Benjamin Graham, often referred to as the dean of Wall Street, said:
“In the short term the market is a voting machine, in the long term it is a weighing machine”
What is a weighing machine? To put it simply, this is a measurement applied to every single stock, usually referred to as intrinsic value.
Intrinsic value is the true worth of a stock, a fair stock price or a fundamental value.
Based on financial information, intrinsic value shows whether to buy or sell.
If the intrinsic value is high compared to the stock price then the stock is selling cheap and it is worth to buy it.
Otherwise there is no meaning to purchase it.
Fundamental assumptions: the price of a stock will move forward its true intrinsic value.
The main problem with the intrinsic value approach that there are many ways of calculating it.
Some methods apply in certain situations while other methods have different assumption and requirements. As for me, normal common sense should be applied to any method used to value a stock.
1. Balance Sheet approach
According to financial statements, assets minus liabilities are the equity of a company.
The equity divided by the number of shares outstanding is the book value.
Book value is a simplest type of intrinsic value of the company and is more accounting measure rather than economic.
The book value can be compared with the current market price which gives Price/book ratio, P/B:
Shareholders’ equity: $100 millions
Total shares outstanding, diluted: 10 millions
Market price: $50
P/B = $50/10 = 5
Book value, as well as other approaches such as liquidation value, benchmark valuation, replacement value and q-Theory, is poor estimates because many assets such as goodwill can be overestimated or not included on the balance sheet.
However, there is net current asset value, NCAV, derived by subtracting all the liabilities from the current assets and calculated on a per share basis.
This method can eliminate the disadvantage of the latter balance sheet methods by setting all the noncurrent assets to zero.
This can be effective when screening stocks but the method itself oversimplifies the notion of value.
2. Discount Methods
Dividends as well as free cash flow (both can be considered as cash that can be taken out of business) can be estimated and discounted back to present time.
Usually, it is assumed that the growth rate of the cash flow is constant for an initial period, typically 10 years.
3. Payback Method
The payback method measures the time taken for the discounted payments to pay back the cost of the original investment.
This is a simple approach based on DCF method that applies discounting over a finite time period.
In contrast, DCF is said to be a method to use an infinite period. As for me, they are both the same if the period is set to 10 years.
4. Common and Price ratios Methods
4.1.The most common method is the PEG ratio, the ratio of the price-to-earnings (P/E) divided by a forecast of the growth rate of earnings. Stocks with a PEG ratio of 1.0 are considered fair value. The goal is to find stocks with a PEG ratio as low as possible. It is obvious that the higher the company’s P/E ratio, the stock is less attractive and the higher the growth rate of the earnings, the more attractive the stock is.
P/E = 20
EPS growth =10%
PEG = 20 / 10 = 2
As a rule of thumb, look for stocks with a PEG ration of 0.5 and avoid those that have 2 or more.
PEGY ratio is a modification of the PEG ratio that includes the dividend yield:
PEGY = (P/E) / (growth rate of earnings + Dividend yield)
4.2.Price ratio method is based on P/E ratio estimation however the metric does not tell the whole story.
The P/E ratio is particularly useful when comparing stocks in the same industry.
P/E ratio = price per share / earnings per share (EPS)
4.3.Price to Sales Ratio, P/S is calculated the same way as P/E, except with a company’s annual sales as the denominator instead of its earnings:
P/S ratio = price per share / sales per share = Market Capitalization / Total Sales
An advantage to using the P/S ratio is that it is based on sales, a figure that is much harder to manipulate and is subject to fewer accounting estimates than earnings.
4.4.Graham’s Intrinsic Value:
Intrinsic Value = EPS * (8.5 + 2 * average earnings Growth)
The average annual growth of earnings per share is expected over the next seven to ten years. This period is similar to DCF assumptions.
EPS growth =10%
EPS = $2
Intrinsic Value = $2 * (8.5 + 2 *10) = $57
According to the formula Price = EPS *P/E, it is easy to derive P/E = $57/$2 = 28.5
Graham’s Intrinsic Value do not allow for changes in the basic rate of interest. Therefore the adjustment was made in the form of:
Intrinsic Value = [EPS * (8.5 + 2 * average earnings Growth]*(4.4/Y)
When the formula was invented, 4.4% was the yield on AAA corporate investment bonds, an adjusted by the new yield on corporate AAA bonds is required if the bond yield is different.
EPS growth =10%
EPS = $2
Y = 5%
Intrinsic Value = [$2 * (8.5 + 2 *10)]*(4.4/5) = $50.16
From this calculation it follows that stock price varied inversely with the interest rates, i.e. when rates rise, value goes down and when rates decrease, value goes up.
This is a logical assumption capturing market expectations.
As for me, forecasting earnings per share and free cash flow are two major factors when dealing with intrinsic value.
Both numbers are important and incorporated in many different valuation methods.
Stability of growth and stability of return on equity are key factors to potential profits.