There are multiple key figures for value investing that investors like Benjamin Graham or Warren Buffet use(d) to evaluate individual businesses and eventually identify whether the stock undervalued or overvalued.
Now, more than ever, it is a good time to valuate stocks with a value investing approach whether they are cheap to buy due to the most recent market crash. To do this, I am sharing my favorite key figures that I found in books, articles and in Berkshire Hathaway’s shareholder letters.
This article solely focuses on quantitative value investing. Of course, value investing comprises a qualitative approach as well, but I will leave this out for the moment.
If you are completely new to investing, you may check out this article, where I describe the basics and my personal journey.
It is important to note that in the end it is a combination of multiple figures, depending on the industry the figure is either less or more relevant. There is no one-size-fits-all figure that can be used to valuate stocks. Always view them with a grain of salt and make your own decision.
General value investing figures: Revenue, earnings, P/E Ratio, debt ratio
The simplest figures to start with value investing are revenue and earnings: Have a look whether they are growing, why and how much profit there is at the bottom line. Did the company achieve positive cash flows after a high growth phase? Are they declining and why? Also, take a look into the gross and net margins and see how much they spend on selling products and services.
The price to earnings (P/E) ratio determines how much time the company would theoretically need in order to pay back the invested money to the shareholder. So if a company has a P/E of 15, it would take them 15 years to pay back your investment. Benjamin Graham stated that an appropriate P/E ration for a no-growth company would around 8.5; generally I would suggest to look for a P/E less than 15. But it really depends on margins and the current stage of the company.
Lastly, always take a look into the amount of debt a company has. For example, Apple has high debt, but high cash equivalents, so their net debt is actually not that high. Facebook and Google to me are very appealing, because their have zero and very low debt levels, respectively. In recessions and economic shutdowns as we are facing currently, a company is well suited if they are not relying on further loans by the government. I am curious to see what companies file for chapter 11 when this current market drawback is over.
Discounted Cash Flow (DCF) Method
The Discounted Cash Flow (DCF) method is used by many value investors to project cash flows (CF) into the future and discounting them based on equity and debt equity interest claims. The result aims to determine the value of a company based on the cash flows they are producing.
To begin you start with calculating the income based on a growth rate that is realistic for the next 10 years and the free cash flow (FCF).
Next, you calculate a discount factor that is used to discount future cash flow to the present. The last “1” in the formula represents the year number. So in an Excel spreadsheet you would calculate this discount factor for the next 10 years and the year number would increase with each year. The Weighted Average Cost of Capital (WACC) indicates the cost the has to be paid to investors. This number is usually published in annual reports of companies. Generally, IT and technology companies have a higher WACC than stable and conservative companies.
… and so forth.
Now, all values of cash flows for the next 10 years are summed up and a terminal value (TV) is calculated.
Lastly, you can subtract the net cash (cash minus total debt) from the Terminal Value and sum of all cash flows:
Benjamin Graham’s Formula
In Security Analysis as well as in The Intelligent Investor (page 295) by Benjamin Graham, a formula is described for growth stocks that aims to calculate an approximate intrinsic value.
Later in 1974 he revised his formula to include an average yield of corporate bonds (4.4) as well as the yield of AAA 20-year bonds. The Earnings Per Share (EPS) account for the last 12 month period and the 8.5 represents an appropriate P/E ratio for no-growth companies (proposed by Benjamin Graham).
1 Dollar Value Creation
Warren Buffet uses a figure to describe how much value was created for each dollar invested.
If it is higher it means that the increase in market value is higher than the sum of the retained earnings. Also known as above-average return on investment.
It can be easily calculated by using the market value (market capitalization, which represents the number of shares available multiplied by the stock price) and the Retained Earnings from the balance sheet all incorporated in the following formula:
Note that I used an example where 1 dollar invested in 2018 created a certain amount of value in 2019.
Return on Invested Capital (ROIC)
In the book The Intelligent Investor Benjamin Graham Jason Zweig outlines in his comment note on page 398 that the Return on Invested Capital (ROIC) is far better compared to Earnings Per Share (EPS), because EPS has been distorted by stock option grants and accounting gains and charges (page 398). You simply take Warren Buffet’s Owners Earnings (or use Free Cash Flow) and divide it by total assets minus total cash. He considers the stock a great investment if the result is greater than 10%, because every dollar invested generates 10% return.
There are many different versions that people use to calculate this number, another variant is to use net income and divide it by the equity plus long and short term debt.
For companies like Amazon it doesn’t make huge sense to use the P/E ratio for valuation, because especially in the e-commerce business they have very low margins. It is rather interesting to look into the revenue and income upside potential and return on invested capital.
Contrary to Amazon, Apple has high margins on their products and services and produces enormous amounts of cash flow that they use for R&D, dividend payout and stock buybacks. Here, looking at DCF, P/E ratio and revenue and profit upside potential is more applicable.
Again, always have a combined and objective view on those figures and put them in perspective when applying a value investing approach in times when the market is down: is the company fundamentally hit by a virus outbreak? Is the whole industry declining? Is the market saturated? There are multiple qualitative indicators that will help putting the key figures into perspective, but this is part of a future article.
*Disclaimer: I am not a professional investment advisor, before making any investment decision seek and consult professional advice.