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.

FCF Yield in Context (Malaysian Market)

 

FCF Yield in Context

Comparison with Malaysian Market:

FCF Yield	Interpretation
< 2%	Low/Expensive
2-4%	Average
4-6%	Attractive
> 6%	Very attractive

The Critical Flaws of EBITDA

 

Thursday, 9 January 2020

EBITDA: analytically flawed and resulted in the chronic overvaluation of businesses

https://myinvestingnotes.blogspot.com/2020/01/ebitda-analytically-flawed-and-resulted.html

Summary for Investors: The Critical Flaws of EBITDA

Bottom Line Up Front: EBITDA is not free cash flow. Using it to value businesses will likely cause you to overpay for stocks, because it ignores two critical cash expenses that every real business must pay.

The 3 Fatal Flaws of Using EBITDA as a Valuation Tool:

1. It Ignores the Cost of Staying in Business (Capital Expenditures - "CapEx")

   • Problem: EBITDA adds back all depreciation (the accounting cost of assets wearing out) but doesn't subtract the actual cash needed to replace those assets (CapEx).

   • Reality Check: A factory's machines will wear out. A delivery fleet will need replacement. If you spend depreciation cash on dividends or debt payments instead of new equipment, you are liquidating the company slowly.

   • Investor Takeaway: A company with high EBITDA but no profits and high CapEx needs may be a value trap.

2. It Ignores Taxes (A Very Real Cash Expense)

   • Problem: EBITDA pretends taxes don't exist. For any profitable company not buried in debt, taxes are a major, unavoidable cash outflow.

   • Reality Check: "Earnings Before Interest and Taxes" is exactly that—it stops before the taxman gets paid. Your share of the profits is what comes after taxes.

   • Investor Takeaway: Valuing a company on pre-tax cash flow will systematically overstate the cash available to shareholders.

3. It Was Popularized to Justify Unsustainable Prices & Debt

   • Historical Context: In the 1980s LBO boom, bankers and analysts used EBITDA to make sky-high takeover prices and dangerous debt levels look affordable. It created a circular logic: high prices required a new metric to justify them.

   • Reality Check: Be skeptical of metrics that suddenly become popular during market manias. They often exist to enable deals, not to reveal truth.

What You Should Look At Instead: Free Cash Flow (FCF)

The Article's Formula for True Owner Earnings:
Free Cash Flow = After-Tax Profit + Depreciation & Amortization - Capital Expenditures

• This is the cash a business actually generates after covering the essential costs of running and maintaining itself. This is the cash that can be paid to you (dividends/buybacks), used to pay down debt, or reinvested for growth—without harming the business.

Smart Investor Action Steps:

1. Always Look Beyond EBITDA. See it as a very rough starting point for understanding operating performance, never as a final measure of value or cash generation.

2. Calculate and Focus on Free Cash Flow (FCF). This is the single most important metric for assessing a company's financial health and its ability to reward shareholders. You can find the components easily on any cash flow statement.

3. Scrutinize the Cash Flow Statement. The "Cash from Operations" and "Capital Expenditures" lines tell the real story. A company with strong, growing Cash from Operations after CapEx is creating genuine value.

4. Be Wary of "Adjusted EBITDA." This is often an even more aggressive version where companies add back other "one-time" expenses. Always ask: "Is this a real cash cost the business will likely face again?"

Final Thought: Warren Buffett famously prefers to value businesses based on their "owner earnings," which is essentially their free cash flow. His partner Charlie Munger has called EBITDA "bullshit earnings." As an investor, your goal is to think like an owner buying the entire business. Ask yourself: "After all the bills are paid—including for new equipment and taxes—how much cash is left for me?" That's the number that matters. EBITDA deliberately obscures that answer.

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Here is a list of the main points, followed by discussion, commentary, and a summary.

Main Points of the Article

1. Historical Shift in Valuation: In the late 1980s, public market investors began imitating private equity buyers by shifting from valuing companies based on reported earnings to valuing them based on cash flow.

2. The Rise of EBITDA: In this shift, investors sought a simple, single-number proxy for cash flow. They widely adopted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), especially for leveraged and takeover-target companies.

3. The Core Flaw: EBITDA is analytically flawed because it ignores essential cash outflows:

   • It adds back all depreciation, but fails to subtract necessary capital expenditures (CapEx) needed to maintain the business.

   • It ignores taxes, which are a real cash cost for any company not solely financed by debt.

   • It treats amortization of goodwill as a non-cash add-back, which, while often justified, further inflates the cash flow figure.

4. Correct Cash Flow Measure: True free cash flow should be measured as:

   • After-tax earnings (profit), plus

   • Depreciation & Amortization, minus

   • Capital Expenditures (the net investment in the business's assets).

5. Why EBITDA Was Embraced (Despite Its Flaws):

   • Simplification & Laziness: It was a easy, single-number heuristic; detailed CapEx analysis is complex and requires insider knowledge.

   • Leveraged Buyout (LBO) Justification: In the high-leverage environment of the 1980s, with tax-deductible interest, pretax cash flow (like EBIT) became more relevant to debt service. EBITDA extended this logic dangerously.

   • Circular Reasoning for High Prices: EBITDA allowed analysts and deal-makers to justify ever-higher takeover prices and fees that traditional metrics could not support. The metric was adapted to serve the desired outcome (making deals happen).

6. The Dangerous Consequences: Using EBITDA led to chronic overvaluation.

   • It assumed businesses could operate without reinvesting in their physical assets.

   • It created a false sense of safety for lenders and bondholders, as companies spending depreciation on debt service instead of CapEx faced eventual decay, distress, or bankruptcy.

Discussion & Commentary

The article presents a timeless and crucial critique of a metric that remains pervasive today. Its arguments are powerful and largely correct:

1. Enduring Relevance: The critique is not just historical. "Adjusted EBITDA" and the misuse of EBITDA continue to be points of contention, especially in high-growth tech, telecom, and leveraged industries. The article's warning that ignoring maintenance CapEx leads to a "gradual liquidation" is a fundamental truth of corporate finance.

2. The CapEx Fallacy: The point on capital expenditure is the most critical. Depreciation is an accounting estimate of asset consumption, while CapEx is the actual cash spent to offset it. Assuming they match is optimistic; assuming CapEx can be zero (or fully financed forever) is reckless. The article correctly frames this as a survival-level expense.

3. Context Matters: The article astutely notes that EBITDA's utility is context-dependent. It was less nonsensical for a specific late-80s LBO model where:

   • The capital structure was designed to maximize tax shields.

   • The plan involved aggressive asset sales or operational turnarounds.

   • However, using it as a universal valuation metric for public equities was the fatal error.

4. Modern Nuances: Today's discussion would add:

   • Goodwill & Intangibles: For modern businesses (software, brands), amortization of other intangibles (patents, customer lists) and investments in expensed intangibles (R&D, marketing) complicate the picture further. EBITDA fails here too.

   • Working Capital: A complete free cash flow measure also requires adjusting for changes in working capital (inventory, receivables, payables), which the article's simplified formula omits but is vital for a full picture.

5. Broader Lesson on Metrics: The article is a masterclass in how Wall Street can adopt "innovative" metrics that serve transaction volumes and fees rather than rigorous analysis. It warns against the seduction of simple answers to complex questions (like "what is this business's cash-generating ability?").

Summary

This article is a critical analysis of the rise and misuse of EBITDA as a valuation tool during the 1980s leveraged buyout boom. It argues that investors, eager to mimic private buyers and simplify analysis, erroneously adopted EBITDA as a proxy for free cash flow. This was a profound analytical error because EBITDA ignores capital expenditures (necessary to maintain the business) and taxes (a real cash cost), leading to the systematic overvaluation of companies.

The piece explains that true cash flow is derived from after-tax earnings, adjusted for depreciation minus capital spending. It posits that EBITDA gained traction due to a combination of simplicity, its usefulness in justifying high leverage and tax strategies, and, most cynically, circular reasoning—it was the only metric that could rationalize the soaring prices and lucrative fees of the takeover era. The ultimate consequence was a misallocation of capital into businesses whose claimed cash flows could not be sustained without vital reinvestment, risking their long-term health and stability. The critique serves as an enduring warning about the dangers of flawed financial metrics.

How is a P/E multiple used? The Price/Earnings Multiple Enigma

 

How is a P/E multiple used?  The Price/Earnings Multiple Enigma

https://myinvestingnotes.blogspot.com/2009/11/how-is-pe-multiple-used.html

Summary

The article from November 2009 explains the Price-to-Earnings (P/E) ratio and its variants as fundamental tools for stock valuation. Key points include:

1. Definition and Calculation:

   • The P/E ratio is calculated as the market price per share divided by earnings per share (EPS).

   • The trailing P/E uses historical (past year or last four quarters) EPS.

   • The forward P/E uses projected future EPS, which incorporates growth expectations.

2. Usage and Interpretation:

   • P/E reflects the premium investors are willing to pay based on a company’s future growth prospects.

   • It helps assess whether a stock is overvalued or undervalued, but must be compared within context (industry, growth rates, management quality).

   • A higher P/E may indicate higher expected growth or superior company fundamentals, not necessarily overvaluation.

3. Limitations of Historical P/E:

   • Trailing P/E fails to capture recent events (e.g., mergers) or future expectations, making forward P/E more relevant for investment decisions.

4. Introduction to PEG (Price/Earnings-to-Growth) Ratio:

   • PEG refines P/E analysis by dividing the P/E ratio by the expected earnings growth rate (e.g., over the next 2–3 years).

   • A lower PEG suggests a more attractive investment. A rule of thumb:

     • PEG < 0.5: Undervalued

     • PEG = 1: Fairly valued

     • PEG > 2: Overvalued

5. Important Caveats:

   • P/E cannot be used for loss-making companies (no earnings).

   • Qualitative factors (transparency, management quality) influence P/E multiples.

   • Comparisons should account for industry differences (e.g., utilities vs. tech).

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Discussion and Commentary

The article remains largely relevant today, as P/E and PEG are still widely used in equity analysis. However, some nuances and modern contexts can be added:

Strengths of the Article:

• Clarity on Forward vs. Trailing P/E: It correctly emphasizes that forward P/E is more meaningful for investment decisions, as markets are forward-looking.

• Context Matters: It highlights that P/E cannot be viewed in isolation—industry dynamics, growth rates, and qualitative factors must be considered.

• PEG as a Refinement: Introducing PEG helps adjust for growth, addressing a key limitation of P/E.

Limitations and Additional Considerations:

1. Earnings Manipulation: Both trailing and forward P/E rely on reported or projected EPS, which can be distorted by accounting practices or one-time items. Analysts often use adjusted EPS to mitigate this.

2. Interest Rate Environment: The article briefly mentions macroeconomic factors but does not deeply explore how interest rates affect P/E multiples. In low-rate eras, higher P/Es are more common (and vice versa).

3. Sector Exceptions: While P/E works for most sectors, it is less useful for capital-intensive, cyclical, or high-growth companies (e.g., early-stage tech) where earnings may be volatile or negative. Alternatives like P/S (Price-to-Sales) or EV/EBITDA may be preferred.

4. PEG’s Shortcomings: PEG assumes a linear relationship between P/E and growth, which may not hold for very high or low growth rates. It also depends on the accuracy of growth projections, which are often unreliable.

Modern Context:

• With the rise of FAANG-style tech stocks and unicorns, many investors now tolerate high P/Es (or negative earnings) based on disruptive potential, network effects, or scalability, challenging traditional P/E frameworks.

• Quantitative easing (post-2008) and low-interest-rate regimes have pushed P/E multiples higher globally, making historical averages less reliable benchmarks.

• ESG (Environmental, Social, Governance) factors are increasingly priced into multiples, affecting investor perception beyond pure earnings growth.

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Conclusion

The article provides a solid foundational understanding of P/E and PEG ratios, emphasizing their utility and limitations. While its core principles endure, investors today must also consider macroeconomic conditions, sector-specific nuances, and alternative metrics—especially in markets dominated by growth and innovation. P/E remains a starting point for valuation, but a holistic approach combining quantitative metrics with qualitative judgment is essential.