GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Methods for Arriving at the Fair Value of Companies

April 11, 2012 | About:
10qk

GuruFocus

353 followers
GuruFocus will add valuation numbers to the summary pages of stocks. We will try to use these numbers as proxies of the intrinsic values of the stock. When compared with the stock price, these numbers will give us some idea of whether the stock is overvalued or undervalued.

We will use different methods to calculate these values. The details are summarized below. In general, the value of a company is calculated based on either its asset value, earning power or the combination of both. We will explain how each one works, compare them and give examples of the values they arrive at for some familiar stocks.

Net Cash

Net Cash = Cash & Cash Equivalents + Short Term Investments – Total Liabilities.

Guru Explains:

In the calculation of a company’s net cash, assets other than cash and short-term investments are considered worth nothing. But the company has to pay its debt and other liabilities in full. This is an extremely conservative method of valuation. Most companies have negative net cash. But sometimes a company’s price may be lower than its net cash.

Ben Graham invested in situations where the company’s stock price was lower than its net cash. He assigned some value to the company’s other current assets. The value is called Net Current Asset Value (NCAV). One research study covering the years 1970 through 1983 showed that portfolios picked at the beginning of each year and held for one year returned 29.4 percent, on average, over the 13-year period, compared to 11.5 percent for the S&P 500 Index. Other studies of Graham’s strategy produced similar results.

You can find companies that are traded below theirNet Current Asset Value (NCAV) with our net-net screener. GuruFocus also publishes a monthly net-net newsletter.

Net Current Asset Value (NCAV)

Benjamin Graham defines Net Current Asset Value (NCAV) as:

Net Current Asset Value (NCAV) = Cash and Short-Term Investments + (0.75 * Accounts Receivable) + (0.5 * Inventory) - Total Liabilities

Guru Explains:

In calculating the Net Current Asset Value (NCAV), Benjamin Graham assumed that a company’s accounts receivable is only worth 75% its value, its inventory is only worth 50% of its value, but its liabilities are paid in full. This is a conservative way of estimating the company’s value.

One research study covering the years 1970 through 1983 showed that portfolios picked at the beginning of each year and held for one year returned 29.4 percent, on average, over the 13-year period, compared to 11.5 percent for the S&P 500 Index. Other studies of Graham’s strategy produced similar results.

Benjamin Graham looked for companies whose market values were less than two-thirds of their net-net value. They are collected under our net-net screener. GuruFocus also publishes a monthly net-net newsletter.

Intrinsic Value (DCF)

This is the intrinsic value calculated from the Discounted Cash Flow model with default parameters. In a discounted cash flow model, the future cash flow is estimated based on a cash flow growth rate and a discount rate. The cash flow of the future is discounted to its current value at the discount rate. All of the discounted future cash flow is added together to get the current intrinsic value of the company.

Usually a two-stage model is used when calculating a stock’s intrinsic value using a discounted cash flow model. The first stage is called the growth stage; the second is called the terminal stage. In the growth stage the company grows at a faster rate. Because it cannot grow at that rate forever, a lower rate is used for the terminal stage.

GuruFocus DCF calculator is a two-stage model. The default values are defined as:

· Discount rate: 12%

· Growth rate in the growth stage = average earnings growth rate in the past 10 years or 20%, whichever is smaller

· Growth stage lasts 10 years

· Terminal growth rate = 4%

· The terminal stage last 10 years

· GuruFocus DCF calculator is actually a Discounted Earnings calculator, the earnings per share is used as the default. The reason we are doing this is we found that historically stock prices are more correlated with earnings than free cash flow.

· All of the default settings can be changed and the results are calculated automatically.

Guru Explains:

Unlike valuation methods such as Net Current Asset Value, Tangible Book Value per Share, Graham Number, Median Ratio, etc., Discounted Cash Flow model evaluates the companies based on their future earnings power instead of their assets. What you need to know about the DCF model:

· The DCF model evaluates a company based on its future earnings power.

· Growth is taken into account; therefore a faster growth company is worth more if everything else is the same.

· Since we are projecting future growth, it is assumed that the company will grow at the same rate as it did during the past 10 years. Therefore this model works better for the companies that have relatively consistent performance.

· The DCF model works poorly for inconsistent performers such as cyclicals.

· What discount rate should you use? Your expected return from the investment is a good discount rate assumption.

· A larger margin of safety should be required for companies with less predictable businesses.

You can screen stocks that trade below their intrinsic value (DCF) and Intrinsic Value (Discounted Earnings) with the GuruFocus All-in-One Screener. Companies with a high Predictability Rank that trade at a discount from their Intrinsic Value (DCF) and Intrinsic Value (Discounted Earnings) can be found in the screen of Undervalue Predictable Companies. (/Undervalued/)

Intrinsic Value (Discounted Earnings)

This is the intrinsic value calculated from the Discounted Earnings model with default parameters. The calculation method is the same as the Discounted Cash Flow model except earnings are used in the calculation instead of free cash flow. This is the default method of calculation with the GuruFocus DCF calculator.

Usually a two-stage model is used in calculating the intrinsic value with the Discounted Cash Flow model. The first stage is called growth stage; the second is called the terminal stage. In the growth stage the company grows at a faster rate. Because it cannot grow at that rate forever, a lower rate is used for the terminal stage.

GuruFocus DCF calculator is a two-stage model. The default values are defined as:

· Discount rate: 12%

· Growth rate in the growth stage = average earnings growth rate in the past 10 years or 20%, whichever is less

· Growth stage lasts 10 years

· Terminal growth rate = 4%

· The terminal stage last 10 years

· The earnings per share is used as the default. The reason we are doing this is we found that historically stock prices are more correlated with earnings than free cash flow.

· All of the default settings can be changed.

Guru Explains:

Unlike valuation methods such as Net Current Asset Value, Tangible Book Value per Share, Graham Number, Median Ratio, etc., the discounted Cash Flow model evaluates the companies based on their future earnings power instead of the value of their assets. What you need to know about Discounted Earnings model:

· The Discounted Earnings model evaluates a company based on its future earnings power.

· Growth is taken into account; therefore a faster growth company is worth more if everything else is the same.

· Since we are projecting future growth, it is assumed that the company will grow at the same rate as it did during the past 10 years. Therefore this model works better for the companies that are relatively consistent performers .

· The DCF model works poorly for inconsistent performers like cyclicals.

· Your expected return from the investment is a reasonable discount rate assumption.

· A larger margin of safety should be required for companies with less predictable businesses.

You can screen for stocks that trade below their intrinsic value (DCF) and Intrinsic Value (Discounted Earnings) with the GuruFocus All-in-One Screener. Companies with a high Predictability Rank that trade at a discount to their Intrinsic Value (DCF) and Intrinsic Value (Discounted Earnings) can be found in the screen of Undervalue Predictable Companies. (/Undervalued/)

Intrinsic Value (DCF Projected)

Since the intrinsic value calculations based on the Discounted Cash Flow (DCF) or Discounted Earnings (DCE) cannot be applied to companies without consistent revenue and earnings, GuruFocus developed a valuation model based on normalized Discounted Cash Flow and Book Value of the company.

The details of how we calculate the intrinsic value of stocks are described in detail here.

This method smooths out the free cash flow over the past six to seven years, multiplies the results by a growth multiple, and adds a portion of total equity.

Value = (Growth Multiple)*FCF(6 year avg) + 0.8*Total Equity(most recent)

In the case of negative total equity, the following formula is used (see the Total Equity section for the reason):

Value = (Growth Multiple)*FCF(6 year avg) + Total Equity(most recent)/0.8

The growth multiple is capped between 8.35 and 17.74.

Total equity weighting is more art than science and it should always be revisited in more detail when researching a company. Weightings from 0% to 100% to more than 100% are possible. Eighty percent was chosen as a happy medium after taking the above ideas into consideration. Learn more here.

Graham Number (grahamnumber)

Graham Number is calculated as follows:

Graham Number = SquareRoot of (22.5 * Book Value * Earnings per share)

= SquareRoot of (22.5 * Net Income * Shareholder’s Equity) / Shares Outstanding

Guru Explains:

Ben Graham actually did not publish a formula like this. But he wrote in "The Intelligent Investor" (1948 version) regarding to the criteria for purchases:

“Current price should not be more than 15 times average earnings of the past three years.”

“Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5. (This figure corresponds to 15 times earnings and 1.5 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)”

Unlike valuation methods such as DCF or Discounted Earnings, the Graham number does not take growth into the valuation. Unlike the valuation methods based on book value alone, it takes into account the earnings power. Therefore, the Graham Number is a combination of asset valuation and earnings power valuation.

In general, the Graham number is a very conservative way of valuing a stock. It cannot be applied to companies with negative book values.

Median P/S Value

Median P/S Value is calculated as follows:

Median P/S Value = Total Annual Sales / Shares Outstanding * 10-Year Median P/S Ratio.

Guru Explains:

This valuation method assumes that the stock valuation will revert to its historical mean in terms of Price/Sales Ratio. The reason we use the Price/Sales ratio instead of Price/Earnings ratio or Price/Book ratio is because the Price/Sales ratio is independent of profit margin and can be applied to a broader range of situations.

It also assumes that over time the profit margin is constant. If a company increases its profit margin to a sustainable level, this value might underestimate its value. If it has permanently declined profit margins, this may overestimate the company’s value.

Peter Lynch Fair Value

Calculated as follows;

Peter Lynch Fair Value = PEG * 5-Year Earnings Growth Rate * Earnings

If the 5-Year Earnings Growth Rate is greater than 20% a year, we use 20.

Guru Explains:

Peter Lynch Fair Value applies to growing companies. The ideal range for the growth rate is between 10 – 20% a year.

Peter Lynch thinks that the fair P/E value for a growth company equals its growth rate, that is PEG = 1. The earnings here are trailing 12-month (TTM) earnings. The growth rate we use is the average growth rate for earnings per share over the past five years.

GAVA™

A stock’s GAVA™ (pronounced like “lava”) is a measure of its intrinsic value. The GAVA™ (GuruFocus Automatic Value Appraisal) is calculated using a formula developed by GuruFocus and four pieces of public data:

· Earnings

· Dividends

· Past growth

· Current interest rates

The GAVA™ also takes into account three special situations:

· Unsustainable growth

· Unprofitable growth

· Inadequate earnings

The GAVA™ calculation is fully automated. And never requires more than seveninputs:

· Earnings

· Dividends

· Book value

· Revenue growth rate

· EBITDA growth rate

· Book value growth rate

· Stock classification: financial/non-financial

Every GAVA™ calculation uses four variables. The three additional inputs are only used to determine when special rules apply to a stock. Depending on which special rules apply to a stock, different metrics are used to calculate the stock’s GAVA™.

Unlike most measures of intrinsic value, the GAVA™ is equally applicable to holding companies, banks, railroads, retailers and industrials.

The GAVA™ needs to be combined with a stock’s business predictability rating before you can use it to make a buy or sell decision. The more predictable a company is, the more accurate its GAVA™ will tend to be.

Finally, never buy a stock simply because its GAVA™ is higher than its current price. Only buy a stock when there is a sufficient margin of safety. GuruFocus – following in Ben Graham’s footsteps – recommends a margin of safety of 50%.

In other words, a stock’s GAVA™ should be at least 1.5 times its price for the stock to be a good buy.

GAVA = (E + D) * (7 + (G-B))

(Earnings) E equals:

FINANCIALS

The highest of:

· 10-Year average return on equity * book value

· 10-Year book value hrowth * book value

· Moody’s 30-year AAA bond yield * book value

NON-FINANCIALS

The highest of:

· 10-Year average net margin * sales

· Moody’s 30-year AAA bond yield * book value

(Dividends) D equals:

· Dividends per share

(Growth) G equals:

FINANCIALS

The lowest of:

· 10-Year revenue per share growth

· 10-Year book value per share growth

· 20%

NON-FINANCIALS

The lowest of:

· 10-Year revenue per share growth

· 10-Year EBITDA per share growth

· 20%

(Bond Yield) B equals...

· Moody’s 30-year AAA bond yield

These are the comparison of these methods:

Valuation Methods Asset Based Earning Power Based Combination of Asset & Earnings Power Growth Considered
Net Cash X No
Net Current Asset Value (NCAV) X No
Discounted Model (DCF, Discounted Earnings) X Yes
Intrinsic Value (DCF Projected) x Yes
Graham Number x No
Median P/S Value X No
Peter Lynch Fair Value X Yes
GAVA x Yes


These are some examples of the calculation results with different methods for five well-known stocks.

symbol Price Net Cash NCAV Tangible Book DCF Discounted Earnings DCF_projected GAVA Mid PS Peter Lynch Graham Number
AAPL 626.2 -19.9 -5.9 92.2 265 119.5 539.5 702.2 207.3
COST 87.32 -17.4 -10.6 28.7 34.4 66.9 52 55.4 85.9 29 45.4
JNJ 64.13 -5 -4.8 8.4 62.1 91.4 62 68 94.7 28.4
PEP 65.15 -26 -25.9 -7.9 42.6 89.1 56 89.8 105.4 37.5
WMT 59.8 -31.5 -25.2 16.1 67.7 98.7 56 70 111.6 42.1 39.3


We can see all of the stocks listed here have negative net cash and negative net current asset value. They are all traded far above tangible book. The market values these stocks on their earnings power.

As we all know, investing is more art than science. The key in investing is to understand the underlying business. Once you understand the business, you will know better when to apply each of the valuation methods – the science part. The goal that we have in providing these numbers is to give us some idea of valuation. None of these numbers will free you up from the heavy-lifting part of the work – understanding the business.

These numbers will be added to the new stock summary page we are developing.

As always, we work hard to improve the services we provide. If you are not a Premium Member, we invite you for a 7-Day Free Trial.

About the author:

GuruFocus
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.1/5 (78 votes)

Voters:

Comments

hheffermehl
Hheffermehl - 2 years ago
Regarding GAVA: I have not found a GAVA screener or GAVA mentioned anywhere else on GF. Could you provide a link?
gurufocus
Gurufocus premium member - 2 years ago
GAVA is not released yet. thank you for the interest!
tonyg34
Tonyg34 - 2 years ago
that's really cool to have all those value models calculated by GuruFocus. Now I have a couple spreadsheets I can delete. Two thumbs up for a great idea.

Will the screeners be able to access this data for customized searches?
gurufocus
Gurufocus premium member - 2 years ago
yes the new All-in-One screener will be able to do the searches based on these parameters. It already does some of them.

Thanks!
jasonmbaxter
Jasonmbaxter premium member - 1 year ago
Is the GAVA calculation available on any of the GuruFocus stock screens yet?
sam.sivaskandan
Sam.sivaskandan premium member - 9 months ago
I do not see a Gava calculation screen anywhere on the opening page. Can you please help?
mgrngj
Mgrngj - 22 hours ago

Start working at home with Google! It's by-far the best job I've had. Last Wednesday I got a brand new BMW since getting a check for $6474 this - 4 weeks past. I began this 8-months ago and immediately was bringing home at least $77 per hour. I work through this link, go to tech tab for work detail

----------------------> W­W­W.j­o­b­s­7­0­0­.­C­O­M

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK