How to value stocks PDF explains three methods to estimate a company’s intrinsic value: Price-Earnings (P/E) multiple, Discounted Cash Flow (DCF), and Return on Equity (ROE) valuation. Using examples like Google, Apple, and Joy Global, it illustrates how to apply these models with inputs like earnings, growth rates, and cash flows, emphasizing a margin of safety.
The book highlights their limitations, urging investors to combine results with fundamental analysis of “wonderful companies” (per Warren Buffett’s criteria: cash generation, low debt, high profitability). It offers tools like Value Spreadsheet to simplify calculations, stressing disciplined, informed investing.
Contents
Foreword …………………………………………………………………………………………………………………… 3
Method 1: Price-Earnings multiple ……………………………………………………………………………….. 4
Method 2: Discounted Cash Flow (DCF) model ………………………………………………………………. 7
Method 3: Return on Equity valuation…………………………………………………………………………. 11
Wonderful companies……………………………………………………………………………………………….. 14
Conclusion ……………………………………………………………………………………………………………….. 16
Appendix: Formula’s & definitions………………………………………………………………………………. 18
Excerpts
Method 1: Price-Earnings multiple
This first method is also the most straightforward one. It involves determining a five-year
price target based on a reasonable, historical P/E valuation. We will use Google (GOOG) to
illustrate this method in practice.
Input 1: the median historical price-earnings multiple
Let us start by finding out what a reasonable P/E ratio is for Google. If we look at the past 10
years, we see that Google’s median* historical price-earnings multiple is 21.6, which is quite
common in the technology sector.
See: AVG P/E
* We use the median to negate the effect which extreme values can have on the mean.
Input 2: earnings per share (ttm)
We also need to find out how much Google earned in the most recent four quarters.
Fortunately we do not have to manually add these quarters together, because most major
financial websites like Google Finance, Yahoo Finance, and MSN Money have done this for us
in the EPS value they report. Google’s trailing twelve months earnings are $31.92 at the time
of writing.
Source:
http://finance.yahoo.com/q?s=goog&ql=1
See: EPS (ttm)
Input 3: expected growth rate
The final piece of the puzzle is the rate at which Google is expected to grow its profit in the
coming five years. You could make your own estimate based on past performance or other
metrics, but you can also look up how analysts expect the company to perform in the near
future. Analysts predict that Google will grow at a rate of 13.44% year-over-year for the
coming five years.
However, predictions are hard to make, especially about the future, as the Nobel Prize
winning physicist Niels Bohr once commented. Therefore it is crucial to apply Benjamin
Graham’s Margin of Safety principle to give our intrinsic value estimate some room for
error. We suggest a margin of safety between 15% and 25%. In this example we will use 25%
to arrive at a conservative growth rate of 10.08% (13.44 * 0.75).
Source:
See: Next 5 Years (per annum)
Let’s put it all together!
Now that we have all the necessary inputs, we can calculate the five year price target for
Google:
$31.92 x 1.10085 x 21.6 = $1114.45
According to our calculation, Google is worth $1114.45 five years from now. However, what
we really want to know is what Google is worth today, its intrinsic value. To arrive at this
estimate we have to discount the five year price target, which will give us the net present
value (NPV)*. We will use a 9% discount rate, which is approximately equal to the long term
historical return of the stock market. This is the minimum rate of return you would have to
earn to justify stock picking over investing in an index fund. Without further ado, let us to
the math:
$1114.45 / 1.095 = $724.32
Awesome, we just calculated our first intrinsic value! Google is worth $724.32. But please
leave out the decimals, because remember: this is only a rough estimate. Google’s stock
price at the time of writing is $737.97, which means the company is currently fairly valued
and so we should skip this one and look for other opportunities in the market.
TIP
At what price should you consider buying if you want to earn 20% per year? Simply discount
the five year price target with 20% to calculate your maximum buy price. In the case of
Google, this means you should not consider buying until the price drops below $447.87
($1114.45 / 1.25)