The Ultimate Guide to Stock Valuation

The Ultimate Guide to

Stock Valuation Learn and Profit using 8 Valuation Techniques to Value Any Stock

by Jae Jun

The Ultimate Guide to Stock Valuation

Table of Contents 03. How to Use and What to Expect

35. Valuing Stocks with EBIT Multiples

04. Introduction to Stock Valuation

38. What is Asset Reproduction Value?

05. Taking a Bird's Eye View

45. The Full Earnings Power Value (EPV)

08. Benjamin Graham's "Net Net" Stocks

51. Your Valuation, Your Art, Your Way

12. Graham's Growth Formula for Value

52. Bonus: Top 7 Books on Valuation and

Stocks

Analysis

18. Intrinsic Value of a Business

56. About the Author

20. How to Value Stocks Using DCF

57. Get Started with Old School Value

26. How to Value a Stock with Reverse DCF 28. Katsenelson's Absolute PE Model

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How to Use & What to Expect Thank you for your interest in this book. This book is best served as a companion to the Old School Value Stock Analyzer and its sole focus is to guide you through a variety of ways to value stocks. It assumes that you already have a working knowledge of accounting and understanding of financial numbers. Throughout the book, you will see examples and screenshots that were taken from various parts of the Stock Analyzer to help you visualize and understand. Even if you are not a user of the Stock Analyzer, you will find it easy to follow along and apply yourself. Click on images that look too small. It will open up a bigger version in your browser. Links you come across will take you to various helpful resources for further reading and understanding. Feel free to distribute this to your family, friends and anyone else interested in the art of valuing stocks. http://www.oldschoolvalue.com

The stock market is filled with individuals who know the price of everything, but the value of nothing. - Philip Fisher

The Ultimate Guide to Stock Valuation

Introduction to Stock Valuation Valuation Matters

Valuation is an Art

You can purchase the best stock in the world, but if you buy it at a lofty premium, it is a bad investment.

Valuation is important, but it is not black and white.

Vice versa, the stock could be the worst company in the world, but if you buy it at such a cheap price that it cannot go down any further, it may just turn out to be your best investment.

Every valuation method requires assumptions and inputs because valuation itself is a forward looking calculation. A stock price is made up of an asset value and a growth value. Without considering the growth value, you end up with just half the equation.

That is why valuation is a huge part of the game. The problem I fell into as I started my investing journey was trying to value every stock the same way. If you play golf, do you use the same club to hit every shot? It is the same with valuation. Just because you know how to do a DCF, it does not mean you should apply it to every company you come across. You must use the right tool in the right situation.

It is an art.

Make realistic assumptions and the inputs will be acceptable. Do not use numbers to match what you want the output to be. Your role as an investor is to be a realist. Not an optimist or a pessimist or to have your views confirmed. There will be people who disagree with the methods used in this book and with how you end up valuing stocks. Who cares? Stocks are valued in all sorts of ways and you will learn 8 valuation techniques from this book. It is time to let your art shine.

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Taking a Bird's Eye View Hold up.

2. Benjamin Graham Valuation Formula

Before you go off racing, let's go through a brief overview of each valuation method.

Type: Earnings and growth stock valuation method

8 Valuation Techniques That Will Help You Value Any Stock

When to Use: Cyclical companies, volatile cash flows, growth stocks, and young companies investing in growth.

Type: Balance sheet and tangible asset valuation

Description: Ben Graham was a balance sheet investor first and foremost, but he created this formula to simulate growth investing with value investing principles.

When to Use: Liquidation valuation, net net stocks, and when trying to determine the stock price relative to a stock's net assets. Does not work well for service or low asset companies such as software.

Since the companies that existed back in Graham's day did not have the growth of today's environment, I have made adjustments to the final formula to make it more applicable to today.

1. Net Net Working Capital and Net Current Asset Value

Description: When Ben Graham was around, the main types of businesses that existed were industrial businesses. Mainly factories, manufacturers and retailers. There were no consulting, software, or high tech companies you see today. He would analyze the balance sheet and invest in stocks with high tangible assets as it protected the downside.

3. Discounted Cash Flow (DCF) Stock Valuation Type: Cash flow valuation When to Use: Companies with consistent free cash flow, predictable companies.

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Description: No need for any introductions to the DCF method. It has its weaknesses and advantages which I will discuss, but overall, it is a highly effective tool for calculating predictable companies or with realistic projections and to test scenarios. The DCF I use is derived from F Wall Street which is a practical real world version and great for small investors. 4. Reverse DCF Type: Cash flow valuation of market expectation When to Use: Any situation to figure out what the market is expecting from the stock. Description: A backwards valuation to find what the market is expecting from the stock. Instead of entering the future growth rate, the goal is to find out what the market is expecting the stock to achieve. 5. Katsenelson Absolute PE Model Type: Fundamentals based multiples When to Use: Companies with positive earnings Description: When you think of multiples for valuing stocks, it is relative. This version is an absolute

version. Instead of using whatever a competitor is being valued as the benchmark for the valuation, the multiple is calculated based on the business fundamentals. Created by Vitaliy Katsenelson, author of Active Value Investing. 6. EBIT Multiple Valuation Type: Multiples method When to Use: Capable of valuing all companies Description: Used by many on Wall Street and a good back of the envelope calculation method. It has the advantage of being simple and concise. EBIT is the main driver of the valuation which makes it applicable for all companies. 7. Asset Reproduction Value Type: Balance sheet valuation When to Use: Calculate asset value by making adjustments to the balance sheet. Also used to see how much a competitor would have to spend in order to replicate the company's business. Description: In a way, this is a health and moat test. If the value of the balance sheet after making

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adjustments to its line items are strong, the company is protected by its assets and it is easy to identify the floor for the stock price. The way it acts as a moat test is that if the asset reproduction value is high relative to its stock price, then new entrants will have difficulty entering the market. 8. Earnings Power Value (EPV)

This will give you a range of valuations instead of anchoring on a single absolute fair value. Think about the low end, high end, and market expected scenario to form a rounded conclusion about what the stock is worth.

Key Old School Value Subscriber Tips

Type: Adjusted earnings valuation When to Use: For all companies but even better for cyclical, volatile, and young companies. Description: It is best to use EPV in conjunction with the Asset Reproduction Value method. It is a technique for valuing stocks by making an assumption about the sustainability of current earnings, and the cost of capital but assuming no further growth.

Each of the valuation techniques and ratios mentioned in this book is included in the Old School Value Stock Analyzer. Follow the examples with the Stock Analyzer and maximize your time by quickly identifying and valuing profitable stock ideas.

Sound complicated? It is at first, but you will get it.

Important Note as You Value Stocks As you learn about each method and start to perform these valuations, get in the habit of finding values based on different scenarios.

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Benjamin Graham's "Net Net" Stocks In 1932 at the bottom of the Great Crash, Ben Graham's fund had lost 70% of its value. It was precisely at this time when he wrote a Forbes article stating how cheap the market was. In fact, Graham remarked about how the market was selling the United States for free. What made Graham make this claim?

Liquidation Value Graham defined liquidating value very conservatively. The common definition used is Net Current Asset Value. NCAV = Current Assets - Total Liabilities

Deep Value Companies It all came down to the way Graham looked at companies. Stocks were being quoted in the market for much less than its liquidating value, priced as if they were destined to be doomed. This still happens today. But does it make sense to be quoted for less than the cash in your hand? Such deep value stocks are referred to as "net nets" and the idea is to calculate the liquidation value.

You can see how conservative the above definition is. But the term current assets is rather broad. It consists of cash, accounts receivables, inventory, and other assets easily convertible to cash. A company with 100% cash is much better off than a company with 100% in prepaid assets. And so, to define it clearer, I use a variation of NCAV which is stricter, but makes more sense and offers extra security when valuing and selecting net net stocks. That variation is called Net Net Working Capital.

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Net Net Working Capital

Let's look at a couple of examples.

The formula for NNWC is

ADDvantage Technologies (AEY) is a net net with ● ● ● ● ● ●

Net Net Working Capital = Cash and Short-term Investments + (75% x Accounts Receivable) + (50% x Inventory) - Total Liabilities

NCAV = $2.89 per share | NNWC = $1.62 per share

The formula states that ● ●

●

Cash and equivalents: $7.54m Accounts receivables: $3.42m Total inventory: $21.54m Total Current assets: $33.63m Total liabilities: $4.62m Shares outstanding: 10.03m

cash and short term investments are worth 100% of its value accounts receivables should be taken at 75% of its stated value because some might not be collectible inventories should be discounted by 50% in the event a close out sale occurs

NNWC places importance on the main parts that make up current assets; cash, accounts receivables and inventory. When it comes to valuing net nets, you want to find high quality ones. This is an oxymoron because net nets are trading at deep value ranges for a reason, but out of the dump, you can find a few stocks that shine brighter than the rest.

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iGo Inc (IGOI) is a company that is extremely cheap. ● ● ● ● ● ●

Cash and equivalents: $8.21m Accounts receivables: $3.53m Total inventory: $6.03m Total Current assets: $20.35m Total liabilities: $3.04m Shares outstanding: 2.91m

The key to valuing and investing in net nets is to purchase a basket of them. A few days after writing this, iGo was bought out at a 50% premium to its stock price. This is the way net nets make you money.

NCAV = $5.95 per share | NNWC = $4.46 per share iGo is a typical net net selling well below its net net value. Numbers look good, but always consider the history of losses and business model.

By buying a basket of them at dirt cheap prices, you protect the downside even though the company has a horrible business model and operational issues. There are always bigger companies who may see value in acquiring such companies. For bigger companies, it is easy because they can strip out money losing divisions and merge it into their existing lines or distribution networks. This will immediately return results whereas the acquired company may never have been able to achieve such returns on its own. You can calculate the NNWC of any stock. For some stocks, the NNWC will be negative and that just means that the company has more liabilities than the net net value. A negative NNWC does not indicate a bad business. Apple currently has one of the strongest balance sheets in the world but it has a NNWC of -$24. It just means that referencing NNWC is unimportant for such companies. "Normal" companies like MIcrosoft have stock prices far higher than its NNWC. Compare the

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NCAV or NNWC is not a pure valuation. It is designed to be used as a measuring stick for cheapness and show you what the assets of a company is worth.

Key Old School Value Subscriber Tips The Net Net section of the Stock Analyzer will import the necessary balance sheet items automatically to make it easy to calculate. Experiment with the percentage multipliers. You can increase or decrease the values depending on your situation. There is no hard rule that it has to be 75% of receivables and 50% of inventory. numbers for Microsoft with ADDvantage or iGo and you will get a good idea of how cheap a stock can really get. Microsoft has a NNWC and NCAV of $3.24 and $4.32 respectively. The total stock price is always made up of two parts, the asset value and the growth value. $3.24 is the asset value which means that $31.57 of the stock price is attributable to growth and future returns.

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Graham's Growth Formula for Value Stocks Benjamin Graham liked cheap net net stocks. What you may not have known is that Graham also came up with an intrinsic value formula to simulate growth investing valuation but applied a value investing twist.

The Corporate Bond Rate

The Graham Growth Valuation Formula

The entire formula is then divided by Y which is the current AAA corporate bond rate, which you find it on Bloomberg or Yahoo. Dividing by the AAA rate normalizes the 4.4% bond rate to today's environment.

This is the formula that Benjamin Graham published in The Intelligent Investor. V = EPS x (8.5 + 2g) ● ● ● ●

V is the intrinsic value EPS is the trailing 12 month (TTM) Earnings Per Share 8.5 is the PE ratio of a stock with 0% growth g is the expected growth rate for the next 710 years

The formula was later revised as Graham included a required rate of return.

The 4.4 was the average yield of high-grade corporate bonds in 1962 when this model was introduced.

The reason for the inclusion is that Graham wanted a minimum required rate of return for investing in stocks. You see, Graham knew that intrinsic value was more than just growth rates and EPS estimates. He knew that intrinsic value was related to fixed income rates or bond rates and that stocks and bonds compete with each other and are therefore related. Graham wrote a lot about how the stock PE ratios were affected by the bond yield levels as well as the changes. Here is a quote from Graham that talks about this.

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It seems logical to me that the earnings/price ratio of stocks generally should bear a relationship to bond interest rates. Viewing the matter from another angle, I should want the Dow or Standard & Poor's to return an earnings yield of at least four-thirds that on AAA bonds to give them competitive attractiveness with bond investments. - Ben Graham As you test the formula yourself, you will notice that bond rates affect valuation. The lower the yield the higher the price. This goes back to bond basics. If the yield is low, the price is high. If the yield is high, the price is low.

The common consensus is that you should use forward estimates of EPS. However, Graham did not intend the formula to be used in this way. Use a 5 to 7 year average of EPS to normalize the value. If the company is a high growth company, then the EPS should be calculated by using rolling averages. Remember that if you use analyst EPS estimates, it tends to be on the optimistic side and will result in a valuation at the upper range.

What To Do About Growth? Growth for a value investor? Yes, and that is what Graham wanted to mimic.

Graham designed the formula to replicate this line of thought. Think of it as inflation adjusting.

Although trying to estimate growth in general is a drawback, it is a big element of the whole valuation method.

So it is important to understand the current bond environment as you value stocks with the Graham formula.

There are two parts that make up the growth variable.

Adjust Earnings Per Share Further discussion on how to use the EPS value of the formula is required.

● ●

The PE of 8.5 and the growth rate, g

Graham defined 8.5 as the PE for a company with zero growth. There is no clear indication of how this number was derived, so I will have to take Graham's word and his research.

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But instead of using 8.5 as the no growth PE, I have reduced it to a PE of 7 in my version of the formula.

Final Adjusted Graham Formula Here is what the final formula looks like.

Nowadays, even if a company has zero growth prospects, if it is able to maintain cash flows and distribute dividends, the PE is easily higher than 8.5. And I prefer to err on the side of conservatism. Choosing the growth rate is very much the same as how you find the EPS.

Time for some examples.

Instead of using a single forward estimate, calculate the average 5-6 years of growth experienced by the company. If a company has 3 years of operating history, then take the average of the three years.

The Graham Formula in Action

Next is the "2" multiplier which I find to be too aggressive. This is understandable if you take things into context. Graham never experienced companies with growth rates of 20-30% which is common today. There was no Amazon or Facebook in Graham's time.

I am going break the rules of what I wrote already, but follow along to see why.

Instead of 2, you can reduce the multiplier to 1.5 or 1. From all the valuations I have performed using the Graham formula, I have found that using 1 is completely satisfactory and still yields an optimistic value.

Let's run this formula through a couple of stocks. Microsoft (MSFT) is up first.

First, here are the inputs that I will be using for the calculation. ● ● ●

EPS = $2.51 g = 13.9% Y = 4%

For a company like Microsoft with a huge moat and good predictability, you do not need to worry so much about using the past 5 - 7 year averages.

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Companies like MSFT do not grow or die overnight. In this case, I like to average the past 2-3 years instead.

Click to enlarge the screenshot and view in your browser.

That is how I get the EPS of $2.51. To find growth, I looked at the 5 year and 10 year rolling median. Surprisingly, the growth rate between the 5 year and 10 year rolling periods are identical at 13.9%, which is what I will stick with. Get the 20 year AAA corporate bond from Yahoo. It is currently 3.2%. About one to two years ago, the bond rate was in the 5% range. As discussed in the previous section on bond rates, the low yield is going to give a high valuation. So do you use the 3.2% yield or something else? Since the other inputs use averages and the bond rate is bound to go up, the long term bond rate comes out to be 4%, which is why I have chosen to use it for the basis of this valuation. ● ● ●

Current Price: $33.49 Graham Formula @ 3.2%: $72.31 Graham Formula @ 4%: $57.70

See the difference in the values when different bond rates are used?

Applying it to Slow Growth Companies Although the Graham formula is meant for growth stocks, it works even better for low growth stocks. Take a look at American States Water Company (AWR). It is a utility stock with low growth prospects but pays regular dividends. The inputs used are:

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● ● ●

Super Duper Growth Stocks

EPS = $2.63 g = 7.8% Y = 4%

For a company to grow at rapid speeds, what does the Graham formula show?

Refer to the calculations in the screenshot below. ● ● ●

Current Price: $53.05 Graham Formula @ 3.2%: $53.31 Graham Formula @ 4%: $42.65

A hot stock like Netflix (NFLX) with an expected growth rate of 36%. Since Netflix has such high growth expectations, it is impossible to use an average. This is where you have no choice but to use the analyst estimates. The inputs are: ● ● ●

EPS = $1.41 g = 36.1% Y = 4%

If the valuation in today's environment was most important, then 3.2% bond rate shows that AWR is fairly valued at the moment. However, if you consider what bonds might do in the future, it is overpriced.

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●

● ●

Current Price: $223.52 Graham Formula @ 3.2%: $83.65 Graham Formula @ 4%: $66.92

Key Old School Value Subscriber Tips Practice makes perfect.

Regardless of whether I value Netflix for the present or for the future, the Ben Graham model has decided that Netflix is extremely overvalued.

Load different types of companies and look at how the valuation is affected based on the inputs you enter.

Out of curiosity, I wanted to see what growth rate the market is expecting from Netflix.

Understanding the inputs is the key to valuation success.

I will get into the details of this later, but by performing a reverse Graham valuation, using an EPS of $1.41 and bond rate of 3.2%, the expected growth comes out to be 108%! In other words, Netflix must be able to grow by 108% for the current stock price to be justified. Download this free excel spreadsheet of the Graham formula valuation and try it. Now go find three stocks. One that you believe is undervalued, fairly valued and over valued and test it out for yourself.

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What is the Intrinsic Value of a Business? So far, you have been introduced to two valuation methods. I want to break it up here with some background before diving into the more complicated valuation models.

Small companies can witness events occurring quickly, but for bigger companies like McDonalds, a Big Mac will taste like a Big Mac even if earnings come in lower or higher than expected.

This discussion ties in with how you should value stocks using the DCF model.

How to Value a Business

Valuing a Business, not a Stock

When it comes to the idea of valuing businesses, there is no one better to ask than Warren Buffett.

Learning to use all the valuation methods laid out in this book is fine and dandy, but there is one big theme I want you to recognize.

Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. - Warren Buffett

Each method focuses on finding the intrinsic value as if it were a business and not just a stock. As an example, let's say McDonalds' earnings tanked. Immediately, Wall Street will publish sell reports and how the company is doing horribly. But for the value investor, if the fundamental core of the business is operating strongly, then why worry? One bad quarter does not change the outlook of a business. A business does not survive from quarter to quarter.

This brings me to the discussion of the DCF valuation method used at Old School Value. The method is derived from F Wall Street with some adjustments. The main components to valuing a business using a DCF centers on: 1. 2. 3.

Finding the sum of the future cash flows Adding the excess cash Subtracting interest bearing debt

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The intrinsic value of a business in a broad sense becomes: Intrinsic Value = Present Value of Future Cash Flow - Excess Cash - Interest Bearing Debt

A Real Life Small Business Example To put it into perspective, toss aside the modern financial modeling hat for a second and think of yourself as a small business owner. The truth is that most small business owners do not understand financial statements or much about accounting beyond the basics. However, what the small business owner does understand is how much cash the business generates and what their business is worth. If you look in the local papers or do a quick search for businesses on sale on the internet, you will find a common theme in the asking price. Take a look at this example of a B&B in the state of Washington where I live.

The intrinsic value as defined by the seller is very simple. You have gross income to show how much the business makes in a year, net cash flow, inventory, real estate and FF&E (Furniture Fixtures & Equipment) aka PPE. These are assets that produce cash flow and anything remaining will then be added to the intrinsic value. Subtract any debt like bank loans and you get the formula highlighted previously. In business school, where valuation is taught as an absolute measure, you will fail if you value stocks like this, but valuation is an art and in the real world, this is how it is done. The next chapter will show you how this comes together.

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How to Value Stocks Using DCF Now let's dive into the technical side of a DCF model. There are many people against the use of DCF's. The main argument is that it requires too many input assumptions. This is only true if you do not understand the components and the makeup of a DCF. Do not do blind DCF's. By understanding each component of a DCF, you will be able to make accurate valuations and test ranges of values based on different scenario assumptions.

Disadvantages of the DCF 1. Projecting Future Cash Flow

2. Sensitive to Discount Rates The discount rate you use has a great impact on the final valuation. If you are unfamiliar with discount rates, it is a rate of return you desire by quantifying the importance of current value of cash versus the future value of cash. I encourage you to read this full explanation on discount rates. A discount rate of 6% could value a company at $114 per share. Increase it to 9% and it drops to $88.17. That is a big range and shows you that the higher the discount rate, the cheaper you want to buy tomorrows cash flow today.

The main weakness with the DCF is that you have to project the future cash flows far into the future.

3. Choosing a Growth Rate

How do you know whether a business will still exist 5 years later?

There is no way to accurately predict the growth rate of a company.

How can you predict the cash flow figure 10 years or 20 years out?

In fact, it is impossible and the same points made for projecting future cash flows applies here. Nevertheless, you still need to determine a growth rate to project future cash and to make the DCF work.

With such forecasting, a small error can result in big differences in the final DCF valuation.

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But there are Advantages

Getting That Discount Rate

It is not all doom and gloom for DCF.

You need to know what discount rate you want to use. After all, the word "discount" is in the name of the valuation method for a reason.

There is some art required to get good inputs, but the benefit is that it will give you a good estimate of intrinsic value. Remember the Buffett quote? The intrinsic value of a business is the sum of its future cash flows. That is exactly what a DCF model does. You can also use it as a quick sanity check because you can work backwards to figure out what the market is expecting. This is known as reverse DCF which you will get to in the next section.

The Real DCF Formula

Find the sum of the future cash flow of the business and discount it back to the present value. When a bank lends out money, the interest rate it receives is the discount rate. Remember that discount rate is another way of saying rate of return. How much do you want to earn investments?

off

your

If the bank and fed are risk free investments at 3%, then would you use 3% as the discount rate? No you would not because it would be safer and easier to buy treasury bills for a risk free return of 3%. Instead of trying to calculate it, here is a quick way of quantifying a discount rate.

This is the discounted cash flow formula.

Discount Rate = Risk Free Rate + Risk Premium Don't worry. It is easier than it looks. I will break it down to the following formula.

The long term risk free rate is around 4% which is what I prefer to use. Then decide how much you want to be compensated for investing in the stock market.

DCF = Present Value of Future Cash Flow + Non Operating Assets + Excess Cash - Interest Bearing Debt

For most situations, the risk premium is around 5% which makes the discount rate 9%. However, for

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small and micro cap companies, I prefer to increase the risk premium to around 8%. This means that I use 9% as a minimum for stable and predictable companies like Coca Cola (KO), while 12% is a good return for smaller and less predictable companies. What about WACC? I do not use WACC and other modern finance theories because it over complicates things. The approach I take is from a real world point of view. When you think of discount rates in terms of how real businesses operate, it is simple and it makes sense. That is all you need to get good valuation results. Remember it is all about finding the valuation range. Not whether your discount rate is accurate to the second decimal place.

Choosing a Growth Rate When it comes to growth, I err on the side of conservatism and place more emphasis on the present data rather than what will happen in the future. Do not purely rely on analyst growth rates for one year estimates. Wall Street and the reports they put out are too short term focused.

In the business world, the rearview mirror is always clearer than the windshield. - Warren Buffett To find a growth rate based on past performance, calculate the CAGR over multiple short term periods and then calculate the median of all those values. This will smooth out the data and eliminate any one time years that are either great or horrible. For example, in the OSV Stock Analyzer, the growth rate is calculated by taking the median over 5 years and 10 years. For the 5 year period, the CAGR rolling periods are ● ● ● ● ● ● ● ● ●

2007-2011 (4 year period) 2008-2012 (4 year period) 2007-2010 (3 year period) 2008-2011 (3 year period) 2009-2012 (3 year period) 2007-2009 (2 year period) 2008-2010 (2 year period) 2009-2011 (2 year period) 2010-2012 (2 year period)

Then take the median of all these values to get the median growth rate over the five year span. Apply the same concept over 10 years. This growth rate is then used to calculate the projected free cash flow.

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Terminal Value Once the FCF has been projected, you need to calculate the company's cash flows when the company enters

its mature stage grows at a slower pace. Since the terminal value is so far out in the future, it does not affect the final valuation by large amounts since the present value of cash 20 or even 30 years away is worth very little today. Keep it easy and use 2% or 3% for the terminal value.

Determining the value of non-operating assets is time intensive. Consider looking for this information once you find a company worth digging into and not right away.

Add Excess Cash and Subtract Debt Same with cash. There is cash that you need to run the business and cash that exceeds what the business needs. This non-operating cash does not help create cash flow and so it is classified as a non-operating cash, aka excess cash. Use the following formula to calculate excess cash.

Include Non Operating Assets For the final piece of the DCF, you want to find out what the public stock is worth by including nonoperating assets and subtracting the debt that bears interest. In other words, you are finding the equity value of the shares. A company uses assets to generate FCF. This can include buildings, equipment, chairs, phones and computers. However, there are assets that do not generate any cash flow. For example, a company may own a car park that is sitting in the middle of nowhere doing nothing. The property has value though. Such assets are referred to as non-operating and should be added back to the DCF calculation.

Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets) Subtracting debt is tricky because you need to use the market value of debt which is rarely available. Instead, calculate the present value of any long term debt.

Optional Additions to the DCF A more advanced DCF model involves a multi-stage approach. This is where several growth rates are used, instead of a single growth rate. The benefit in using a multi-stage DCF is that you can simulate the business cycle better.

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The OSV Stock Analyzer is a powerful 3-stage DCF and the inputs have been simplified for ease of use.

Here is the formula again with intangibles added. The brackets around intangibles is to show that it is optional.

Instead of guessing what the future performance will be, the model starts off with the default value for growth and then reduces it by 10% in years 4-7 and then reduces the growth rate further by another 10% in years 8-10. Thus the 3-stage approach.

DCF = Present Value of Future Cash Flow + Non Operating Assets + Excess Cash - Interest Bearing Debt - [intangibles]

The idea is to simulate the business cycle.

Discounted Cash Flow in Action Using the Stock Analyzer to load Microsoft (MSFT), the assumptions used for the DCF are as follows:

The last optional piece to include in the DCF is related to intangibles. If a discounted cash flow is designed to calculate the value of a stock based on cash producing assets, certain companies must have their intangibles added to get the fair value. Coca Cola (KO) outsells all other cola due to its brand recognition. By leaving out the intangibles, you will be missing out on one of the biggest cash generating assets.

● ● ● ● ●

Discount rate: 9% Growth rate: 10% Starting FCF: $27,522m Terminal rate: 2% Intangibles to add back: 10%

Microsoft is a very predictable cash flow generator. It is in the mature stage of its business cycle, so growth above 15% is unlikely. In fact, the growth rate over the past 5 years is 12.3% compared to a growth rate of 7.8% in the past 10 year period. By taking the average of the 5 and 10 year periods, I get my 10% growth rate.

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The FCF to end 2012 was $29,321m but the TTM number is $27,522m which is what I use as the starting point of the DCF. If the numbers were reversed, I would still start with the smaller number. The projected future cash flows looks like this. click to enlarge

.

For intangibles, I like to add 10%. You may think it is too little considering Microsoft is synonymous with Windows and Office, but even if I increase it to 50%, the difference in the stock valuation comes out to be a mere $0.15. The final DCF calculation shows the following:

● ● ● ●

Present value of future cash is $477,429m Excess cash of $74,483m Interest bearing debt of $8,701m Total Present Value of $543,534m

Divide the Total Present Value by the shares outstanding to get the final per share value.

The fair value is $65. Compared to the stock price of $33.67, the margin of safety then becomes 48%. Key Old School Value Subscriber Tips Download and follow along with this Stock Analyzer PDF report on Microsoft (MSFT). Look at the numbers and see how I use it in this example. Download this Free DCF Excel template here.

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How to Value A Stock with Reverse DCF The advantage of a reverse DCF is that it eliminates a lot of the inputs required in a DCF. Instead of starting with a given FCF, and then projecting towards an unknown, the purpose of the reverse DCF is to calculate what growth rate the market is applying to the current stock price.

Application of Reverse DCF Here are the details of the Lumber Liquidators reverse DCF valuation. Click the image to see the full size with notes.

By taking this backwards approach, it simplifies the DCF thought process and output from “what is the future growth rate?”, to “is the expected growth rate realistic?”. Take Lumber Liquidators (LL).

1. Start with the TTM FCF number

The current stock price is $80 and has climbed dramatically on the tailwinds of a housing market "recovery". Using a discount rate of 9% with the TTM FCF number of $35.2m, the required growth rate to come to a valuation equal to the stock price of $80 is 30%.

Enter the TTM value because you want to work backwards from today's valuation.

Is 30% a sustainable growth rate? In this particular industry? At the current lofty valuations, is there more upside or downside?

2. Change discount rate to 9%

Such questions are much easier to answer with the reverse DCF.

The current valuation is best represented by the TTM figures because the market is short term orientated.

You are looking for market expectations and a 9% discount rate best represents the historical average.

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3. Adjust growth rate Change the growth rate so that the fair value number matches the current price. This will show you what the market expectation for growth is. Remember that this is an approximation and a measuring stick to quickly see whether a stock is cheap or expensive. In the case of Lumber Liquidators, a 30% growth rate is unsustainable for a cyclical company. Lumber Liquidators could continue to go up but from a value investor's point of view, the current numbers and expectations are too lofty to merit an investment.

The Temperature Test

Cisco shows that with the TTM FCF and 9% discount rate, the expected growth priced into the stock price is -1%. Back in 2011, I calculated a growth rate of -9.6%. Although the market has eased up a little on Cisco, there is still pessimism and uncertainty surrounding the company. Is Cisco still cheap and worth further investigation?

When you walk into a room, it is obvious whether it is hot, cold, or comfortable. You do not need to concern yourself with knowing the exact temperature.

You bet, and the reverse DCF method will help you identify such stocks quickly so that you can focus on research instead of wandering around looking for companies to analyze.

Stock valuation is the same concept. The reverse DCF will help you with this as you can see in the next example.

Key Old School Value Subscriber Tips The reverse valuation section is the same as the DCF valuation section in the Stock Analyzer.

Identifying Cheap Stocks Lumber Liquidators is an example with high market expectations. Take a look at Cisco for an example of a company with low market expectations.

The only difference is how you enter the inputs.

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Katsenelson's Absolute PE Model This model is named after Vitaliy Katsenelson, Chief Investment Officer of Investment Management Associates, based in Denver. In his book, Active Value Investing, Katsenelson lays out a valuation model using absolute measurements instead of relative numbers. A relative valuation is where you value a stock by comparing it to other stocks. E.g. if company A has a multiple of 15x but a competitor has a multiple of 20x then company A is cheap. The problem with this is that it depends on the market conditions. In a recession, a company could have a multiple of 10x and be considered fairly valued or expensive just because a bear market pushes down all stocks. The Katsenelson approach assigns a company with PE "points" and then calculates the fair value by multiplying it with a final multiple factor. This is an absolute approach to remove the effects of market dependency and competitor bias.

Katsenelson's Absolute PE Model The model derives the intrinsic value of the stock based on the following five conditions. 1. 2. 3. 4. 5.

Earnings growth rate Dividend yield Business risk Financial risk and earnings visibility

Like all valuation models, there is some subjectivity involved. In this case, you are required to grasp an understanding of the business to identify the level of risk involved for points 3, 4 and 5.

Core Idea of the Absolute PE Model No Growth PE Part of the reason why I created the no growth PE screen was for the purpose of this valuation method. I needed to know whether my conservative nature of using a PE of 7 for no growth was factually correct. My results show that a PE range of 7 to 8.5 is perfectly acceptable so you are free to use whatever suits you.

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Graham used 8.5 in his growth formula, and Katsenelson uses a PE of 8 in the book. I will stick to a PE of 7 because if you flip the PE over, the earnings yield is 14.2% compared to 11.8% and 12.5% for Graham and Katsenelson respectively. With the small caps I analyze, demanding an earnings yield of 14.2% is better than 11.8%. However, if I analyze large blue chips such as Microsoft, I am content to adjust the PE to 8.5.

Earnings Growth and PE Relationship Instead of calculating growth projections, Katsenelson's Absolute PE method reverse engineers the PE ratio to come up with a growth rate according to the table on the right. The table has been adjusted to have 0% growth for stocks with a PE of 7 and below. The "Original PE" column is what is used in the book. For every percentage of earnings growth from 0% to 16%, the PE increases by 0.65 points. Once the growth rate reaches a certain level, in this case 17%, the PE value increases by 0.5 points and maxes out at 25% growth. So any stock with a PE higher than 21.9 is capped to a 25% growth rate.

The Value of Dividends Dividends are tangible to the investor whereas earnings are not. Dividends provide you with a hard return whereas you may never get to see earnings.

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In contrast to the non-linear points relationship between earnings growth and PE in the table, the dividend yield and PE has a linear point system. Every dividend yield percentage receives an equivalent PE point. If the dividend yield is below 1%, give a bonus of 0.5 points.

PE Factors for Business, Financial Risk and Earnings Visibility This is where some subjectivity is involved as it requires you to come up with a single number to summarize the risks and earnings visibility. For business risk, you want to consider the industry the company is in, the products, the life cycle, concentration of products and customers, environmental risks, and anything else related to the operations of the business. The level of financial risk can be determined by examining the capital structure of the business as well as the strength of the cash flow in relation to debt and interest payments. Earnings visibility is analyzed in way.

much the same

How Business Risk is Quantified In order to quantify business risk, I went through various ratios and numbers to identify what makes a business good. Everybody has a different definition of business risk, but what I have tried to do is come up with four items that the majority of investors would agree to. The four are: 1. 2. 3. 4.

Return on Equity Return on Assets Cash Return on Invested Capital Intangibles % of Book Value

The first three are self explanatory. Businesses capable of sustaining above average returns or increasing returns each year has a good business model, moat, and capable management. The fourth needs some explaining. I have added intangibles as a percentage of book value because I do not want businesses to grow by acquisition which could lead to issues later on. Growth through intangibles is not a good business model and has no competitive advantage. High intangibles do not reflect business risk, but

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continually growing intangibles is a red flag.

How Financial Risk is Quantified The four factors that make up financial risk are: 1. 2. 3. 4.

1. 2. 3. 4.

Gross Margin Net Margin Earnings Cash from Operations

For a company to be predictable, it has to have stable margins, stable or increasing earnings and cash from operations.

Current Ratio Total Debt/Equity Ratio Short Term Debt/Equity Ratio FCF to Total Debt

A company with a strong current ratio does not run the risk of going under. Total debt/equity and short term debt/equity is included because total debt may not give the whole picture. A large upcoming debt payment is much more worrisome than a low interest, long term debt due in 10 years. FCF/Total Debt displays the financial strength because it shows whether the company is able to pay back its debt through FCF instead of taking on new debt.

Earnings Predictability Trying to quantify earnings predictability is more difficult, so it is best to keep it as simple as possible.

As much as I like FCF or owner earnings, I do not use it for this valuation model as it is volatile and not a good measurement for predictability.

The Absolute PE Formula The formula to calculate the fair value PE is Fair Value PE = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)] where the Basic PE is the starting PE from the table. Business risk, financial risk, and earnings visibility scores are calculated automatically in the Stock Analyzer. However, to do it manually, follow these quick hand instructions.

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For any stock you look at, it will fall into one of three categories. Average, above average, or below average. For each of the three business quality factors, ● ●

●

if the company is an average company, give it a value of 1. if the company is a market leader, select a number less than 1. If you believe a market leader deserves a 10% premium, then use a value of 0.9. If a 15% premium is deserved, then 0.85 is the number to use. if the company is a market lagger, select a number greater than 1. Poor companies should be discounted and so by giving it a higher number, it will minus some points in the final calculation. E.g. a stock is in horrible shape and cannot pay its bills, then you may want to give it a 20% penalty for financial risk. For this, you would assign a value of 1.2.

Checking Out Wal-Mart Starting with Wal-Mart (WMT), the company rules retail and its competitors. Strong balance sheet, huge competitive advantage capable of swallowing any small competitor. Consistent dividend payouts, FCF cow, stable margins, CROIC of 9% with ROE of 20+% makes

this one of the best retailers in the world. Debt is not an issue as FCF can cover all interest payments. It also makes earnings growth and visibility easier to determine. Based on the past 5 year median EPS growth, WalMart achieved 11% earnings growth which sounds about right. Although WMT is the best of breed, it only gets a 6% premium for the business as retail is still a tough industry to be in regardless of who you are competing against. The financials are wonderful. The balance sheet is powerful and extremely efficient. Wal-Mart leads the competitors easily and deserves a 10% premium over its competitors. For earnings visibility, Wal-Mart scores an 8% premium to competitors. It loses a couple of points from down years, but other than that, the company is very easy to predict. Combine all this together and the inputs for the Absolute PE valuation become: ● ● ● ● ●

Expected Earnings Growth: 11% Dividend Yield: 2.5% Business Risk: 6% premium = 0.94 Financial Risk: 10% premium = 0.90 Earnings Visibility: 8% premium = 0.92

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CROIC average of 6%. ROE of 18% and no issues with debt or financial risks. Earnings growth has been a lackluster 5% and likely will be the same. ● ● ● ● ●

Expected Earnings Growth: 14% Dividend Yield: 2.50% Business Risk: 3% premium Financial Risk: 5% premium Earnings Visibility: 5% premium

For a great business such as WMT, the fair value PE comes out to 21.65. However, since WMT is in the retailing business, a business risk of 1.00 could have been applied due to the competitive nature of the industry. As a rule, apply a maximum premium of 30% to the basic PE which means that the final fair value PE should be capped at 22.35. According to this calculation, Wal-Mart is priced attractively with its current PE of 14.69 with room to move up if the business continues to operate strongly.

Comparing with Target Target (TGT) is number two behind Wal-Mart. Margins are solid and consistent, with a sub par

The fair value PE of 21.2 gives an expected future growth rate of 23% compared to the current expected growth of 14% and adjusted PE of 18.7. Some room to move, but the margin of safety is slim.

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An Example of a Bad Company

Summing Up

Both Wal-Mart and Target are great companies. On the other side of the spectrum is RadioShack (RSH).

The advantage of using this method is that you do not have to value the company based on another company's multiple.

Unlike Wal-Mart and Target, RadioShack is a consumer electronics goods and services retailer struggling to turn a profit. It is loaded with debt and does not have a PE as earnings is negative.

The disadvantage is that the calculation uses the current PE as the anchoring and starting point of the valuation. If the PE is already high, and the business fundamentals are strong, it will add on more points to the already overvalued PE.

In a situation like this, the Katsenelson model will not work because the adjusted base PE is zero to begin with. See the image below to see why.

To improve on this and to be able to apply it for companies with negative earnings, you can try substituting PE for EV/EBIT, EV/EBITDA or another variation. One important point to end with is that you need to have a systematic way of quantifying the business risk, financial risk and earnings predictability. It is too easy to randomly apply a premium based on what you feel the company deserves. Having a set of rules and systems will keep the way you value companies consistent and prevent bias. Key Old School Value Subscriber Tips If the starting growth rate is too high, don't be afraid to adjust the "Expected PE" box for a value more inline with what is expected.

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Valuing Stocks with EBIT Multiples Although the downside of relative valuation was described in the previous chapter, there are times where it is useful for valuing stocks. The important part is to know how to perform a relative valuation properly, and not just slapping on a multiple to come up with a fair value. PE multiples are thrown around a lot when talking about stocks, but the better way to value stocks is to use EBIT multiples. EBIT: Earnings Before Interest and Tax. Difference between EBIT and EBITDA? EBIT recognizes that depreciation and amortization are real expenses related to the use and wear of assets.

If DELL corrects their problems, it should trade at similar multiples to its competitors. Therefore DELL is worth $18. Keeping things simple is important, but it should not be simplified to the point where it becomes garbage in, garbage out. Problems Doing it This Way The problem is that PE is a broad metric which can vary greatly depending on adjustments to the income statement. Such adjustments are: ●

How People Perform Multiples Valuation The All Too Common Way

●

Have you heard or read something like this?

●

DELL is trading at a PE of 10.6x with a Forward PE of 8.7x. Its competitors are trading between 9x to 14x.

goodwill charges: this can reduce earnings drastically even though it does not affect the business operation income from discontinued operations can inflate PE share repurchases: reduces the number of shares outstanding which increases the EPS

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Doing it the EBIT Way

Valuing DELL with EBIT Multiples

First, start with a normalized revenue estimate. To get a normalized revenue value, take the average revenue over anywhere from 3 to 5 years, depending on the history of the company.

DELL makes for an interesting case study because it is in the middle of a buyout with several big investors coming up with their own valuation targets.

Multiply revenue with a conservative, normal and aggressive operating margin to get the range of EBIT values. Then decide what multiplier you want to multiply the EBIT value by. A normal case multiplier is considered to be between 8-10. Now add cash and subtract debt to get the total equity value. It is that easy, and that is the attractiveness of the multiples method. Use the online EBIT calculator to see the details of what inputs are required in the calculation. The EBIT multiple valuation also makes it easy to perform a sum of the parts analysis. If a company has several subsidiaries or operating segments, you can perform a EBIT valuation for each segment and then add it up to get the total equity value.

● ●

●

Michael Dell will buy out DELL at $13.36 Carl Icahn has come out and said that he wants DELL to issue a $9 special dividend because he values it at $22.81 Jim Chanos has revealed that he is short DELL going into the deal citing issues with the balance sheet and cash flow. (In other words, he does not think it was worth $13.65)

Three different valuations. Three different scenarios. Let’s jump straight into the numbers and see how this works. The numbers and assumptions used for the normalized case are: ● ● ● ●

normalized revenue over 5-6 years is $59b normalized operating margin of 5.3% fair value EBIT multiple of 8x add cash and subtract debt

These numbers result in the following valuation.

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The three fair value targets are: ● ● ●

conservative fair value of $10.87 normal case fair value of $16.51 aggressive fair value of $21.12

Although Jim Chanos has not revealed his target price, it will likely be closer to $10 which is the lower end of the range. Michael Dell is hovering below the normalized value to get a cheaper deal than the fair value. Current news has Michael Dell not budging on his buy out price. Carl Icahn is the optimistic and aggressive investor of the group. But this example should give you an idea of how to value a business using EBIT multiples. Coming up with the EBIT multiple is the hardest part and this is where you will want to compare to a competitor to find a fair EBIT multiple. The numbers for cash and debt came from the Stock Analyzer and verified against the latest 10-K. Free EBIT Multiple Calculator Use the EBIT Multiple Calculator for free today.

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What is Asset Reproduction Value? Calculating the reproduction value of a company's assets is the first part of the Earnings Power Valuation. But what does it mean to find the cost of reproducing an asset?

replicate the brand recognition. Coca-Cola's intangible value may be listed as $1b on the balance sheet, but for any new competitor, it will have to spend in excess of that to build momentum and market penetration.

Reproduction value looks at how much it will cost a competitor to purchase the assets required to run a competing company.

To really understand the details of asset reproduction, let's dig into National Presto's (NPK) 2010 annual report.

As an example, based on book value, machinery and equipment could have been depreciated over 5 years and is now worth $1m on the books compared to the purchase price of $2m. However, a competitor will have to pay $2m to purchase the same equipment. Not $1m. There are several items like this in the balance sheet where the current value may be more or less than what is required for a new entrant.

Key Old School Value Subscriber Tips You can adjust values in the balance sheet by going to the EPV valuation and using the "Adjustment" section. There is an adjustment section for both assets and liabilities.

Another quick example is brand recognition. For a new cola beverage company to compete with CocaCola, a huge amount of money must be spent to

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1. Make Adjustments to Current Assets Start by grabbing a copy of National Presto's 2010 annual report or load the latest numbers for National Presto into the OSV Stock Analyzer. Using National Presto's numbers, I have organized the data into the following format showing the book value and the adjustment amount.

Cash and market securities will always be 100%. Cash is what it is. No more, no less. You need to add the doubtful reserve to accounts receivables. A competitor will not have the luxury of being able to perform at the same level without a doubtful account for A/R. Inventory is increased by $4.2 million because National Presto uses the LIFO inventory method. Restating it in terms of FIFO results in an increase of $4.2m. Quick Tip To see whether LIFO or FIFO is used, do a search in the 10-K using CTRL+F and type in "LIFO" or "FIFO". Deferred taxes. National Presto expects to receive $6.3m from overpaying taxes. This 2010 report was released at the end of its fiscal year so at the time this report came out, I am assuming that the company received a quarter's worth of deferred taxes.

The only adjustments made were to accounts receivables, finished inventory and deferred tax assets.

$1.6m is a quarter of the deferred taxes ($6.3m/4), so subtract $1.6 from the original amount to represent the adjusted value of $4.7m No adjustments to other current assets.

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of depreciation to buildings and it will be worth more than what is stated on the balance sheet.

2. Make Adjustments to PP&E

To take your analysis one step further, you could get an appraiser to value surrounding land and property to determine how much you should adjust the value. Basic PP&E is $58m but as you go through the report, you will realize that it is worth more. Qualitative research is required to properly identify whether assets are over or undervalued. Thankfully, National Presto is very easy to analyze because the company provides all the stated and adjusted values in its report. The 2010 value of PP&E was $58m, however, $49m was deducted for accumulated depreciation. Depreciation is a non-cash expense so when you add it back in, the adjusted value is $107m. National Presto is over 100 years old. This means that they have assets that have been written off to zero. However, it will cost a competitor to own those same assets. National Presto owns land and buildings and uses a straight line depreciation method giving 15-40 years

A quicker and cheaper way is to perform online searches on real estate services like Zillow to get estimates. According to the 2010 report, NPK has a facility where 314,000 sq ft is used for industrial purposes, and 140,000 sq ft is used for offices. Commercial property searches show that value of industrial buildings are much cheaper than offices. In Wisconsin, where its building is located, industrial buildings go for a range of $2 – $5 per sq ft compared to $7 – $12 per sq ft for office buildings. So you can do something like 314,000 x $5 + 140,000 x $12 = $3.25m for this facility. Repeat for other buildings and land values and then continue making those adjustments. Machinery and equipment in National Presto's business is very specialized. In a liquidation event, highly specialized equipment will be discounted as the number of buyers are limited.

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The demand will also be much lower compared to common high end equipment like photocopiers. But as an ongoing asset, National Presto's equipment is expensive and requires a competitor to pay the full price in order to do business.

3. Make Adjustments to Goodwill

For National Presto, R&D is negligible but it does have important patents for its housewares/small appliance business. The housewares segment make up 30% of revenue and its patents protect that revenue to a certain degree. I have assigned a value of $2m for its patents which is a conservative amount compared to the revenue. National Presto sells its products through distributors and there are no long term contracts set with any of their buyers. I do not see any monetary value here. If you are a big company and you have good products, it is easy to get distribution. Competitors can replicate their distribution channel easily.

The next move is to adjust for goodwill which is trickier. To do it properly, it is important that you learn and understand the business. Goodwill means that a company has overpaid to buy another company. What the additional cost does not specify is the relationship with customers, the brand image, network effect, patents and other skills that cannot be valued on the balance sheet.

The Absorbent Segment requires in-depth know how and special training to operate the machines and to maintain quality. It costs money and time to train employees to ensure that product quality meets specifications and orders.

This is why you need to know the business. It is up to you to think things through and adjust for special cases.

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$2m in value for this skill is a small yet fair amount.

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4. Complete Asset Side Adjustments After completing steps 1-3, the total adjusted asset side of the balance sheet is shown below.

By going through the line items of the balance sheet, it forces you to think about all aspects of the business. You start with a broad view and then with each line item, you try to break it into smaller pieces. The end result of doing this exercise is to find hidden value the market may be overlooking. The process is quite long, but once you practice and find yourself in a rhythm, it will become quicker and easier. The Stock Analyzer will also help with this. Now let's move on to the liabilities side.

Adjusting the Liabilities The accounting definition of the balance sheet is Assets = Liabilities + Equity but the business definition of a balance sheet is Liabilities and Equity are the sources of funds that support the assets. You have the asset reproduction value, but a new business will not pay the same amount. That is because a business has debt. Just like what you saw on the asset side, the same adjustments have to be applied to the liabilities side. Do not subtract total liabilities because you only need to exclude the liabilities that do not support the assets.

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Bruce Greenwald, calls these types of liabilities "spontaneous" and "circumstantial liabilities" as a new entrant is not subject to the same cost.

Circumstantial Liabilities

Spontaneous Liabilities or Non Interest Bearing Debt

Examples include

Liabilities of a company that are accumulated automatically as a result of the firm’s day-to-day business. Spontaneous liabilities can be tied to changes in sales - such as the cost of goods sold and accounts payable. These liabilities can also be “fixed”, as seen with regular payments on long-term debt. - Investopedia Other examples include accounts payable, deferred taxes and accrued expenses. Such liabilities that occur due to day to day operations is not required by a new entrant. Remove such values from the reproduction value to get an accurate picture of the final value.

As the name implies, circumstantial liabilities are incurred by circumstances in the past.

● ● ●

paying penalties for insider trading lawsuits from former employees inventory catching on fire

Remove these liabilities as it adds no value to assets. A competitor is not required to pay for these circumstances to start a competing business.

Subtract Cash not Required to Run the Business The final step to calculate the reproduction value is to subtract cash that is not required in the business because you want to value the assets based on how much a competitor will pay for the same things today. As a rule of thumb, it costs about 1% of sales to run one year of operations so the remaining 99% of cash can be subtracted.

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growth expectations, which you can consider as the “speculative” value making up the stock price.

Final Net Reproduction Value Net Reproduction Value = Adjusted Asset Value - Spontaneous & Circumstantial Liabilities - Cash not Required in Business

So far, National Presto was a very straightforward example. The company is shareholder friendly which is evident in the way the financial data is presented. Other companies will be more difficult because the required information may be buried deep in the report.

The final value comes out to $669.2m - $66.7m (spontaneous) - $4.5m (deferred tax liability) - $4.8m (1% of sales) = $593.2m (Net Asset Reproduction Value) National Presto's asset reproduction value comes out to be $593.2m compared to its book value of $426.5m.

Putting it Together On Dec 31, 2010 at the time of the annual report, the stock price was $130 with 6.86m shares outstanding. ● ●

Market valuation of equity: $889m Enterprise value: $955.7m

If you try the same exercise for a company like Groupon (GRPN), you will see that the adjusted balance sheet will be considerably lower than what is stated on the books. This will be the same for companies that are asset light such as software and services companies. As a final tip, compare the net reproduction value to the market cap and enterprise value. If the reproduction value is close to the market cap, the market is pessimistic towards the stock and that is where you can find hidden value. Further Reading

Both book value and net reproduction value made up about half the market value. This means that half the stock price was supported by the assets. The remaining half of the stock price was made up of

● ●

Liz Claiborne Asset Reproduction Sealed Air Valuation Case Study

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The Full Earnings Power Value (EPV) There are really two parts to Earnings Power Value. Asset reproduction and the EPV itself. To fully grasp the entire method and concept, be sure to have a good understanding of the asset reproduction chapter. To help you see how both net asset reproduction and earnings power value go together, let's go through the asset reproduction of Microsoft and then follow that up with the EPV calculation. This way you can see how the numbers relate to each other and how you should interpret the calculations. If you feel this is too much repetition and wish to skip it, jump to the EPV calculation section.

Reproducing the Assets of Microsoft Company PrintyInk is in the business of selling ink for printers and has a market value of $1m. But when you look at the assets, the company assets are worth around $500k. By performing the asset reproduction, you should be able to determine what it will cost you to do business competing with PrintyInk. That cost is going to be $500k. Now look at Microsoft. Take a step back and think about its products, brand, moat, scale, marketing and more. How much will a competitor have to realistically pay in order to enter Microsoft's market?

Key Old School Value Subscriber Tips Load MSFT into the Stock Analyzer and go to the EPV section. Follow along with the latest numbers because the process is still the same.

It has a huge OS market share, Office suite, internet explorer, the name Microsoft is synonymous with the term PC, they have MSN, Bing, Skype and more. Microsoft has huge names and a huge moat. Because there are so many strong assets, in the balance sheet adjustment, there is no need to subtract anything from Microsoft's balance sheet.

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The only adjustment I made was to reduce goodwill by 50% because I know that Microsoft have not made the best decisions regarding prices paid for acquisitions.

Include Marketing and R&D The next step is to realize that Microsoft has value coming from its marketing and R&D. No competitor will be able to compete if it does not try to spend money to increase brand awareness or on R&D. The competition has to acquire the best talent to develop world class software products and that costs money. The amount of marketing added back to the asset value is calculated by: Taking the 5 year average of SG&A as a % of sales and then multiply that number to the current sales figure. Do the same thing with R&D but for Microsoft, more weight is given to their R&D capabilities as a valuable asset. The easy way to do it for R&D: Take the sum of the past 3 years of R&D and then take 80%.

The adjusted total asset is now $126,764m.

These are rules of thumbs applied for Old School Value subscribers but I recommend testing your own rules.

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The Ultimate Guide to Stock Valuation

on carriage licenses and other network equipment and licenses that will not appear on the balance sheet. Such costs may be a liability when valuing the business as a standalone, but when considering what a competitor will have to pay, it should be included.

Subtract Non Interest Bearing Debt and Unneeded Cash To calculate cash not required in the business, you can use the excess cash formula from the DCF valuation chapter.

Add the marketing and R&D value of $20,290.4m and $21,413.6m to the adjusted asset value of $126,764m. This equals $168,468m. Another note to remember is that off balance sheet liabilities are liabilities, but a significant part of that will also have to be reproduced by a new entrant in order to start business.

The other alternative is to follow the rule of thumb from the book Value Investing from Benjamin Graham to Warren Buffett and Beyond. Unnecessary Cash = Cash and cash equivalents - 1% of sales If 1% of sales is greater than cash and equivalent, use a value of zero.

Take home shopping company, HSN, as an example. On the surface, it may be a another home shopping channel, but for a new competitor to enter the market the company will have to spend money

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The Ultimate Guide to Stock Valuation

Subtract non-interest bearing debt and excess cash to get the net reproduction cost of $68,748m which is equal to $8.22 per share.

Key Old School Value Subscriber Tips You can view all the details and formulas for every valuation model and metric. To view the EPV details, right click any of the tabs and select unhide. Then select "EPVData" from the list to see the behind the scenes of the EPV model. Step 1: Start with EBIT from the income statement. The year ending 2012 EBIT is $22,647m.

Earnings Power Value Calculation What is EPV? EPV is a technique for valuing stocks by making an assumption about the sustainability of current earnings and the cost of capital with zero growth assumptions. The formula is simple. The tricky part is performing the income statement adjustments.

Look to see if there are any one time charges that you need to add back. From the financial report, there is a one time goodwill impairment of $6,193m which needs to be added back. This makes it $28,840m so far. Step 2: Add a certain percentage of SG&A and R&D back to earnings. Keep it simple by adding back 25% for both.

EPV = Adjusted Income / Cost of Capital To get the adjusted income, the best way is to use averages, but for the sake of keeping this simple, I will use the latest numbers.

25% of SG&A: $4,606.5m 25% of R&D: $2,452.8m The Adjusted EBIT is now $35,899.3m.

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The Ultimate Guide to Stock Valuation

Step 3: Apply a tax rate to the adjusted EBIT. Since EBIT is earnings before interest and taxes, account for taxes and it simply becomes earnings. The tax rate in 2012 was 23.8%. Multiply the tax rate to the Adjusted EBIT and the Adjusted Earnings After Tax is $27,3553m.

Step 6: Divide the adjusted income by the cost of capital. Cost of capital is also another term for discount rate. In the EPV, since zero growth is assumed, a 9% cost of capital is a good figure to use. EPV = $26,067.7 / 9% = $248,964.2m

Step 4: Add back a percentage of Depreciation and Amortization.

This number represents the value of the company based on current earnings and ignoring growth.

The best way to do this is to be familiar with the business and industry to accurately assess the equipment needed and how fast it loses value.

Step 7: Add cash and subtract debt.

The rule of thumb here is to add 20% of D&A. By adding 20% of D&A, the adjusted income is now $27,948.7m.

Cash is the previously.

unnecessary

cash

mentioned

Unnecessary Cash = Cash and cash equivalents - 1% of sales Only consider interest bearing debt only because

Step 5: Subtract maintenance capital expenditures. Companies rarely give out the details of maintenance capex, which is what you need. Follow this link to see how to calculate maintenance capital expenditures. Following the steps in the above link, the 2012 maintenance capex comes out to be $1,881m. Adjusted income is now $26,067.7m.

Key Old School Value Subscriber Tips Calculating maintenance capital expenditures is an advanced task. The Stock Analyzer takes the average maintenance capex to give you the best possible number.

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The Ultimate Guide to Stock Valuation

other types of debt may not be relevant to a new competitor as interest bearing debt represents the debt that is applicable to run the business.

Here is a chart that explains how to interpret the relationship between EPV and reproduction value.

The guide for calculating interest bearing debt is Interest Bearing Debt = Notes Payables or Short Term Debt + Current Portion of Long Term Debt + Long Term Debt + Capital Leases This is just a quick rule of thumb for when you use the Stock Analyzer or other financial sites such as Morningstar. When you combine all this, the final EPV numbers look like this.

Tying it All Together When I performed the same valuation in 2009, Microsoft had an EPV in the $22 range. In 3 years, the value of Microsoft has doubled thanks to the large moat identified by the EPV. The EPV per share value is $39.25 compared to an asset reproduction value of $8.22. What does this mean?

By using the EPV, you get an idea of the company's moat as well as a snapshot valuation of the company today which is beneficial in helping you answer what type of expectation the market is pricing in to the stock price.

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The Ultimate Guide to Stock Valuation

Your Valuation, Your Art, Your Way You now have the tools and knowledge to value and understand the value of a stock in 8 different ways. With the new skillset you have access to, go crazy with stock valuation. The more you apply it, the better your art becomes. Just like how a master artist has many techniques and tools to create his final piece, do not limit yourself to using just one valuation method. Broaden your views and value stocks from different angles. ● ● ●

A stock may look horrible from an earnings basis, but the cash flows could be fantastic A stock has an asset loaded balance sheet but zero growth expectations A stocks earnings growth is exponential but it is bleeding cash and diluting shareholders

Key points to remember: ● ● ● ● ● ●

Valuation is an art. There is no single or perfect way to value stocks. Be a realist. Not a pessimist or optimist. You make money by being realistic. Value the downside and upside. Consider the range of possibilities. Value stocks like businesses. Look at cycles, history, business strength. Keep it simple. The best ideas are sometimes the most obvious. Empower yourself to take control.

Three different types of stocks, three different views and three valuations are needed. My hope is that you will keep this book by your side and use it as a guide and a tool to value each of these different scenarios and more.

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The Ultimate Guide to Stock Valuation

Top 7 Books on Valuation and Analysis For further reading, I have included a list of my top recommended books on the topic of valuation and financial analysis. The type of investment books I really love to read, recommend and continually reference are books that are practical and timeless. They require a slower reading pace to absorb the information and more thought and attention, but the stellar lessons contained in these books will launch your investment prowess to another level. The books are recommended in order of difficulty.

[Easy] 1. Why Are We So Clueless About the Stock Market A very good primer for new investors to the world of investing, accounting and financial analysis. This is one of the best investing books that introduces you to what value investing is all about. Start off with accounting basics, how all three statements work and come together and then look at the way the stock market works and how stocks are valued. Detailed, easy to understand and well written in plain english. Definitely a book I recommend to new investors or anyone wanting to learn what value investing is all about.

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The Ultimate Guide to Stock Valuation

[Easy] 2. F Wall Street If you are looking for a book to take you through the fundamentals of valuing stocks, what to look for and a practical way to understand financial analysis, F Wall Street is the right book for you. The book does a fantastic job of making difficult concepts easy to understand. Everyday examples are used to help you understand how to value businesses. After reading the book, you will appreciate looking at stocks like a business owner. There is also a section dedicated to portfolio management making this a solid investment book to keep in your library.

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[Intermediate] 3. Financial Statements: Step-by-Step Guide to Understanding and Creating Financial Reports Financial statements, is as the title suggests; all about financial statements. It is an accounting book that takes you through the basics. Easy to understand and follow. What more could you ask from an accounting book? If you read and understand the concepts from this book, you can understand the numbers in the 10-K and pass any accounting course as a bonus. In fact, why take an accounting course for several hundreds or thousands of dollars, when this sub $20 book will do more for you?

The Ultimate Guide to Stock Valuation

[Intermediate] 4. Active Value Investing This is the book that describes the Absolute PE model. Active Value Investing can be broken into two parts. The first section discusses economics and macro events. The second part details value investing concepts, strategies and valuation. As a value investor, the second part of the book really shines where you learn about the author’s investing framework of QVG (Quality, Value, Growth) and introduces in detail the Absolute PE valuation method. Get this book if you want to learn more on qualitative research and combining it with quantitative assessment.

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[Difficult] 5. Value Investing: Graham to Buffett and Beyond The book on Earnings Power Value. To get through it, it requires a lot of knowledge and confidence in number crunching, accounting and working through financial statements. It is best that you read the easier books and gain confidence before tackling this one. It is very detailed and dry and I do not want you to give up in frustration. As difficult as it is, it is still one of the best investment books on valuation and how you should approach the subject from the qualitative side as well.

The Ultimate Guide to Stock Valuation

[Difficult] 6. Quality of Earnings

[Difficult] 7. Financial Shenanigans

My favorite investment book to date. I reference it all the time.

Rounding up the list is Financial Shenanigans.

From this book, you will learn how to interpret the financial statements from an investors point of view and learn ways to determine the true quality of earnings.

This book is a gem. It is very detailed, thorough and practical. This book will teach you the ins and outs of the accounting games that companies play to either confuse or trick investors.

Instead of relying on what the income statement says, you can apply the methods taught in the book to interpret it in a new light and discover patterns to determine earnings quality of a business.

The information in this book is so good that business schools use it as class text.

The book is full of useful and practical lessons you can start applying immediately. The print is quite old so you can pick up a cheap copy for a few bucks online.

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You have to have a very good understanding of accounting and financial statement analysis for this book to be worthwhile. If there is one book that will immediately take you to another level in investing, it is this one.

About the Author My name is Jae Jun, a value investor, founder of Old School Value and creator of the OSV Stock Analyzer.

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Like you, investing is my passion.

Would you like to save time by quickly finding and valuing stocks?

I started my investing journey after losing $3,000 due to bad advice from a financial advisor. At the time, I had just graduated and was starting my first full time job as an engineer, so it was a lot of money. Long story short, I found a book called the "Intelligent Investor" and was introduced to the school of Graham, Buffett and beyond. I never looked back.

Would you like to make more money in the stock market?

Would you like to make better decisions and avoid disaster stocks? If you answered Yes to any of these questions, check out Old School Value and see how the Stock Analyzer can help you. Email: jae.jun [at] oldschoolvalue.com

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