A value investor seeks to buy a stock for less than its intrinsic value (for example, buying for 50 cents a stock worth a dollar).
How does a value investor establish that the intrinsic value of a stock?
I take a three-step approach to share valuation:
- Asset Valuation
- Earnings Power
- The value of growth
1. Asset Valuation – the most reliable method
Start with the balance sheet – even though these assets currently exist, you will need to make adjustments. The top of the asset list is the most reliable as it contains the cash. As you work down the list, you will find the items become less reliable, and near the bottom you hit intangibles assets, which come with many issues.
If the industry is struggling, it is wise to value at liquidation. If it is viable, however, then you should work out the replacement value of the business. What would it cost a competitor to replace or replicate the business?
2. Earnings Power Value (EPV) – the second most reliable method
This is the business value of its current earnings, properly adjusted for not only depreciation and amortisation, as per the official accounting records, but also for the business ‘current position in the industry lifecycle. The aim is to find the most accurate estimate of sustainable cash flow that can be distributed. No growth is factored in using this method.
3. The value of growth – the least reliable method
Growth is only considered in the intrinsic valuation when a company has a durable competitive advantage.
We look at the return on incremental capital invested (ROIC) and work out a growth rate and use a multiplier to apply to the EPV to come up with a value.
EPV x Multiplier = Value of Growth 4 x 1.3 = $6.2
This value of growth may form part of our margin of safety, but we should avoid paying more than the EPV for a stock.
Examples:
- If the asset value of a stock is $2.00 and the share price is $1.00, it is a potential buy.
- If the asset value is $2.00 and the share price is $3.00 and the EPV is $4.00, it’s a potential buy.
- If the share price is $4.00 and equal to the EPV $4.00, it’s not a buy as there is no margin of safety. If there is a growth value that comes to $5.00, it is potentially a buy as we have used the growth value as the margin of safety.
- If the share price be $4, the EPV $3 and growth $5, we may avoid the stock as the share price is greater than the EPV, as we are not confident enough of growth to include in the valuation.
If you would like to find out more about my approach, or would like a complimentary consultation, please contact me.