The Right Attitude to Value Investing

Value investing is based more on philosophy than on theorems.  Benjamin Graham's purpose was to make his students use the deductive process to think for themselves.

The three key concepts of Benjamin Graham's value investing are:

• Having the right attitude
• The importance of margin of safety
• Knowing the Intrinsic value.

To be successful, a value investor must adopt the right attitude toward investing in general, and an aversion to speculation in particular.  A speculation is not an investment.  Graham insisted, and it is crucial to be able to distinguish between the two.

Graham frowned upon market timing.  He insisted that any financial decision based solely on the prediction that the market will move up or down is a speculation.

Intrinsic Value is understood to be that value which is justified by the facts, e.g. the assets, earnings, dividends and definite prospects.

Before you risk your hard-earned money on a stock, you probably want to know the value you can expect to get in return.  The value you assign to a stock, or that stock's intrinsic value, is the maximum amount that you are willing to pay now for future benefits, which could come from dividends or the potential sale of the stock at a realistic future price.  

It makes no sense to buy a stock when its intrinsic value is smaller than the current price.

Buffett cautions:  "The calculation of intrinsic value, though, is not so simple .... intrinsic value is an estimate rather than a precise figure."

Computing Intrinsic Value

Individuals differ from one another in assessing companies' future prospects.  They also differ in their risk tolerance.  Hence, it should be no great leap to accept that there is no unique intrinsic value that can be assigned to a common stock upon which everyone will agree.  In computing intrinsic value, you should start by examining a company's balance sheet.

• Some assets, such as cash and investments in marketable securities, are reported at market value.  As a first approximation, the intrinsic value of such items can be taken to be the same as their market values.  
• For most companies, however, the major component of intrinsic value comes from their future earnings.

Valuation of future earnings

For valuation of future earnings, you can

1. Start with estimating a growth rate based on your evaluation of the company's past performance.  
2. Then you can apply the estimated growth rate to current earnings to approximate expected earnings for a future year, say, 10 years from the current year.  
3. Finally, apply a P/E multiple to the future earnings per share to estimate the value of those earnings in the future and discount them to their present value.  
4. In addition, dividends should be properly accounted for.

While it is a simple approach, it requires many assumptions.

• For example, you may have to adjust reported earnings in an attempt to obtain underlying or sustainable earnings.  
• You also need to assume a growth rate, a P/E multiple, and a discount rate.  

With this approach, it is important to know the company's business well for you to come up with reliable estimates.

For example:

It is important to learn a lot about the company so that you may consider the appropriate method for computing its intrinsic value.  You should invest only when the margin of safety is high.

Company A:  This is easy to evaluate because most of its assets are in marketable securities.  Earnings play a limited role in this company's intrinsic value.

Company B:  This company's value is driven primarily by its earnings.  


Read also:

Intrinsic value described by Ben Graham in Security Analysis.

Computing Intrinsic Value

Individuals differ from one another in assessing companies' future prospects.  They also differ in their risk tolerance.  Hence, it should be no great leap to accept that there is no unique intrinsic value that can be assigned to a common stock upon which everyone will agree.  

In computing intrinsic value you should start by examining a company's balance sheet.  

• Some assets, such as cash and investments in marketable securities, are reported at market value.  
• As a first approximation, the intrinsic value of such items can be taken to be the same as their market values.  

For most companies, however, the major component of intrinsic value comes from their future earnings.
For valuation of future earnings:

1. You can start with estimating a growth rate based on your evaluation of the company's past performance.  
2. Then you can apply the estimated growth rate to current earnings to approximate expected earnings for a future year, say, 10 years from the current year.  
3. Finally, apply a P/E multiple to the future earnings per share to estimate the value of those earnings in the future and discount them to their present value.
4. In addition, dividends should be properly accounted for.

While it is a simple approach, it requires many assumptions.  For example, 

• you may have to adjust reported earnings in an attempt to obtain underlying or sustainable earnings. 
• You also need to assume a growth rate, a P/E multiple, and a discount rate.  

With this approach, it is important to know the company's business well for you to come up with reliable estimates.

Related posts:

Intrinsic value described by Ben Graham in Security Analysis.

Choosing a Discount Assumption

Intrinsic Value Model

Estimation of Intrinsic Value

Introduction to Valuation - Videos

The Man who Quantifies Everything

I know this man.  He measures everything.  He knows the length of his feet.  He knows the height of the tree.  He knows his heart rate.  He knows how long it will take to complete his walk.  He never stops measuring.  He frames his world on measurements.  He performs very well in his work and life.

Well, in investing, to be successful you should do likewise.  An investor should measure or quantify his investments through careful analysis. 

Benjamin Graham:  " Additionally , we hope to implant in the reader a tendency to measure or quantify.  For 99 issues out of 100, we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they shoudl be sold.  The habit of relating what is paid to what is being offered is an invaluable trait in investment..."

Will Your Stock Hit Rock Bottom?

Will Your Stock Hit Rock Bottom?

By Jordan DiPietro
January 22, 2010

Figuring out what you believe to be the intrinsic value of a stock is one of the most significant things you can do. If you bought shares of Sprint Nextel (NYSE: S) for more than $10 a pop, you better know at what price you'd be willing to sell, or you may find your stock hitting rock bottom.

How you define the floor
When investors try to determine a sales price, it seems as though we all too often let our emotions get the best of us. To illustrate this point, consider an experiment documented by behavioral economist and professor Dan Ariely.

Duke students are fanatical about their basketball program, and they illustrate their passion when it comes to buying tickets. There is a strict procedure where students have to camp out intermittently for an entire semester, responding to arbitrary bull horns and missing classes and exams. These are die-hard fans. For big games, students at the front of the line aren't even guaranteed a ticket -- only a spot in a lottery system. A list is posted later with the winners of the lottery, and often those who have sacrificed the most find themselves without a ticket to the game.

Duke professors wanted to conduct an experiment, so they found students who received lottery tickets and those who did not, and tried to find an equilibrium price where a ticket could be bought and sold. Remember -- both sets of students missed classes, spent evenings in tents, and went through the same rigorous process to obtain these cherished tickets. When the lottery losers were asked how much they would pay for a ticket, the average price was $175. The lottery recipients, on the other hand, would not sell their tickets for anything less than an average of $2,400! How could there be such a price discrepancy when both sets of students were willing to go through the same ordeal?

We all love what we have ...
The reason is that the lottery winners were victims of ownership bias; that is, they overvalued what they owned, simply because they owned it!

• This helps explain why people may have held on to shares of Cisco Systems (Nasdaq: CSCO) or Yahoo! (Nasdaq: YHOO), even when the dot.com bubble was bursting at the seams.
• Or why people were still holding onto financials like Bank of America (NYSE: BAC) in 2007, when the subprime crisis was all but written on the wall.

When investors make a purchase, what Ariely calls an emotional chasm is formed between the "old you" who didn't own the stock and the "new you" who now owns some very precious shares. In the case of Duke basketball, it was an "empirical chasm as well -- the average selling price (about $2,400) was separated by a factor of about 14 from the average buyer's offer (about $175)," Ariely wrote in his book Predictably Irrational.

I fall prey to this bias every time I buy a stock.

• In August of last year, I purchased shares of General Electric (NYSE: GE) when it was trading for about $11 and change.
• Because there is constant controversy surrounding a conglomerate like GE, I find myself ignoring criticisms of the company or critiques about GE's capital division -- just because I own the stock.
• I constantly have to remind myself to step back, impartially evaluate the company, and reassess my prospects for the industry.
• The stock eventually fell as low as $6 (though it has since recovered to $16).

And we never want to let it go ...
Say you were bullish on the solar industry and owned shares of First Solar (Nasdaq: FSLR) and Suntech Power (NYSE: STP), and analysts were coming out with negative industry reports. Instead of listening to the scrutiny and reading the reports, many investors would simply ignore the contrary opinion and convince themselves that their original analysis was correct. Because if in fact the analysts were correct -- and the solar industry was doomed -- then you'd have to sell your shares, and we've already established how we feel about things we already own. We simply don't like to let things go, whether it's a basketball ticket or a share of stock.

Do you know when to hold or sell that stock, because -- let's face it -- conditions change?

Remember, there's no greater way to avoid having your stock hit rock bottom than having received objective analysis and reasonable advice.

http://www.fool.com/investing/general/2010/01/22/will-your-stock-hit-rock-bottom.aspx

Stock-Picking Strategies: Fundamental Analysis

Stock-Picking Strategies: Fundamental Analysis

Ever hear someone say that a company has "strong fundamentals"? The phrase is so overused that it's become somewhat of a cliché. Any analyst can refer to a company's fundamentals without actually saying anything meaningful. So here we define exactly what fundamentals are, how and why they are analyzed, and why fundamental analysis is often a great starting point to picking good companies.

The Theory

Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a fancy term for what you believe a stock is really worth - as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.


Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And these future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today. (For further reading, see Understanding the Time Value of Money).


The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.



Greater Fool Theory

One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute. The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies. This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies. (We'll talk more about technical analysis and how it works in a later section.)



Putting Theory into Practice

The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.


Let's look at a sample of a model used to value a company. Because this is a generalized example, don't worry if some details aren't clear. The purpose is to demonstrate the bridging between theory and application. Take a look at how valuation based on fundamentals would look:




The problem with projecting far into the future is that we have to account for the different rates at which a company will grow as it enters different phases. To get around this problem, this model has two parts:

(1) determining the sum of the discounted future cash flows from each of the next five years (years one to five), and

(2) determining 'residual value', which is the sum of the future cash flows from the years starting six years from now.

In this particular example, the company is assumed to grow at 15% a year for the first five years and then 5% every year after that (year six and beyond). First, we add together all the first five yearly cash flows - each of which are discounted to year zero, the present - in order to determine the present value (PV). So once the present value of the company for the first five years is calculated, we must, in the second stage of the model, determine the value of the cash flows coming from the sixth year and all the following years, when the company's growth rate is assumed to be 5%. The cash flows from all these years are discounted back to year five and added together, then discounted to year zero, and finally combined with the PV of the cash flows from years one to five (which we calculated in the first part of the model). And voilà! We have an estimate (given our assumptions) of the intrinsic value of the company. An estimate that is higher than the current market capitalization indicates that it may be a good buy. Below, we have gone through each component of the model with specific notes:

1. Prior-year cash flow - The theoretical amount, or total profits, that the shareholders could take from the company the previous year.
2. Growth rate - The rate at which owner's earnings are expected to grow for the next five years.
3. Cash flow - The theoretical amount that shareholders would get if all the company's earnings, or profits, were distributed to them.
4. Discount factor - The number that brings the future cash flows back to year zero. In other words, the factor used to determine the cash flows' present value (PV).
5. Discount per year - The cash flow multiplied by the discount factor.
6. Cash flow in year five - The amount the company could distribute to shareholders in year five.
7. Growth rate - The growth rate from year six into perpetuity.
8. Cash flow in year six - The amount available in year six to distribute to shareholders.
9. Capitalization Rate - The discount rate (the denominator) in the formula for a constantly growing perpetuity.
10. Value at the end of year five - The value of the company in five years.
11. Discount factor at the end of year five - The discount factor that converts the value of the firm in year five into the present value.
12. PV of residual value - The present value of the firm in year five.

So far, we've been very general on what a cash flow comprises, and unfortunately, there is no easy way to measure it. The only natural cash flow from a public company to its shareholders is a dividend, and the dividend discount model (DDM) values a company based on its future dividends (see Digging Into The DDM.). However, a company doesn't pay out all of its profits in dividends, and many profitable companies don't pay dividends at all.


What happens in these situations? Other valuation options include analyzing net income, free cash flow, EBITDA and a series of other financial measures. There are advantages and disadvantages to using any of these metrics to get a glimpse into a company's intrinsic value. The point is that what represents cash flow depends on the situation. Regardless of what model is used, the theory behind all of them is the same.

Reference:


http://www.investopedia.com/university/stockpicking/stockpicking1.asp?partner=WBW
Next: Stock-Picking Strategies: Qualitative Analysis

Choosing a Discount Assumption

Choosing a discount assumption

In theory, the discount rate should be your own personal cost of capital for this kind of investment. If you have a million dollars and can invest it with no risk in a Treasury bond at 6 percent, your cost of capital is the risk-free 6 percent you would forgo by not investing in the bond. So the implied cost of your dollars made available to invest in Business XYZ starts at 6 percent. Financial types refer to this opportunity cost as the risk-free cost of capital.

But implicitly, Company XYZ common stock is riskier than the bond investment. Sales, earnings, and myriad other intrinsic things can change, as can markets and the market perception of XYZ’s worth. So an equity premium is added to the risk-free cost of capital rate. In effect, the total cost of capital is your required compensation, or hurdle, for the opportunity you’ve lost by not buying the bond, plus the assumption of risk by investing in XYZ.

Much has gone into identifying appropriate risk premiums and the like. Modern portfolio theory and its reliance on beta – a measure of relative stock price volatility – doesn’t really do much for most value investors. (Remember: Price doesn’t determine value.)

The keep-it-simple-safe (KISS) approach used by most value investors, including Warren Buffett, is to discount at a relatively high rate, usually higher than the growth rate. Buffett uses 15 percent as a discount, or “hurdle” rate – investments must clear a 15 percent “hurdle” before clearing the bar. The 15 percent hurdle incorporates a lot of risk, especially in today’s environment of relatively low interest rate and inflation. Conservative value investors usually use discount rates in the 10 to 15 percent range.

As you build and run models, you’ll see firsthand how the discount rate affects the resulting intrinsic value. Here are a few points to remember:

• The higher the discount rate, the lower the intrinsic value – and vice versa.
• The second-stage discount rate should always be higher than the first stage. Risk increases the farther out you go.
• If you choose an aggressive growth rate, it makes sense also to choose a higher discount rate. Risk of failure is higher with high growth rates.
• If the discount rate exceeds the growth rate, intrinsic value will be low and implode more quickly the larger the gap. Aggressive growth assumptions with low discount rates yield very high intrinsic values.

If you’re worried about earnings and earnings growth consistency and want to factor it in somehow, but don’t want to do a deep statistical analysis on a zillion numbers, Value Line does one for you. At the bottom right corner of the Value Line Investment Survey sheet is a figure called “Earnings Predictability” if the Survey covers the company you’re evaluating.

It’s really a statistical predictability score normalised to 100 (100 is best, 0 is worst). A score of 80 and higher indicates relative safety; below 80 means that you may want to attenuate growth rates or bump up the discount rate to account for uncertainty.

Here again is the set of growth and discount assumptions used for an example. Consistency is important, but growth rates will vary for each company, and discount rates may change also with differing risk assessments.
First-stage growth 10%
Second-stage growth 5%
First-stage discount rate 12%
Second-stage discount rate 15%

Ref: Intrinsic Value Model

Intrinsic Value Model

Intrinsic value is driven by current and especially future earnings. Projecting future growth in these earnings is vital to determining intrinsic value.

First-stage growth
Near-term growth is by nature easier to model, and as a result of the discounting process, they contribute more towards the final result anyway. So intrinsic value models are set up to specifically value a first stage in detail, year-by-year. Typically, the first stage is 10 years, although in some analyses it may be more or less.
More often than not, the first stage is assumed to have a higher growth rate and a lower discount rate than the second stage.

Second-stage growth
The second stage covers the more nebulous period of business life beyond the first stage. Second-stage returns are harder to project accurately, so intrinsic value models use one of two assumptions to estimate what’s known as continuing value:

• Indefinite life: The indefinite life model assumes ongoing returns and uses a mathematical formula to project returns over an indefinite period and assign a value to those returns.
  
• Acquisition: Want a convenient way to bypass mathematical approximations? Assume that someone will come along and buy your business after the first stage at a reasonable valuation. Returns include all future payouts, including lump sums, so this method works too, so long as resale value is projected reasonably.
  
  

Summary.

Each stage of a business life has a growth rate and discount rate applicable to that stage. One growth rate and one discount rate is applied to the first stage, and another growth and discount rate to the second. Then, you calculate net future earnings by first compounding growth over the first stage and then discounting that value back to the present. A generalised formula, either indefinite life or acquisition-based, is applied to the second stage. The value attributed to the second stage is called continuing value.

Estimation of Intrinsic Value

The procedure commonly employed by investment analysts to estimate the intrinsic vlaue of a share consists of the following steps:

1. Estimate the expected earnings per share
http://myinvestingnotes.blogspot.com/2008/09/estimating-expected-eps-cash-flow-per.html

2. Establish a PE ratio
http://myinvestingnotes.blogspot.com/2008/09/establishing-pe-ratio.html

3. Develop a value anchor and a value range
http://myinvestingnotes.blogspot.com/2008/09/determine-value-anchor-and-value-range.html