The three most important words for a value investor are “Margin of Safety”.
As value investors, we look for undervalued stocks that are trading at a discount to what we think they’re worth, aka the stock’s ‘intrinsic value’. The margin of safety is that difference between price and intrinsic value that provides some protection in the event of a major drawdown.
Below is a cheat sheet of different things I look at when evaluating the intrinsic value of a company. It’s meant as a general quantitative framework, and doesn’t cover the more qualitative aspects like understanding the business, barriers to entry, industry dynamics, and macro factors.
When evaluating companies that are of interests to me, I usually perform two types of analysis. A quick and dirty assessment, and a detailed analysis. It’s too time consuming to perform a detailed analysis on all of them, so I only do that if they pass the quick and dirty assessment.
Quick and Dirty Assessment
Enterprise Value to EBIT
Similar to P/E, EV/EBIT gives an idea of how cheap or expensive a company is trading. I don’t like using P/E because earnings are easily (and often) manipulated. EBIT (or operating income) is a more ‘pure’ reflection of how much cash a company generates from its operating activities. Also, since Enterprise Value accounts for both the debt and cash a company carries, it punishes those companies with more debt, and rewards companies with more cash.
A company with an EV/EBIT > 15 starts to get expensive for traditional value investors. Most will exit once in the 20-25 range. A high EV/EBIT puts you at risk of multiple compression and diminished returns.
Free Cash Flow
Again, because earnings are easily manipulated, I like to look at cash flows instead. Cash flow is basically the net income with depreciation and amortization charges added back in. Since dep & amt don’t represent actual outlays of cash, the company is usually generating more cash than shown in the net income. Add back in any one time capex, dividend payments, and other non-recurring charges, and you get free cash flow.
Like P/E the higher the Price to Free Cash Flow ratio, the more the market values the stock.
I like companies that generate a good dividend. However, I also consider the overall distribution yield. This means how much cash the company is returning to the shareholder in the form of both dividends, and share buybacks. To get this number, I look at dividends + share repurchases, and subtract out any interest expense and net borrowing.
Most companies who are ‘shareholder friendly’ usually have a breakdown of these yields in their investor presentations. Make sure to look at how much of the free cash flow is used on debt repayments.
Return on Invested Capital (ROIC)
As investors, we depend on management to be prudent capital allocators and make good investment decisions for us. ROIC is used to measure how well the management team is performing on these investments. For example, if ROIC comes out to be 12%, that means management is returning 12% annually on its investment decisions. That’s a good thing for shareholders!
Return on Equity (ROE) can be used as well, but the ‘equity’ portion can be easily manipulated by write downs to book value. ROIC is a better performance metric because it measures return on all invested capital, including debt financed capital.
ROIC is calculated by taking Net Operating Profits After Tax (aka NOPAT) / Invested Capital.
When calculating ROIC, keep in mind that all published documents show average ROIC, and not marginal ROIC. Average ROIC includes the first and last dollar invested over the life of the company. The first dollar often has a much higher ROIC… ie.. the markets are not saturated, so you get more bang for your buck. What we are interested in is the marginal ROIC… as in the most recent investments, and what the returns were on those investments. This is difficult to calculate, because we don’t always have the info. But it’s important to watch out for.
Discounted Cash Flow
This is a common method used to estimate the value of an investment based on future cash flows. It’s rooted in the principle that the intrinsic value of an investment is equal to the sum of all future cash flows it will produce, with each one of those cash flows being discounted to present value.
Key assumptions and variables needed to calculate this:
- Some starting value, usually cash minus debt on balance sheet
- Year 1 cash flow (I take the trailing twelve months of free cash flow)
- Some growth rate being applied to each year.
- Discount rate
- Number of years to forecast
- Terminal value of business at the # years forecasted. Usually some multiple of the final year’s cash flow.
The result of the calculation is a rough valuation of what the company is worth. Take that number, and divide by # of shares, and you get the intrinsic value per share, which you can then compare to current share price to see if it is under or over-valued. The difference between the share price and the intrinsic value share price is the ‘margin of safety’.
I typically run this back of the envelope calculation using both free cash flow, and earnings per share. They give different results, but together they provide a window into a company’s valuation.
Although the DCF method is the ‘gold standard’ by which most investments are evaluated, it has many drawbacks. It relies heavily on the ability to ‘predict’ the future stream of cash flows and growth rates. This is almost impossible to do, so any intrinsic value determined with this method should be taken with a grain of salt.
One way to get around this, is to only use this for companies that have a very consistent history of returns over the past 10+ years.
Secondly, DCF is extremely sensitive to the input assumptions. Changes in the discount rate, terminal value, and growth rates all have a big impact on the resulting valuations.
That being said, DCF does have its benefits, and it provides one piece of the overall puzzle when evaluating a company.
Tangible Book Value
I look at tangible book value since it is easy to calculate. It’s the book value of assets minus intangibles and goodwill. I use this for reference only, since book value is just an accounting concept, and doesn’t provide an accurate reflection of what the asset is really worth. To get that, we need to do the detailed analysis covered in the next section.
However, tangible book value does provide some insights, especially when a company has large amounts of cash or debt.
If I am still interested in the company after the quick and dirty round, then I will start doing more research on the business. This includes going through investor presentation decks, skimming through the annual reports, and performing a slightly more rigorous assessment of the financial statements in trying to come up with a valuation. Usually only 1 out of 10 companies make it to this round.
Most companies have an ‘Investors’ section on their website. Rather than diving right into their 10k, I look for an ‘Investors Presentation’ deck from the most recent investors meeting. This is typically a 10-15 page PowerPoint presentation describing some high level information about the company. Topics usually cover things like business model, why the company has a competitive advantage, shareholder returns, current and future projects etc… I found this to be a good starting point in familiarizing myself with the company and their business.
Annual Report / 10K
I usually only read the first section, which describes their business in detail. I also pay close attention to the ‘risks’ section. Here the company identifies the many areas that could potentially have a negative impact on their business. The rest of the report, I use as reference. I use the search function to look for certain financial statement details and footnotes used in my analysis.
This is the worst case scenario valuation, and the first step I take when performing a detailed analysis of the company’s assets. If the company went out of business, and had to liquidate all its assets. How much would it be worth?
To calculate liquidation value we take the total assets from the balance sheet, and then make the following adjustments:
- Accounts receivable - Specialists can be used to recover accounts receivable. Usually a % of book value.
- Inventory - How transferrable is it? Transferrable inventory keeps a higher value. If it is super specialized or not really transferrable, I adjust it down
- Property, Plant and Equipment - Generic buildings retain more book value than specialized structures. Land is typically at full value, maybe more.
- Goodwill - In an asset sale, we ascribe no value to goodwill. It merely represents the excess over fair market value that the firm paid in making those acquisitions that may have gotten them in trouble!
- Deferred taxes - The refunds expected over time from the IRS - should be offset with deferred taxes owed.
- We then subtract out all the debt, as debt holders will get paid before equity holders.
Whatever is left over after all these adjustments is the liquidation value. Again, this is worst case scenario in terms of valuation. Sometimes distressed companies will be trading at less than liquidation value. There may be some opportunities there, but I’m not savvy enough to take advantage of those.
Asset Reproduction Value
Assuming the business is economically viable in a sustainable industry, what would it take for a competitor to get into this business? This is known as the asset reproduction value (or just asset value). It’s a bottom up approach, and more accurate than just book value because we make numerous adjustments as part of the valuation process.
Most of these adjustments are determined through qualitative assumptions. It’s helpful to understand a little bit about the business, and sometimes I have to Google 3rd party sources to piece together a clear picture.
The following adjustments are made to calculate asset value:
- Accounts receivables adjustment A new firm starting is more likely to get stuck by customers who do not pay their bills. We need to add back allowance for doubtful accounts.
- Inventory - If company uses FIFO our attention should be drawn to an inventory that has been piling up. Example: if it equals 150 days worth of the cost of goods sold in the current year, whereas previously it had averaged only 100 days, then the additional 50 days may represent items that will never sell or will sell only at closeout prices. In this instance, we would lower the reproduction costs. On the other hand, if company uses LIFO for inventory, and if prices of the items it sells has been rising, then reproduction costs exceed the old recorded costs and should be marked up.
- Land - Property as land does not depreciate. Depending on where the land is located, and when it was purchased, the land may be worth more than is indicated on the balance sheet.
- Buildings - Disparity between book value and reproduction cost could be large, depending on depreciation.
- Equipment - Easiest to value at reproduction costs. It is depreciated over its useful life, and if it lasts somewhat longer, we are ahead of the game. If state of the art tools are required, then it actually may be cheaper for a new entrant, since these technologies become cheaper and more productive over time.
- Goodwill - Should be done on a case by case basis. Identify the source, and if we think the excess paid to book value for acquisition was worth it.
- Workforce Reproduction - We need to reproduce the workforce as well. There is a cost associated with hiring and training employees. Typically 10% of annual salary replacement costs for blue collar workers, and 20% for white collar.
- Brand value - Determine whether or not the brand has any value. What would it take for us to reproduce the brand? This can done by taking the amount it has spent each year on sales and marketing, and discounting it by the weighted average cost of capital. If it is a large firm, many times we can just google online for the brand value. We also apply a brand relevancy factor, so that firms in industries where the brand is more relevant get a higher weighting than firms in commoditized industries.
- Product portfolio - Under GAAP accounting, firms cannot capitalize R&D. One conservative approach is estimate the average product life cycle, then multiply that by annual R&D costs.
- Licenses franchises or contracts - The firm may hold licenses to operate in certain markets, or have take or pay contracts with clients. These should be considered in the overall valuation.
Once all these adjustments are determined, I add the changes to total assets, and subtract out debt. The result gives me an estimate of what it would take to reproduce this company. I can then divide by total number of shares, and it gives me the intrinsic value per share. Again, taking the difference between this and the current share price gives me an idea of whether the company is under or over-valued, and if there is a margin of safety.
Earnings Power Value (EPV)
With EPV, we care only about current earnings, and do not try to forecast any future growth into the calculation. It is one step less conservative than looking at pure asset values, but not as unreliable as trying to forecast some future growth rate as with DCF.
To get EPV, I take the adjusted earnings and divide by the current cost of capital. With EPV, cash flows are assumed to be constant, and growth rate is zero. EPV basically says, if this asset (company) continues to generate these earnings at a constant rate, what would the current value be.
The following adjustments are made to earnings prior to calculating EPV:
- Cyclicality - Adjust for the current position in business cycle.
- Accounting misrepresentations / One-time charges - Adjust for ‘one-time’ charges that are not connected to normal operations. This could include special write downs, acquisitions, one time costs etc…
- Capex, depreciation & amortization – Calculate maintenance capex, which is required to restore a firms existing assets. Remove capex that was spent for growing the business. Adjust for goodwill writedowns.
Once all the adjustments are made, divide the adjusted earnings number by the cost of capital to get the EPV. Divide EPV by number of shares to get the EPV per share. This intrinsic value could then be compared to the current share price to determine the margin of safety.
Asset Value vs. Earnings Power Value
Comparing AV and EPV provides some insights into the company. Consider the following scenarios:
AV higher than EPV means the firm has a disproportional amount of assets relative to its earnings. Possible reasons:
- Industry in decline
- Mismanagement of assets
- Assets that should not be in that firm, industry is dying out.
- Should be squeezing more profits
EPV higher than AV means the firm is generating a lot of earnings with very little assets. Possible reasons:
- Barriers to entry
- Company generating more earnings than assets warrant
- Superior management, can price well above cost.
AV equal to EPV could mean:
- Efficient asset management
- Operating in competitive environment
Not all growth creates value. Only growth if the company enjoyes barriers to entry or a competitive advantage. Growth is difficult to value, so only buy at a margin of safety large enough to make up for the greater uncertainty. Ideal price to pay for growth is zero.
Paying a premium for growth is a risky bet because:
- We assume there will be growth for number of years into future
- That growth must take place within the franchise aka be profitable
Profitable growth is defined as growth in earnings in excess of the cost of the investments needed to support growth. ie.. Return on capital must be higher than cost of capital. In a competitive environment, ROC = WACC. Therefore growth must occur within the franchise where the firm enjoys barriers to entry in order for ROC > WACC.
If we believe a firm has a wide moat ie… enjoys barriers to entry, competitive advantage, then how do we value growth? It is important to view growth in terms of expected returns, rather than trying to assign a dollar value or share price.
Expected returns are the distribution yield plus earnings growth. The distributions are the total returns going back to the owners and shareholders. This includes:
- Share repurchases
- Interest expense
- Net issuance of debt
However, we need to normalize this by the value of the firm, so we divide by the enterprise value.
Now what about earnings growth? There are two ways to estimate earnings growth. The first is to look at historical growth in earnings. The second is to look at return on invested capital (ROIC), which is dependent on assessing the capital allocation within the firm. The second approach is more complex, so I usually just use the historical earnings approach.
Once we have an estimate of Earnings Growth based on historical earnings and revenues, then we add that growth rate to the distribution yield to get our expected returns. This is the % we would expect to get back on our investment each year.
For example, if a company’s distribution yield was 5%, and their average earnings growth over the past 5 years was 7%, then the expected return for every dollar we invested into this company would be 12% a year.
That covers all the quantitative stuff I look at when assessing a company’s intrinsic value. There’s a bunch of qualitative analysis that should be factored in as well, along with some macro environment considerations, but those are done on a case by case basis. This at least gives me a good baseline to work with when trying to understand valuations.