Value investing is based on the premise that the market is irrational, and that stock prices therefore do not always match the actual value, or intrinsic value, of the security they represent. Value investors like Warren Buffett try to calculate a company’s intrinsic value to see if its stock is currently selling at a discount or a premium, and by how much.
Notice that in the title of this post, I chose the term estimate instead of calculate. There are so many ways to value a company and so many strategies for investing that no single calculation of intrinsic value can possibly be perfectly right. That is why Warren Buffett says “it is better to be approximately right than precisely wrong.”
There are dozens of ways to calculate intrinsic value, which you may see various investors advocating in books, blogs, podcasts, etc. This is because you can value a company based on its earnings, its cash flow, and its underlying assets. There are also multiple methods of calculating each.
It would be impossible to say that any one of these methods is the right one. Each is probably right some of the time. In an effort to be “approximately right,” I use up to 11 different calculations of intrinsic value. Here are the 11, along with the sources that each are based on:
- Discounted Cash Flow (Value Spreadsheet)
- Dividend Discount Model (Gordon Growth Model)
- Earnings Power (GuruFocus)
- Earnings-based Discounted Cash Flow (GuruFocus)
- FCF-based Discounted Cash Flow (GuruFocus)
- Graham Valuation (GuruFocus)
- Lynch Valuation (GuruFocus)
- Price-Earnings Multiple (Value Spreadsheet)
- Projected FCF (GuruFocus)
- Return on Equity Valuation (Value Spreadsheet)
- Tangible Book Value (Investopedia)
I do vary these methods somewhat from what the original sources suggest. For example, I have my own ways of determining exactly what numbers I will put into the formulas, calculating growth rates and determining discount rates. I may delve into these methods in future blog posts.
I can then look at the mean, median, minimum, and maximum to get an idea of the range in which the company’s intrinsic value falls. Median is often the most reasonable number to use, as it doesn’t allow outliers to heavily influence the outcome.
These calculations make an excellent screen for finding undervalued stocks and for comparing stocks within a given industry. For example, if I were looking at department stores right now, this method would yield the following results:
- Dillard’s (DDS) – 37% undervalued
- Kohl’s (KSS) – 8% undervalued
- Macy’s (M) – 7% overvalued
My search doesn’t end there. It is really only the beginning.
In addition to intrinsic value, I dig into each company’s fundamentals, calculating various ratios for determining how fair the price is and how sustainable the business model is. I will explore these further in another blog post.
So far in this post I have only mentioned quantitative analysis. The next step is qualitative analysis, which involves a more in depth study of how the company makes money and how sustainable those methods are.
I find this analytical process to be quite intellectually stimulating. I enjoy doing the math as well as evaluating the business. It is very interesting to see where the quantitative and qualitative characteristics of a company overlap.
Kohl’s is a great example of a company that meets all of my criteria. It is currently priced at $38.79 per share, which is 11x earnings, 5x owner’s earnings, and 5x free cash flow. It has had 5 consecutive dividend increases, with a 5-year dividend growth rate of 14.9%. It’s dividend is 45% of earnings and 27% of FCF, indicating that it is sustainable. Total debt-to-equity is a little high at 91.83%, and growth is a little slow, but this is a predictable company that can probably get away with it. Kohl’s return on equity (trailing twelve-month) is 11.76%, which is not ideal but acceptable. Kohl’s intrinsic value calculations fall in a range between $24.91 and $120.25. The median is $41.91, 8% above the current share price, and the average is $53.70, 38% above price. Quantitatively, Kohl’s is a great value.
Kohl’s is not as cheap as Dillard’s, but as Warren Buffett would say, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Qualitatively, Kohl’s looks like it is in that “wonderful company” category.
While much of the retail industry is hurting–particularly department stores–Kohl’s is still attracting shoppers with sales, smart partnerships with apparel companies, and its customer rewards program. They are the best in the business at creating customer value. Kohl’s customers walk out of the store feeling like they just robbed the bank, and they keep coming back for more. I imagine that as a shareholder I would share that sentiment, collecting a 6% dividend yield that I could reinvest into more shares.
There is no perfect model for investing. It’s all about finding the strategy that works best for you. I personally love value investing, but could never trust one single method of calculating intrinsic value. I want to look at a company at every angle and feel that I am getting “a wonderful company at a fair price.”