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How To Determine The Intrinsic Value Of Any Company (Part 5)

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As you can see the calculation itself is fairly simple and straight forward. What is not easy when it comes to doing Intrinsic Value calculation is doing the fundamental research and figuring out which inputs to use.  A slight deviation in any of the variables above can have a huge impact on your overall Intrinsic Value calculation and your subsequent valuation estimate.   

For example, are you 100% confident in your management team analysis? Are you sure they will be able to turn the company around? Is your estimate of $0.50 EPS in 2015 and a growth rate of 11% thereafter really valid or is it full of holes?  Are you sure the company turns around and what about the competition?

These are the real variables and the real questions that determine the Intrinsic Value. Yet, none of them can be known with 100% certainty. They can be very well researched and you can make very accurate estimates, but they are not exact. In many cases these are guesses at best.  That is the point I want to drive home. You will NEVER have an exact Intrinsic Value, it will always be an estimate.

That is why Margin Of Safety plays such an important role. Let’s say you have worked very hard on determining RadioShacks Intrinsic Value at $10.72. With today’s stock price of $3.75, it gives you a 70% Margin of Safety. That is exactly what you are looking for. This type of a large margin of safety will protect you on the downside should your analysis fail to deliver.

If the management team has failed, if the growth rate or the P/E ratio don’t materialize the chances of this stock going much lower is small. Why? Because it is already selling at 70% discount from what a reasonable fundamental research and valuation work indicate. Should you make a mistake your losses will be limited. Yet, should the company surprise to the upside your return will be significantly higher. A low risk and high return setup.

Can the stock still go to zero? Absolutely. The company can still fail and file for bankruptcy, but if you have done your work right and continue to follow the company on the daily basis you should be well aware of that long before it happens. That is what value investing is all about. Finding these undervalued gems, doing a lot of fundamental research, valuing companies and trying to identify investment opportunities that sell well below their intrinsic value. That in return provides you with a low risk and a high return type of a setup.

Chapter Summary:   If you take anything away from this section of the book, take away the fact that no Intrinsic Value calculation can be exact. Even complex models used by investment banks and Quants yield best guess estimates.  There are just too many unknown variables that depend on future events that comprise the calculation.  

That is why you will be very well served by doing your own fundamental research and concentrating on stocks that provide your with the biggest margin of safety and plenty of upside.  

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How To Determine The Intrinsic Value Of Any Company (Part 4)

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With that said, let’s take a look at our previous  example, RadioShack,  for clarification.

  • Stock Market Price: $3.35 (Oct 18, 2013)
  • Current EPS (Earnings Per Share): $-2.71 (EST $0.50 in 2015)
  • Estimated Future Growth Rate:  11%
  • Weighted Average Cost Of Capital (WACC): 7%
  • Average P/E (Price/Earning) Ratio To Use:  14.8

RadioShack presents us with an interesting real life valuation example that you will run into more than you can imagine. Particularly if you are looking for cheap value oriented stocks.  First, you will notice that last year EPS were negative. 

Well, we cannot perpetuate negative earnings into the future in order to determine Intrinsic Value. Earning have to be positive.  In addition, negative earnings means that you do not have a workable P/E ratio to use in our formula. That is where fundamental analysis comes in so handy.

It is obvious that RadioShack is going through a rough time and its stock price reflects it.  If this continues,  in the not so distant future RadioShack is likely to be filling for bankruptcy.  Yet, if the company is able to turn itself around and grow again, the stock price will appreciate significantly….providing investors with large gains and very little risk.

Let’s assume that your in depth fundamental analysis has yielded the following points (this is done for valuation explanation purposes and NOT  based on the real life analysis of RSH).

  • The new and highly experienced management team has taken over operations.
  • The new management team has put forth a plan that you believe they will be able to execute.
  • Based on your fundamental research you estimate that the company will turn around and earn  EPS $0.50 in 2015.
  • Thereafter the company will grow at 11% per annum(based on your research).
  • After looking at RSH average P/E Ratio and industry averages you feel comfortable with using a P/E ratio of 14.8 for your valuation work.
  • Most importantly, based on your work you believe the company will turn around and prosper.

Let’s take a look at the valuation.  

STEP#1:  Figuring out EPS in 10 years.

  • Formula:  (Annual EPS x Estimated Growth rate^10)
  • RadioShack:  $0.50 x  1.11%^10 = $1.42

Explanation:  If RadioShack grows its EPS at 11% over the next 10 years (after EPS of $0.50 is acheived),  in 2025 its earnings per share will be equal to $1.42

 

STEP #2:  Figuring out stock value at year 10

  • Formula (EPS at year 10 x Average P/E Ratio)
  • RadioShack:  $1.42 x 14.8 = $21.02

Explanation: This means that if EPS and Average P/E ratio holds, the price of RadioShack stock should be $21.02 in the year 2025.

STEP #3:  Discounting future value to determine today’s Intrinsic Value

  • Formula (Future Stock Value/ WACC^10)
  • RadioShack $21.02/(1.07^10)=$21.02/1.9671=$10.72

Explanation: That means the stocks Intrinsic Value today should be is $10.72. With the stock price being $3.35 today, it appears that RadioShack is selling at about 70% discount to its Intrinsic Value. 

To be continued…..

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A Little Known Way To Blow $1 Billion

Obamacare Website Trainwreck

Shocking data released Thursday by a highly regarded Bloomberg government analyst put the Obamacare website rollout cost at over $1 billion. This represents a $600 million increase over the price tag usually associated with the Affordable Care Act, according to the Government Accountability Office. 

Unfortunately, the bad news does not end here. Due to the multitude of kinks and glitches so far encountered and the anticipated overload of problems yet to be exposed, the website costs will continue to escalate.

Bloomberg’s Peter Gosselin offered, “Given the seriousness of the IT problems and the fact that most of the contracts are on a cost-plus basis, the companies almost certainly are in line for another burst of spending aimed at quickly making repairs.”

Just yet another sign that the US Government has completely broken down.  How can anyone spend $500 Million (with cost estimated to balloon to $1 Billion) on a website that doesn’t even work is beyond me. 

As someone who has build a number of fairly complex websites I cannot understand how the website they have built can cost anywhere close to that much money. They could have outsourced it to India or Russia or they could have found a few college kids who would have built them a killer application for as little as $10 Million. I guarantee you that.  The cost that they are paying is astronomical and just shows how broken down the system is.

It is just another symptom of complete mismanagement and fraud that is the US Government. They borrow money they do not have and repay it with money printed out of thin air, they wage wars against cave dwellers with AK-47 by shooting at them with Million dollar missiles,  they spent $1 Billion on a website that should only cost $10 Million and they goose the economy with cheap credit at the expense of a future collapse. How is any of this going to end well?

 It will not. 

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Here Is A Quick Way To Destroy Confidence

Bloomberg Writes: Is JPMorgan Getting a Bad Deal?

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In resolve a handful of state and federal investigations, JPMorgan Chase (JPM) has tentatively agreed to pay $13 billion—more, as my colleague Nick Summers points out, “than the combined salaries of every athlete in every major U.S. professional sport, with enough left over to buy every American a stadium hot dog.” Thirteen billion is also equal to 61 percent of the bank’s profit for 2012, so it’s a significant sum. But does that make it a “shakedown,” as some have suggested?

But there’s no getting away from the fact that the Obama Administration has taken a great deal of criticism over the lack of accountability pertaining to the financial crisis and for not punishing those who had a role in bringing the economy near collapse.

Read The Rest Of The Article Here

I am no fan of big banks nor the bailout of said banks in 2008. In fact, I was a big proponent then, as I am now, that those banks should have failed. Yes, it would have caused a lot of economic pain, but we would have been on the way to a real economic recovery now.  Instead, they have created even a bigger moral hazard.

With that said, I am troubled by this settlement. The US Government is now going after the those who were  willing to step in and backstop the economic collapse by taking over failed financial institutions on request from the US Government. It’s like begging your neighbor for money to buy food (because you are starving) only to slap him with a lawsuit a few years later for lending you that money.  Not only is it unfair, it is downright idiotic as it brings even more risk into the financial system.

Listen, I understand that there was a lot of back room dealings and billions of dollars changing hands that we do not know about. Yet, one thing is clear. If this is to happen again, good luck finding anyone willing to step in. Yes, I am talking to you US Government.  

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Stock Market Update, October 25th, 2013

daily chart Oct 25, 2013

Summary: Continue to maintain a LONG/HOLD position

In the last couple of updates I have mentioned that the market will bounce to the 15,300-15,500 on the DOW in order to close all the gaps and to satisfy all of my requirements. Well, we are here, what’s next?

This is where the picture gets a little bit fuzzy.  According to my mathematical work there is no doubt that we are at the inflection point with two possible outcomes.

  1. September 2013 top was indeed the top and the bear market down leg will resume shortly.
  2. The final top (a little bit higher or lower than September 2013 top) will be set in March of 2014. Thereafter the market will roll over and begin its bear phase.

As I have mentioned many times before, my mathematical work is clearly showing that the bull is ending and the 2-3 year Bear market is just beginning.  I would call the exact date, but there is just too much interference right now.  Unless a severe down leg starts over the next 2 weeks, we will have to wait until March of 2014 for the Bear to start. Until that happens a lot of ups and downs without so much as going anywhere.  The rest of my analysis remains the same.

Over the next few weeks we will find out if the if the bear market has already started or will start in March of 2014. Should the market break below 14,600 over the next two weeks, the probability is high that we have already started the bear market leg into the final 2016 bottom.  The market is certainly going back into the 14,800 as it left a huge gap there, but a firm break below 14,600 will give us a confirmation that the bear is back.

At the same time we cannot yet ignore the technical picture with the market being near an all time high. As such, I continue to advise you to maintain a LONG/HOLD position while waiting for the confirmation that the bear market has indeed started.  

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How To Determine The Intrinsic Value Of Any Company (Part 3)

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Further Notes & Valuation Explanation

Based on the calculation above there are 2 important dynamic areas that require our further attention and explanation.  They are an integral part of the calculation and just a small adjustment can have a significant impact on the overall Intrinsic Value outcome. These variables are…

1. Estimated Future Growth Rate:  Determines the future growth rate of the company over the next 10 years. It is an impossibly difficult number to get right. We can look at the historic growth of the company and use that number OR we can use the existing (last few quarters) growth rate OR we can use our future projected growth rate based on our understanding of the fundamental factors, the economy, company products and so forth.

Whatever your decision might be, understand that you are somewhat guessing here. The future is fuzzy. In 10 years the company might be collapsing with negative growth rates or it might be growing at an

+40% rate due to new product introduction. I often find it helpful to concentrate on the historic/average growth rate and then reduce it by a few percentage points to reduce Intrinsic Value output.  This give me a little bit more margin of safety and a little bit more room if I have made a mistake. 

2. Average P/E Rate:  Very similar situation to the Estimated Future Growth Rate discussed above. While we can look at the average P/E  ratio of the company over the last 10 years and perpetuate it over the next 10 years, in reality we have no idea what that ratio will be in 10 years.  In Microsoft’s example above we have estimated that the P/E ratio will be at P/E= 15 in 10 years.

Yet, no analyst can say that with 100% certainty.  Once again, the company might stumble over the next 10 years and find itself with a P/E Ratio of 5 OR it might surge its growth and find itself with a P/E Ratio of 35. Of course, that greatly impacts the Intrinsic value calculation and any perceived Margin of Safety that you have.  As discussed in the previous point you are better off using historic/average P/E Ratio and then reducing it by a few points to give yourself some extra margin of safety.

It is often helpful to play around with different inputs for these variables based on your research. It will give you a range of Intrinsic Values (Best Case, Average, Worst Case) type of scenarios that can give you a better understanding of what the company is really worth.

For example, in Microsoft’s case you can have a range of ($45.15 I  $54.82 I $59.28) based on playing around with a few numbers.  These prices can act as markers for future developments.  If the company is performing better than your original research has indicated, a higher range IV is appropriate. If worse,  the lower one.  In either case, you are at least aware that the Intrinsic Value is not an exact number, but a constantly changing one.

Once again, the formula above is a highly simplified version of a standard Intrinsic Value calculation.  It can be made a lot more complicated for the purposes of being more precise. Plus, there are multiple ways to calculate the Intrinsic Value.  Whatever the situation is I want you to understand that an Intrinsic Value number cannot be determined with exact precision.  It is your best guess based on the past and the research that you have done.  

Finally, some of the most important variables in the Intrinsic Value calculation rely on the future performance. While the future can be estimated, any such estimate is rarely accurate. As such, you must have a clear understanding that you are making predictions based on unknown future developments that might or might not be anywhere close to what you have originally estimated. 

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How To Determine The Intrinsic Value Of Any Company (Part 2)

That is why I argue that most investors out there do not need a complex “discounted cash flow Intrinsic Value calculation”.  Yes it will give you a more precise answer, but a much easier valuation technique can give you the same answer within 5 minutes. Here is what you have to do.

Coins and plant, isolated on white background

First, let’s take a look at Microsoft Inc and estimate its Intrinsic Value.

We need the following inputs easily available from any financial website (Ex: Yahoo Finance)

  1. Stock Market Price: $33.75 (Oct 23, 2013)
  2. Current EPS (Earnings Per Share): $2.58
  3. Estimated Future Growth Rate:  10.8%
  4. Weighted Average Cost Of Capital (WACC): 7 to 8%
  5. Average P/E (Price/Earning) Ratio To Use:  15

STEP#1:  Figuring out EPS in 10 years.

  • Formula:  (Annual EPS x Estimated Growth rate^10)
  • Microsoft:  $2.58 x  10.8%^10 = $7.19

Explanation:  If Microsoft continues to grow its EPS at 10.8% over the next 10 years,  in 2023 its earnings per share will be equal to $7.19

STEP #2:  Figuring out stock value at year 10

  • Formula (EPS at year 10 x Average P/E Ratio)
  • Microsoft:  $7.19 x 15 = $107.85

Explanation: This means that if EPS and Average P/E ratio hold, the price of Microsoft stock will be $107.85 in the year 2023.

STEP #3:  Discounting future value to determine today’s Intrinsic Value

  • Formula (Future Stock Value/ WACC^10)
  • Microsoft $107.85/(1.07^10)=$107.85/1.9671=$54.82

Explanation: That means the stocks Intrinsic Value today should be is $54.82. With the stock price being $33.75 today, it appears that Microsoft is selling at about 38% discount to its Intrinsic Value.

The Weighted Average Cost Of Capital (WACC) used in the calculation above was 7%. In simple terms WACC is the average combined cost of debt and equity. It is not a particularly hard calculation, but it does require some work.  I do not believe that you need to do this calculation.  

Instead, there are two other ways to think of WACC.  You can think of it as ROI % required by you for this investment or as the average stock market return over the last 50 years. To simplify things even further I tend to use 7-8% WACC at this time, unless there are company specific issues that lead me to either increase or decrease the cost of capital.   

To be continued…..

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Warning: Another Hedge Fund Manager With A Perfect Track Record Is Predicting A Market Crash

CNBC Writes: Scary! This bearish call points to 40% market drop

 market crash investiwthalex

The stock market is trading at unsustainable levels that could eventually lead to a major sell-off, with a possible 40 percent drop in stock prices, hedge fund executive Mark Spitznagel told CNBC Wednesday.

“The simple answer, the mom and pop answer, I think, is just to step aside,” said Spitznagel, founder of Universa Investments and an associate of “Black Swan” pioneer Nassim Taleb.

Spitznagel, incidentally, has some Street cred when it comes to predicting downturns: He called it in 2000 and 2008 and made one of the biggest profits on Wall Street during the 2008 financial crisis, while many other investors were losing money.

Appearing on “Closing Bell,” Spitznagel suggested the Federal Reserve, which last month reaffirmed its policies on bond purchases and record-low interest rates, is basically propping up stocks and otherwise distorting the market.

“It’s a market that is sort of set up, I think, for a major crash, a major sell-off,” said Spitznagel. “I would argue all the major tops we’ve seen in the market over the last 100 years look very much like it does today.”

“The ultimate causes of crashes is the distorted environment we’re in,” he continued. 

In turn, Spitznagel recommends retail investors step aside and wait for opportunities to come.

Watch The Video Here 

I agree with his analysis 100%. The only thing I would add is my mathematical timing work. There will be a 40% decline but it will happen over the next 2-3 years and not in a crash type of an environment. It will be very similar to the 2000-2003 move.  Further, my work indicates that this decline will really get going after March of 2014.  

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Greenspan The Oracle

Bloomberg Writes: Greenspan Says Stocks Are ‘Relatively Low’ and Headed Upward

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Former Federal Reserve Chairman Alan Greenspan said the stock market has room to rise from record levels.

“In a sense, we are actually at relatively low stock prices,” Greenspan, who guided the central bank for more than 18 years, said in an interview with Sara Eisen on Bloomberg Television today. “So-called equity premiums are still at a very high level, and that means that the momentum of the market is still ultimately up.”

Greenspan said the stock market is “just barely above 2007” and the average annual increase in stock prices “throughout the postwar period” is 7 percent, which leaves room for a rise.

Read The Rest Of The Article Here

I am not sure why anyone even listens to this guy anymore.  Greenspan only has one gear. To lower the interest rates and to flood the market with cheap credit. Let’s take a look at just some of his accomplishments.

  • 1998 Asian Bubble/Crisis
  • 2000 Tech/Stock Bubble and Crash
  • 2006 Real Estate Bubble/Collapse
  • 2007 Financial Collapse
  • Current Developments

Do I blame Greenspan for all of that? Absolutely. That’s what happens when you flood the market with cheap credit. You start a perpetual cycle of bubbles and crashes. The money has to flow somewhere and when it does, it creates a bubble. That bubble eventually pops and wrecks havoc on the entire economy. That leads Greenspan or Bernanke to flood the market with even more money/credit until it recovers and creates another bubble. So on and so forth until the whole thing blows up.

Greenspan has always claimed that you cannot sport bubbles. I disrespectfully disagree, but him claiming that stocks are cheap is nothing short of adding insult to injury. Anyone listening to Greenspan in this matter is likely to see their money vanish.

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How To Determine Intrinsic Value Of Any Company (Part 1)

How To Determine Intrinsic Value Of Any Company In 5-10 Minutes
No Harvard MBA Is Required

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In the last chapter we took a closer look at how the margin of safety works and what kind of things we should look for in order to make a proper value investment. As previously discussed, one of the most important things to know when figuring out the true margin of safety is the Intrinsic Value (IV) of any given company.

Wikipedia defines Intrinsic Value as the actual value of a company or stock determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.

Now, there is something very important you must understand.  Determining the IV of any company is arbitrary at best. It could be a highly complex process involving hundreds of excel sheets and data points or it could be a fairly easy process involving a few easy to understand middle school algebra calculations. At the end of the day, neither approach will give you an exact IV of any company. 

Why? Because we are dealing with the unknown. What we are doing when we are determining an IV of any company is taking various existing data points and projecting them well into the future.  In fact, most models call for at least a  5 year discounted cash flow projection to value a company.  The problem is, the future is unknown and in the fast paced business world everything can change on the dime. Making your original IV calculation obsolete.

New products, new technologies, new competition, economic booms and busts, political developments, regulations, etc….. and the list never ends.  How can we make an accurate IV calculation when so many different “unknown” factors can impact your model.  Well, we cannot. 

We can make our best estimates, but we can never achieve a 100% proper IV valuation for any given company. Give 10 different analyst a company to value and they are likely to come up with 10 different answers. Most likely within +/- 20% of each other.  The point I am driving at is this. There is no possible way to achieve perfection when it comes to IV calculation. We are dealing with too many unknowns and future developments. All we can do is estimate.

Let me give you a quick example. Why did Investment Banks who were involved in the Facebook IPO (initial public offering) valued the company at $38 a share?  Did these Investment Banks have a bunch of complex and secret valuation algorithms valuing Facebook before the IPO.  It’s probable, but not likely. You see,  whatever number any such valuation yields would technically be garbage because the future of Facebook is unclear. It is a fast growing tech company, but without a clear path. Everyone is making assumptions. No one knows if Facebook will grow at 20% per annum over the next 10 years or make a series of mistakes that will put it on the path previously walked by MySpace.

As such, everyone can make estimates in order to derive the IV, but in reality no one truly knows. Anyone who claims they can properly determine the IV value of Facebook is simply lying. What ends up happening in a situation like this is investment bankers basically figure out what “the market” is willing to pay and set their IPO price based on that.  

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