buffett was at last able to do away with Graham's need to diversify over hundreds of stocks.

Fisher's contribution was the idea of investing only in top-notch businesses and never selling them. This contrasted starkly with Graham's strategy of buying undervalued businesses and then selling them when they reached fair value.

Putting it all together, Buffett now had the seed of his investing strategy. Look for fundamentally solid stocks that represent good value with a built-in margin of safety, invest only in top companies that have a high barrier to entry, only invest in what you know, concentrate your holdings and hold your investments for a very long time.

If you'd like to outperform the stock market, then you can do very well following Buffett's method. He's already proved it works, so why not put it to work for you?

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Mark's best-selling software package is the acclaimed Value Stock Selector. It was designed for investors of all levels to help them find undervalued stocks sporting exceptional fundamentals with just a few mouse clicks.

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Equity Research for Value Investing

Despite many of the negatives that we hear about DCF-based stock valuation these days, it is still a mainstream method for stock valuation as part of fundamental equity research. In his 1992 Berkshire Hathaway (BRK.A) annual report concerning the DCF stock valuation method, Warren Buffett stated "In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset." Many of the popular stock market report bands equity analysis resources that retail value-investors rely on utilize this stock valuation method. This article will examine the strengths and weaknesses of DCF-based intrinsic value calculations and why it is importing for value investing.

Let's review the main weaknesses of DCF-based stock valuation.

The first is that it requires us to predict cash flows or earnings long into the future. Data shows that most equity analysts cannot predict next-year's earnings accurately. On a macroeconomic level, the "experts" have a terrible track record in predicting jobless claims, the year-end S&P, or GDP. This is no different when it comes to projecting the future cash flow of a business when picking stocks. We have to admit to ourselves that we have tremendous limitations in the ability to forecast future cash flows based on past results and recognize that a small error in the forecast can result in a large difference in the stock valuation.

The second challenge is determining the appropriate discount rate. What is the discount rate? Should we dust off our college or graduate school notebook and look at the CAPM, which calculates the discount rate as the risk-free rate plus the risk premium?

Well, since this I learned this formula from the same guy (by business school finance professor) that convinced me as a 22-year old, wet-behind the ears student that markets are efficient, I am skeptical. The most famous value investor Warren Buffett's public comments about the issue have evolved as he has stated that he uses the long term US treasury rate since he tries "to deal with things about which we are quite certain but reminded us in 1994 that "In a world of 7% long-term bond rates, we'd certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we're willing to play." I'm inclined to take these seemingly contradictory guidelines from Buffett and from there derive a reasonable estimate of the discount rate as part of my stock research. With the September 1, 2011 30-Yr treasury yield at 3.51%, we must think that our discount rate for large cap stocks is closer to 10% than to the risk-free rate.

Finally, the problem with determining a feasible growth rate is that a DCF will simulate the growth rate to be eternal, and we know that no business can sustain an above-average growth rate in perpetuity.

Let's now move to the strengths of a DCF model as a stock valuation tool.

George Edward Pelham Box, a Professor of Statistics at the University of Wisconsin, and a pioneer in the areas of quality control and experimental models of Bayesian inference famously remarked:

All models are wrong, some are useful.

I would argue that the DCF model can provide a useful stock valuation estimate as part of fundamental stock research if the user follows the following principles:

1. Invest in companies that have a sustainable competitive advantage. Stock investing should be though of as ownership interests in these companies.

2. As Buffett alluded to in his 1994 letter, certainty in the business is essential. I therefore look at different measures of stability in revenues, earnings, book value, and free cash flow as part of my equity research.

3. Your stock research should include through due diligence in analyzing companies financials (income statement, balance sheet, cash flow statement, efficiency ratios, and profitability ratios over at least a 10-year period of time.

4. Before using a DCF stock valuation model or a PE and EPS estimation method for valuation, kick the tires by using a valuation model that requires no assumption of future growth. Jae Jun at http://www.oldschoolvalue.com has some very nice articles and examples on this topic (reverse DCF and EPV). I like to use the Earning's Power Value (EPV) model (described below).

5. Look at simple relative valuation metrics such as P/E, EV/EBITA, PEPG, P/B etc.

6. Employ conservative assumptions of growth and a discount rate between 8-13%.

7. A healthy dose of intellectual honesty is needed so as not to modify the key growth and discount rate assumptions to arrive at a pre-conceived intrinsic value.

8. Always use a Margin of Safety!

As mentioned, I am a big fan of Professor Bruce Greenwald's Earnings Power Value calculation. Earnings Power Value (EPV) is an estimate ofstock valuation that puts a value of a company from its current operations using normalized earnings. This methodology assumes no future growth and that existing earnings are sustainable. Unlike discounted cash flow models, EPV eliminates the need to predict future growth rates and therefore allows for more confidence in the output. It is a valuable tool as part of thorough equity research.

The formula: EPV= Normalized Earning's x 1/WACC.

There are several steps required to calculate EPV:

1. Normalization of earnings is required to eliminate the effects on profitability of valuing the firm at different points in the business cycle. This means that we consider average EBIT margins over the past 10, 5, or 3- years and apply it to current year sales. This yields a normalized EBIT.

2. Subtract the average non-recurring charges over the past 10 years to the normalized EBIT.

3. Add back 25% of SG&A expenses to, as a certain percentage of SG&A contributes to current earnings power. We use a default add back of 25%. This assumes that the company can maintain current earning's with 75% (1-input) of SG&A. The input range can be 15-25% depending on the industry. Where applicable, repeat for research and development expenses.

4. Add back depreciation for the current year. We use a default add back of 25%. This assumes that the company can maintain current earning's with 75% (1-input) of capital expenditures. The input range can be 15-25% depending on the CapEx requirements of the industry.

5. Subtract the net debt and 1% of revenues from normalized earnings (this is an estimate of cash required to operate the business)

6. Assign a discount rate (or calculate WACC if you wish).

7. Earnings Power of Operations = Earnings of the firm * 1/cost of capital

8. Divide the EV of the firm by the number of shares, to get Price per share.

The DCF stock valuation model.

In this 3-stage DCF model, free cash flow growth rates for years 1-5, 6-10, 11-15, and the terminal rate, are estimated. The sum of the free cash flow is then discounted to the present value.

The formula for a DFC model is as follows:

PV = CF1 / (1+k) + CF2 / (1+k)2 +... [TCF / (k - g)] / (1+k)n-1

Where:

• PV = present value

• CF1 = cash flow in year I (normalized by linear regression or 10, 5, 3-yr average of FCF)

• k = discount rate

• TCF = the terminal year cash flow

• g = growth rate assumption in perpetuity beyond terminal year

• n = the number of periods in the valuation model including the terminal year

Again, we must recognize that intrinsic value that is produced by our model is only as good as the numbers put into the model. If as part of our stock research we assume unrealistic growth rates (or terminal value), or discount rates, you will get an unrealistic intrinsic value result. No stock valuation model is going to magically provide the completely accurate intrinsic value but, if you are conservative and intellectually honest, and dealing with a company with solid underlying economics in addition to a long track record, you can find this method useful in identifying stocks that are priced below their intrinsic value. Buffett seemed to do OK for himself using this methodology so, if you follow the above principles, you can too.

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