How to Value Stocks Using Multiple Methods

Valuing stocks can be a daunting task, but it doesn't have to be. By using multiple methods, you can get a more accurate picture of a stock's worth. This is especially true when analyzing companies like Amazon, which we learned uses a combination of GAAP and non-GAAP accounting methods to report its financials.

One method is the Price-to-Earnings (P/E) ratio, which we discussed in the context of Coca-Cola's historical stock performance. By comparing the company's current stock price to its earnings per share, you can get an idea of how much investors are willing to pay for each dollar of earnings. This ratio can be a useful indicator, but it's not the only one.

Another method is the Discounted Cash Flow (DCF) model, which we saw applied to a fictional company in our example. This model estimates a company's future cash flows and discounts them to their present value, giving you an estimate of the company's intrinsic value. By combining the DCF model with other valuation methods, you can get a more comprehensive picture of a stock's worth.

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Market strategists often choose the P/E valuation method if they can only have one because it's a quick reference point. However, they caution investors not to rely solely on this method, as it has caveats to consider.

The P/E ratio is just one of many valuation techniques, and investors should look out for its limitations. Virtually all valuation techniques carry caveats for investors to be aware of.

Katsenelson's Absolute P/E Model is an alternative value investing analysis tool that provides a more reliable P/E ratio, known as the "absolute P/E." This model adjusts the traditional P/E ratio in accordance with earnings growth, dividend yield, and earnings predictability.

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The price to book ratio is another important valuation technique used by analysts. It's calculated by dividing the stock price by the book value per share.

To compute the book value per share, you need to know the company's total assets minus its total liabilities. For example, if a company's total assets are $100 million and its total liabilities are $50 million, the book value per share would be $50 million divided by the number of outstanding shares.

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A low price to book ratio may indicate that the stock is undervalued, while a high ratio may indicate that it's overvalued. Analysts should also consider historical trends of the price to book ratio, just like they do with the P/E multiple.

By analyzing the price to book ratio, analysts can get a better sense of a company's financial health and make more informed investment decisions.

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The constant growth approximation is a fundamental concept in valuation, and it's used in a model called the Gordon model. This model assumes that dividends will increase at a constant growth rate forever.

The growth rate of dividends is a crucial factor in this model, and it's denoted by the symbol g. This growth rate is usually expressed as a percentage and is assumed to be less than the discount rate.

The discount rate, denoted by k, is also a key factor in the model. It's the rate at which future cash flows are discounted to their present value.

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Here's a table that summarizes the symbols used in the Gordon model:

In practice, the dividend growth rate is not always known, but earnings growth can be used as a substitute, assuming that the payout ratio is constant.

The cornerstone of stock valuation is understanding the primary metrics investors use to value a stock. Understanding P/E ratios is crucial for assessing stock value.

A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value. For example, Walmart's P/E ratio of 29.24 in August 2024 was calculated by dividing its stock price by its EPS.

Several metrics can be used to estimate the value of a stock or a company, with some metrics more appropriate than others for certain types of companies.

Here are some key metrics to keep in mind:

Consider factors that aren't easily quantified, like a company's economic moat and its relative cost advantages, when evaluating a stock's value.

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Return on Invested Capital (ROIC) is a valuation technique that measures how much money a company makes each year per dollar of invested capital.

The ratio is expressed as a percent, and one looks for a percent that approximates the level of growth expected. The higher the number, the better the return.

To compute the ROIC, take the pro forma net income and divide it by the invested capital, which can be estimated by adding together stockholders equity, total long and short term debt, and accounts payable, then subtracting accounts receivable and cash.

This ratio is much more useful when comparing it to other companies being valued.

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ROA measures a company's ability to make money from its assets, expressed as a percent. It's calculated by dividing the pro forma net income by the total assets.

This ratio is not always a good indicator of a company's potential due to irregularities in balance sheets.

The Price to Sales metric is a useful figure that compares the current stock price to the annual sales of a company. It describes how much the stock costs per dollar of sales earned.

This metric is particularly useful for investors who want to understand how a company's stock price relates to its revenue. It can help identify companies that are undervalued or overvalued based on their sales performance.

A high Price to Sales ratio may indicate that a company's stock is overvalued, while a low ratio may suggest that it's undervalued. This metric is useful for companies that generate most of their revenue from sales.

It's essential to use this metric in conjunction with other valuation metrics to get a comprehensive picture of a company's value.

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Calculating a company's P/E ratio using GAAP earnings is the most common method, but you may want to consider using adjusted earnings for a more accurate picture.

Most financial websites report P/E ratios using GAAP-compliant earnings numbers. However, non-repeating events can cause significant increases or decreases in profits, making adjusted earnings a more reliable option.

To calculate a company's adjusted P/E ratio, you'll need to use its adjusted earnings per share (EPS) value. This can be found in the company's latest quarterly earnings report.

Adjusted EPS takes into account one-time events such as investment gains and losses, reorganizations, and other unusual items that can skew the GAAP earnings picture.

For example, Walmart's adjusted EPS for a given period was $2.22, after accounting for investment gains and losses, as well as various reorganizations within the business.

Using this adjusted EPS value, Walmart's adjusted P/E ratio can be calculated as 30.69, which is the result of dividing its stock price by its adjusted EPS.

Here's a quick comparison of GAAP and adjusted P/E ratios:

As you can see, the adjusted P/E ratio provides a more nuanced view of a company's value, taking into account unusual events that may not be reflected in GAAP earnings.

The Benjamin Graham Formula is a stock valuation method that uses earnings to determine a company's intrinsic value. This formula is particularly useful for cyclical companies, volatile cash flows, and young companies with limited history.

Graham initially introduced the formula as V = 8.5 x EPS, where V is the intrinsic value, EPS is the trailing 12-month earnings per share, and 8.5 is the P/E ratio of a stock with 0% growth. However, he later revised the formula to include a required rate of return.

The revised formula is V = (8.5 + g) x EPS / (4.4 + g), where g is the growth rate for the next 7-10 years. However, this formula was found to be too optimistic for today's companies, which can achieve higher growth rates.

A modified version of the formula is V = (4.4 + g) x EPS / (g - 0.4), which takes into account the higher growth rates of modern companies. This formula provides a more accurate estimate of a company's intrinsic value.

Here's a summary of the Benjamin Graham Formula:

A good P/E ratio is subjective and can vary depending on an investor's objectives. Value investors prefer low P/E ratios.

For value investors, a low P/E ratio indicates that a stock's market value is below its intrinsic value. This can make the stock attractive to value investors.

Growth investors, on the other hand, often prefer high P/E ratios. They believe a high P/E ratio is justified by the stock's superior rate of earnings growth.

In the eyes of growth investors, a high P/E ratio isn't necessarily a bad thing. It's a reflection of the stock's potential for future growth.

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Value investing and growth investing are not mutually exclusive approaches to picking stocks. In fact, value investing is focused on expected growth, and the main difference between value and growth investing is a matter of emphasizing different financial metrics.

Investors use P/E ratios to compare stocks in similar industries, but growth-oriented investors often use variations of the P/E ratio, such as the forward-looking P/E ratio and the price-to-earnings to growth (PEG) ratio. The PEG ratio is calculated by dividing the company's P/E ratio by its expected rate of earnings growth, and a stock with a PEG ratio below 1.00 is considered exceptionally valuable due to its impressive projected growth rate.

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A key concept in traditional value investing is intrinsic value, which involves determining a stock's real value using a stock analysis method. Value investors look for undervalued stocks that are selling for a price lower than their genuine value, with the belief that the market will eventually correct the share price to a higher level that more accurately represents its true value.

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Calculating the future growth rate of a company requires personal investment research and familiarity with the company. This is essential before making a forecast.

The historical growth rate of both sales and income can be used as guidelines for future growth, but solely relying on these rates can be inaccurate due to changing circumstances.

Companies often provide growth guidance through quarterly conference calls or press releases, but their forecasts may not always be accurate. In fact, unforeseen macro-events can impact the economy and the company's industry.

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A more conservative growth rate is often appropriate, especially if a company has been through restructuring. For example, a company growing earnings at 10-15% due to cost-cutting may see sales growth slow when the cost cutting has fully taken effect.

The Gordon model assumes that dividends will increase at a constant growth rate forever, but this is not always the case. Dividend growth rate is not known, but earnings growth may be used in its place, assuming a constant payout ratio.

Here are some examples of growth rates:

These examples illustrate the importance of considering a company's specific circumstances when forecasting growth.

Ben Graham's investing approach is centered around finding undervalued stocks. He believed that a stock's current share price should be lower than its true value, and that the market will eventually correct the share price to a higher level.

Graham's method involves using a stock analysis formula to determine a company's intrinsic value. He introduced the Benjamin Graham Valuation Formula, which uses earnings per share (EPS) and a growth rate to calculate a stock's intrinsic value.

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The formula is V = 8.5 x EPS x (1 + g)^10, where g is the growth rate. However, this formula was later revised to include a required rate of return, which is adjusted for the current risk-free interest rate.

To make the formula more practical, Graham created the Ben Graham Number, which is calculated as the square root of [22.5 x (Earnings Per Share) x (Book Value Per Share)]. This number represents the intrinsic value of a company.

Graham generally felt that a company's P/E ratio shouldn't be higher than 15 and its price-to-book (P/B) ratio shouldn't exceed 1.5. However, with today's valuation levels, the maximum allowable P/E might be shifted to around 25.

Here's a summary of the key points to keep in mind when using Graham's approach:

By following these principles, you can apply Graham's investing approach to find undervalued stocks that may be worth buying.

Market strategists often choose the P/E valuation method if they can only have one, but it's not a one-size-fits-all equation.

Virtually all valuation techniques carry caveats for investors to look out for. This means you should be cautious and not rely solely on one method.

Alternative methods for identifying underpriced stocks have arisen, including the Discounted Cash Flow (DCF) formula.

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Value investing is not just about finding cheap stocks, but also about understanding the underlying value of a company. Ben Graham, the father of value investing, believed in determining a stock's intrinsic value through analysis.

A key concept in value investing is the idea of intrinsic value, which is the real worth of a company or its stock. Value investors aim to buy stocks whose current share price is below their genuine value.

Discounted cash flow (DCF) analysis is a popular method for determining a company's intrinsic value. It involves discounting future profits to their present value, taking into account the time value of money.

The DCF method assumes that borrowing and lending rates are the same, and it includes a risk premium based on the capital asset pricing model. This method is well-suited for companies with stable and predictable cash flows.

However, DCF analysis has its weaknesses, particularly when it comes to estimating future cash flows. To overcome this, some analysts use reverse DCF analysis, which starts with the current share price and calculates the required cash flows to sustain it.

A value trap is a stock that appears cheap but is actually not, often due to deteriorating business conditions. These types of stocks can be identified by looking at the company's fundamentals and industry trends.

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The Perpetuities Method is an alternative to the Gordon Growth Model, derived from the compound interest formula using the present value of a perpetuity equation. This method considers the effects of dividends, earnings growth, and the risk profile of a firm on a stock's value.

A generalized version of the Walter model (1956), the Sum of Perpetuities Method (SPM) is an approach that takes into account various factors. It's an alternative to the Gordon Growth Model, which is a well-known method for estimating a stock's value.

The variables in the SPM equation are: P (the value of the stock or business), E (a company's earnings), G (the company's constant growth rate), K (the company's risk-adjusted discount rate), and D (the company's dividend payment).

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The capital structure substitution formula is a powerful tool for understanding how a company's share price is influenced by its bondholders. It's based on the capital structure substitution theory (CSS), which describes the relationship between earnings, stock price, and capital structure of public companies.

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The formula is Px=ExRx[1− − T], where P is the current market price of the company, E is the earnings-per-share, R is the nominal interest rate on corporate bonds, and T is the corporate tax rate.

This formula shows that company share prices are strongly influenced by bondholders. It's a key concept in the CSS theory, which suggests that company managements can drive up earnings-per-share through active repurchasing or issuing of shares.

The asset pricing formula only applies to debt-holding companies. It's a crucial distinction, as it highlights the importance of considering a company's capital structure when evaluating its share price.

Here's a breakdown of the variables in the formula:

Understanding the capital structure substitution formula can help investors make more informed decisions about a company's share price. By considering the relationships between earnings, stock price, and capital structure, investors can gain a deeper understanding of a company's financial health and potential for growth.

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Using the P/E valuation method can be a quick reference point, but it's not a one-size-fits-all equation, and investors should look out for caveats.

Market strategists often choose the P/E valuation method because it's a quick reference point.

Alternative methods, such as the Discounted Cash Flow (DCF) formula, have arisen as well, and value investors continue to give Graham and his value investing metrics attention.

The PEG ratio is a useful metric that accounts for the rate at which a company's earnings are growing, and it's calculated by dividing the company's P/E ratio by its expected rate of earnings growth.

Some investors prefer to calculate a company's P/E ratio using a per-share earnings number adjusted for the financial effects of one-time events.

A company's P/E ratio can be calculated using a company's current and past P/E ratios to calculate two other metrics: the forward-looking P/E ratio and the PEG ratio.

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The forward P/E ratio substitutes EPS from the trailing 12 months with the EPS projected for the company over the next fiscal year.

The PEG ratio is considered exceptionally valuable if it's below 1.00, due to its impressive projected growth rate.

A company's PEG ratio can be compared to its peers to see how it stacks up.

Walmart has a significantly higher PEG ratio than the overall supermarket industry average of 1.79.

A value investor searches out and snaps up what they determine are undervalued stocks, with the belief that the market will eventually "correct" the share price to a higher level that more accurately represents its true value.

The absolute PE model is a robust method that can be used for any company, and it takes into account five subjective inputs: earnings growth rate, dividend yield, business risk, financial risk, and earnings visibility.

The fair value PE is calculated using the formula: Fair Value PE = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)].

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Net-net stocks are companies where the stock price is below the liquidation value, and there are two ways to calculate this: Net Current Asset Value (NCAV) and Net-Net Working Capital (NNWC).

The NCAV is calculated as Current Assets - Total Liabilities, and the NNWC is calculated as Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities.

A net-net stock could work out to be a fantastic investment, provided the company has a decent business model and is not burning cash.

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Asset Reproduction is a valuation approach that estimates how much a competitor would need to spend to replicate a company's business. This method is essentially part 1 of the Earnings Power Value (EPV).

It involves going through each line in the balance sheet to see if anything needs adjustment. This requires a good understanding of the industry to make accurate adjustments.

The asset reproduction value includes goodwill, which a new competitor would need to acquire, such as brand recognition, partnership agreements, and patents. This is a key difference from other valuation methods that might ignore goodwill.

This method requires a lot of work, but it's a valuable tool for understanding a company's competitive advantage. It's like testing a moat to see how high it is.

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