the mosiac of stock analysis part 2: basic valuation

7/29/2019 The Mosiac of Stock Analysis Part 2: Basic valuation

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Overview Vigilant management Long term prospects Stable and understandable Undervalued Summary

The Mosaic of Stock AnalysisPart 2: Basic valuation

Based on Warren Buffetts four rules

David J. Moore, Ph.D.

www.efficientminds.com

May 14, 2013


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The four rules

The company under consideration must...

1 be managed by vigilant leaders,2 have long term prospects,

3 be stable and understandable, and

4 be currently undervalued.


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Indicators of vigilant management

vigilant: keeping careful watch for possible danger or difficulties

Too much debt possible danger or difficulty

DebtEquity

< 0.5

For every $1 of equity there is no more than $0.50 of debt.

Unable to meet short term obligations possible danger or

difficultycurrent ratio =

Current assets

Current liability> 1.5


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Why hold for the long term?

Sustained earnings. Wouldnt you like to receive dividends yearafter year?

Taxes. Take a look at tax rates vs. holding periods1:

Ordinary income rate ST gains LT gains 5yr gains15% 15% 10% 8%28% 28% 20% 18%31% 31% 20% 18%36% 36% 20% 18%

39.6% 39.6% 20% 18%Also note that selling every 5 years reduces the amountreinvested and therefore long-run returns.

1Source: www.buffettsbooks.com


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How to assess long term prospects

Do you see the products being used 30 years from now?

iPhones 30 years from now? No. Some type of communicationdevice, Yes.

Apps 30 years from now? The app itself no. Programming skills,yes.Candy 30 years from now? Yes.Fans 30 years from now? Yes.

This is perhaps one of the most subjective of the rules.

I have no metrics. Perhaps R&D as a percent of sales?What makes you believe this company is going to be around 30years from now?

O i Vi il t t L t t St bl d d t d bl U d l d S


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Indicators of stability

Equity: Steady or growing equity. BVPSEarnings: Steady or steadily growing EPS.

Debt: Steady Debt-to-Equity ratio averaging 0.5 or less.

The more volatility the more difficult it is to forecast and value.



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Understandability

Not understandable to me

Facebook: falsified accounting statements, very likely that no onereading this has spent a dime there, not sure how they are going to

make money.XM Radio: with MP3 players, iPods, Pandora, etc., who would payfor XM service?

Understandable to me

Chevron: people drive to work and buy gas.

Kraft: people must eat.Cisco: this presentation once converted to ones and zeroes passesthrough Cisco equipment.



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How to calculate intrinsic value

Determine growth and discount rates. More on this subject in thenext slide.

Use LOGEST to compute BVPS growth rate g. Compare to IGRand SGR.Use the 10 year treasury rate for i.

Compute value of BVPS 10 years from now.

BV10 = BV0 (1+g)10

Compute present value of 10 years of dividends.

DPStot=DPS

0i

1

1

(1+ i)n

Compute intrinsic value

IV=BV10

(1+ i)10

+DPStot



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Growth and discount rates

The two most critical factors are also the most difficult toestimate: gand i.

Your value add will be in the justification of gand i.

Growth rate g

Will BVPScontinue to grow at the same rate gover the next 10years?If yes, why? If higher or lower, why?

Discount rate i

In the previous slide the 10 year treasury was used to establish a

maximum price. At that price or above you are better offpurchasing a 10 year treasury for the same return with no risk.The discount rate should be commensurate with the companiesrisk and your required return.Could just use 10% or an industry specific number frommy research.

http://wp.me/p2GooX-fehttp://wp.me/p2GooX-fehttp://wp.me/p2GooX-fe


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The whole presentation on one slide

Rule Description Metrics

1 Vigilant leadership D/E< 0.5, CR> 1.52 Long term prospects ?

3 Stable and understandable BVPS, EPS, D/E4 Undervalued MV< PV[BV10]+PV[Div]

The stock analyst adds value (pun intended) by determining longterm growth prospects, growth rates g, and discount rates i.

The intrinsic value model presumes book grate will grow at g

over the next 10 years, dividends will remain constant, andP/B= 1 10 years from now.



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g g g p p y

Future enhancements

Incorporate risk .

The resulting E[R] must have risk associated with it.The model is highly sensitive to g. Perhaps use LOGEST toproduce g as well.

Include P/B multipliers

The model currently presumes stock will/could be sold in 10 yearsat the then-current book value, i.e., P/B= 1.However, some stocks trade at P/B multiples way over 1.Could combine E[P/B] and [P/B] to arrive at E[R] and [R].

Incorporate VAR-type analysis

What is the 5% worst case P/Bover the past 10 years?What is the 5% worst case gover the past 10 years?

the mosiac of stock analysis part 2: basic valuation

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