How to Tell When a Stock is Cheap/Expensive (Masterclass in Stock Valuation)

 

Comprehensive Summary: How to Value a Stock Like a Pro

Core Philosophy

Stock valuation isn't about absolute price (e.g., "Ford costs two Big Macs") but determining whether you're paying less than a business's intrinsic value. This requires multiple analytical approaches and always demands a Margin of Safety—a buffer for error, as famously championed by Benjamin Graham.

The Three Essential Valuation Methods

1. Relative Valuation (The "Comparison" Method)

• What it is: Determining if a stock is cheap relative to its own history or its peers.

• Key Tool: Price-to-Earnings (P/E) Ratio (Current Price / Earnings Per Share).

• Process for Coca-Cola:

  1. Look Backwards: Coke's 10-year average forward P/E is ~23x.

  2. Look Sideways: The average forward P/E of its peer group (Pepsi, Dr. Pepper) is ~21.3x.

  3. Compare: With a current forward P/E of 24.3x, Coke appears slightly overvalued on a relative basis.

• Powerful Insight: This process can reveal better opportunities. For example, peer AG Barr showed a potential 18-33% upside, making it a more attractive candidate than Coke at the time of analysis.

• Major Limitation: Entire sectors can become overvalued (e.g., the 2000 Tech Bubble). A stock can be "cheap relative to peers" but still catastrophically expensive.

2. Intrinsic Valuation - Discounted Cash Flow (DCF) (The "Fundamental" Method)

• What it is: Calculating the true worth of a business based on all the cash it will generate for shareholders in the future, discounted to today's dollars.

• Guiding Principle (Warren Buffett): Answer three questions:

  1. How much cash? Forecast Free Cash Flow (FCF), not just earnings.

  2. When will you get it? Future cash is worth less than cash today. Apply a Discount Rate.

  3. How certain are you? Favor predictable businesses with a durable competitive advantage.

• Critical Input - The Discount Rate: Use the 10-Year Treasury Yield + 3% as a baseline. With yields at ~4.5%, a 7.5% discount rate is appropriate. This is your personal "hurdle rate."

• Result for Coca-Cola: Using a 7.5% rate, Coke's intrinsic value landed between $248-$320 billion, not offering a compelling margin of safety at its market price.

• Buffett's Key Filter: He avoids complex, fast-changing businesses. For him, certainty isn't compensated for with a higher discount rate—it's a prerequisite for investment.

3. The Hybrid Model - Growth, Yield & Multiple Expansion

• What it is: A practical model that projects total shareholder returns by combining revenue growth, margin changes, dividends/buybacks, and an expected future valuation multiple (e.g., P/E).

• Advantage: More intuitive than a full DCF while still being forward-looking.

• Applied to Coca-Cola: Assuming 4% growth, the model suggested a 6.2% annualized return, translating to a stock price of ~$91 by 2029.

• Applied to AG Barr: The same process projected a 9.3% annualized return.

The Unifying Framework: Margin of Safety & Triangulation

1. Calculate Your Required Return: Based on your discount rate (e.g., 7.5%).

2. Compare to Expected Return: From your DCF or hybrid model.

3. Quantify the Margin of Safety:

   • Example for AG Barr: Model expects 49% total return over 4.5 years. Your required return is 38%. The margin of safety is 1 - (38/49) = ~22%.

The Ultimate Takeaway (from Charlie Munger): No single model is perfect. Valuation is not a mechanical exercise but a process of triangulation. The most promising investments will appear attractive when viewed through multiple lenses—relative value, intrinsic DCF value, and a forward-looking returns model. Always insist on a margin of safety to protect yourself from the inevitable errors in prediction.

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Here is a summary of the video from 0:00 to 10:00:

Main Goal: Learn three methods to properly value a stock, using Coca-Cola as an example.

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1. Introduction & Relative Valuation (P/E Ratio)

• The Problem: Stock prices alone (e.g., Ford vs. Berkshire Hathaway) don't tell you if a stock is cheap or expensive.

• Relative Valuation: The strategy is to buy stocks when they are cheaper than their historical averages or their peers, similar to trading items in a game like World of Warcraft by comparing prices.

• The P/E Ratio: The most common valuation "multiple."

  • Definition: Price-to-Earnings ratio. It shows how many years of current earnings it would take to recoup your investment.

  • Example: Coca-Cola at ~$72 per share earning $2.5 per share has a trailing P/E of 28.8 ($72 / $2.5).

  • Forward P/E: Uses future earnings estimates, which for Coke is 24.3, indicating expected growth.

• Applying Relative Valuation to Coca-Cola:

  • Historically (10-yr avg): Investors paid ~23x forward earnings for Coke.

  • Compared to Peers (Pepsi, Dr. Pepper, etc.): The peer group average forward P/E is ~21.3.

  • Conclusion: At a forward P/E of 24, Coke appears slightly overvalued compared to both its own history and its peers, suggesting a potential ~12% downside if it reverts to the peer average.

• Finding a Better Opportunity (AG Barr):

  • Analysis of peer AG Barr shows it trades below its historical average and the peer group, indicating a potential 18-33% upside—a seemingly better deal than Coca-Cola.

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2. The Margin of Safety

• Concept (Benjamin Graham): Never buy a stock at its full intrinsic value. Always demand a discount to account for error and uncertainty.

• Warren Buffett's View: The required margin of safety depends on business certainty.

  • For predictable, stable businesses like Coca-Cola or See's Candy, he doesn't need a "huge" margin and will buy at prices close to intrinsic value (though he prefers a 40% discount).

  • For unpredictable businesses, he avoids them rather than applying a larger margin.

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3. Limitations of Relative Valuation

• Sector-Wide Bubbles: If an entire industry is overpriced (e.g., tech in 2000), a stock can look cheap relative to peers but still be catastrophically overvalued.

• Everything is Not Equal: Historical or peer comparisons can be misleading if the company's fundamentals (growth, competitive position) have changed.

• Buffett's Warning: Metrics like P/E are not valuation in themselves; they are only useful as clues to future cash flows.

Key Takeaway (First 10 mins): Relative valuation (P/E analysis) is a useful first step to gauge if a stock is cheap, but it has significant pitfalls. It must be complemented by a method that focuses on the company's intrinsic value based on its future cash flows, which is introduced in the next part of the video (Discounted Cash Flow analysis).

Here is a summary of the video from 10:00 to 20:00:

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Part 2: Discounted Cash Flow Analysis (DCF)

• Core Principle: The intrinsic value of a business is the sum of all the cash it will generate in the future, discounted back to today's value.

• Warren Buffett's Three Key Questions for any investment:

  1. How much cash are you going to get?

  2. When are you going to get it?

  3. How certain are you?

Step 1: Forecast Future Cash Flows (The "How Much")

• Use Free Cash Flow (FCF), not earnings. FCF = Cash from Operations - Capital Expenditures. It's the actual cash available to shareholders.

• For Coca-Cola: Historical FCF has been stable and growing at ~3.5% annually.

• Forecast: Start with a reasonable base (~$10B). The video assumes a 4% annual growth rate for the next 10 years, reaching ~$14.8B in Year 10.

• Terminal Value: To account for cash flows beyond 10 years, estimate a sale price (exit multiple) or use a perpetuity growth formula.

Step 2: Discount Future Cash to Present Value (The "When")

• Money today is worth more than money tomorrow. Future cash must be "discounted."

• Discount Rate: The rate used to calculate the present value of future cash. It's a critical, fuzzy variable.

• Buffett's Guideline: The discount rate should be significantly higher than the risk-free rate (e.g., the 10-year Treasury yield). He suggests adding at least 200-300 basis points (2-3%).

• Applied to Coke: With a 10-year Treasury at ~4.5%, a discount rate of 7.5% (4.5% + 3%) is used.

Step 3: Calculate Intrinsic Value

• Using the 7.5% discount rate and an exit multiple (P/FCF of 33, based on Coke's historical median), the DCF values Coca-Cola at ~$320 billion.

• Using the perpetuity growth method (3% perpetual growth), the value drops to ~$248 billion.

• Conclusion for Coke: Neither method suggests Coke is a "screaming buy" at its current market price. The result is sensitive to the discount rate and terminal value assumption.

Applying DCF to AG Barr

• With similar assumptions (3% growth, 7.5% discount), AG Barr's intrinsic value is estimated between £660-860 million.

• This wasn't a clear buy at the time of filming, but the video notes it was closer to a buy (at £620M) just a few months prior, illustrating the need for patience.

Step 4: Assess Certainty (The "How Certain")

• Look at the Past Record: A stable, predictable history (like Coca-Cola's) increases confidence in forecasts.

• Buffett's Preference for "No Change": He seeks businesses resistant to major change, viewing change as a threat, not an opportunity. This is why he favors businesses like Coca-Cola over fast-changing tech firms, even if they miss out on some big winners.

• Certainty as a Go/No-Go Factor: For Buffett, lack of predictability often disqualifies a business; he doesn't just compensate by using a higher discount rate.

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Key Takeaway (10-20 mins): DCF is the fundamental method for calculating intrinsic value based on future cash flows. However, it relies heavily on subjective assumptions about growth, discount rates, and terminal value. For stable, predictable businesses with a long history (like Coca-Cola), DCF can be applied with more confidence.

Here is a summary of the video from 20:00 to the end (36:06):

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Part 3: The Third Valuation Method & Conclusion

A. The Third "TIKR" Method: Growth + Dividends + Multiple

• This is a hybrid, more accessible method that sits between simple multiples and complex DCF.

• How it works: You input key drivers of shareholder return into a model:

  • Sales Growth

  • Operating Margins

  • Interest, Taxes, Buybacks, Dividends

  • A terminal Valuation Multiple (e.g., future P/E)

• The TIKR Tool: The sponsor's platform automates these calculations, using 10 years of historical data and 5 years of analyst estimates as a starting point for your assumptions.

• Applied to Coca-Cola: With a 4% growth assumption (aligning with analysts), the model values Coke at $91 per share by Dec 2029, implying a ~6.2% annual return.

• Applied to AG Barr: The same process suggests a ~9.3% annual return.

B. Unifying the Methods with "Margin of Safety"

• To decide if the expected return is good enough, compare it to your required return (the discount rate from the DCF).

• Example Calculation for AG Barr:

  • Required Return (7.5% over 4.5 years): (1.075^4.5) - 1 ≈ 38% total return

  • Expected Return from Model (9.3% over 4.5 years): (1.093^4.5) - 1 ≈ 49% total return

  • Margin of Safety: 1 - (38/49) ≈ 22%. This is considered a decent margin for a stable business.

C. Key Conclusion: Triangulation is Essential

• Charlie Munger's Wisdom: There is no single, mechanical formula that guarantees investing success. Valuation is a game played with multiple models and techniques, where experience is crucial.

• The Best Approach: Use all three valuation lenses—Relative (P/E), Intrinsic (DCF), and the hybrid (Growth + Multiple) method—to triangulate on a company's value.

• The Ideal Investment: A company that looks like a phenomenal opportunity no matter which valuation method you use.

D. Final Sponsor Note & Call to Action

• The TIKR tool featured can be accessed via the link in the description.

• A 15% discount on annual plans is available until July 2nd.

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Final Takeaway: No single valuation method is perfect. A disciplined investor should use a combination of relative valuation, discounted cash flow analysis, and a practical growth/multiple model to build conviction and demand a margin of safety before investing.

Valuation Inputs: The critical pieces of data required to perform a robust valuation

 

Valuation Inputs

These are the critical pieces of data required to perform a robust valuation.

• Financial Statements: The foundational data.

  • Income Statement: Reveals profitability (Revenue, Gross Margin, Net Income, EBITDA).

  • Balance Sheet: Shows the company's financial position—what it owns (Assets) and owes (Liabilities) at a point in time.

  • Cash Flow Statement: The ultimate truth-teller, showing how cash is generated and used from operations, investing, and financing activities. Free Cash Flow is a key output.

• Growth & Return Metrics: The forward-looking drivers.

  • Growth Rates: Historical and projected growth rates for revenue and earnings indicate the company's trajectory and potential.

  • Discount Rate: The investor's required rate of return, which is directly tied to the perceived risk of the investment (see next section).

• Contextual & Market Data: The external checks.

  • Industry Data: Analysis of comparable businesses provides benchmark multiples and performance metrics.

  • Market Conditions: The broader economic environment (e.g., interest rates, inflation, economic cycle) significantly impacts valuation.

  • Trends: Analyzing business performance over time (e.g., margin trends, customer acquisition costs) provides insight into its stability and direction.

• Risk & Verification:

  • Credit History: Assesses the company's ability to meet its debt obligations, a key risk factor.

  • Due Diligence: The process of rigorously verifying all financial, legal, and operational assumptions before finalizing a valuation or deal.

Valuation cheat sheet. What are some of your favourite metrics?

 

Valuation Cheat Sheet

What are some of your favourite metrics?

1.  How to think about valuation

All intelligent investing is value investing:  you try to buy stocks for less than what they're worth.

Here are some valuation ratios you can use:

P/E ratio:  stock price / earnings per share

EY (Earnings yield):  earnings per share / stock price

P/B ratio:  stock price / book value

PEG ratio:  P/E ratio / yearly EPS growth

FCF yield:  free cash flow per share / stock price

2.  Always buy stocks at a discount

When you go to the mall, you like to buy your favourite products on sale.

The same goes for stocks.  You want to buy a stock at its cheapest possible price and valuation.

The beautiful thing about the stock market is that Mr. Market often acts as a Manic-Depressive.  You can use this volatility to your advantage by buying when there's blood running through the streets.

3.  Short term versus long term

Over a one-year period, most stock price fluctuations are driven by changes in valuation. 

versus 

In the long run, stock prices are driven by the evolution of the intrinsic value of a company.

This means that in the short term the valuation you pay for a company is very important while in the long term the rate at which a company can grow its earnings per share is the crucial factor.