As we start our discussion about stocks, I want to begin by saying that most people should not be investing in individual stocks. Beating the market is ultimately a fool’s game. Not even most hedge funds can beat the market after fees. Take a look at Warren Buffet’s million dollar bet that over ten years he could outperform a “high-powered hedge fund” team by simply investing in a market fund (VFINX, a Vanguard mutual fund that tracks the S&P 500). The bet is almost over and his investment is up 65.7% compared to 21.9% for the hedge fund folks. That’s a single instance, sure, but the large majority of regular investors lose to the market and that’s the truth.
So if individual stock investing is a fool’s game, why would anyone do it? Well after you secure the funds you need for your future in well-diversified market-tracking investments (more on that in a future article), investing in individual stocks can be a great “game” with your excess savings. If you’re young, that game may end up paying well if you happen to buy into the next Amazon or Apple. And just like any game, if you spend time practicing, you may get good at it! And then, perhaps, you can count yourself in the small minority of market-beaters.
Most people choose stocks for reasons such as: they like the company, they like management, movement in the stock price, etc. These are not bad reasons. But just like buying anything in life, it’s not just about the quality – it’s about the price! Would you buy anything else in life, besides stocks, without developing an understanding of what it’s actually worth? That’s where valuation comes in. I used to buy stocks without developing a valuation. I got lucky for some time, but then I realized that in market downturns, my ignorance was costing me dearly.
So from my background in finance, my first thought was to do a discounted cash flow (DCF) valuation for companies. For those who don’t know, a DCF values a company by the amount of free cash flow the company is expected to generate in the future, discounted by the amount of time it takes to generate that cash flow. I can’t knock a good DCF, but it’s ultimately a complicated calculation with a lot of speculative variables. I tried valuing stocks this way and I just wasn’t seeing a strong correlation to stock price. Then I came across this simple calculator at moneychimp.com. The calculator applies the principles of DCF, but instead of using free cash flows, it discounts the earnings per share (EPS). You can read more of their valuation theory here. Using their calculator, all you need to know about a company is its EPS and their EPS growth rate. It was simple enough so I thought I would give it a try.
Using this EPS DCF calculator, I was finding that the valuations were often coming very close to the actual stock price. In general, I was not seeing wide disparities. After using the calculator for some time and following stock prices over that same time, I have concluded (in my opinion) that this easy, simple calculator provides a fair estimate of what a stock price should be. This calculator has become my first step in my stock researching process and it helps me easily identify undervalued stocks and set an internal price target for the stock.
So let’s go over how I fill out this calculator. I get the earnings per share for the last 12 months from Yahoo Finance.
I also recommend viewing EPS by quarter at NASDAQ as seen below:
With that quarter-by-quarter breakdown, you can pinpoint quarters which may have had a non-representative quarter of EPS. In other words, there may have been a quarter with a specific situation causing an unusually high or unusually low EPS. In this case, it is best to do more research to determine whether that special situation is likely to occur again or if it was truly one-off. If it was one-off, I try to adjust the 12 month EPS to what it would have been without that one-off anomaly.
For the growth rate, I use the 5-year analyst estimates from NASDAQ. Sometimes, I will adjust the 5-year growth rate if it seems unreasonable given the growth rates shown for the next four years or if I personally think that analysts are overconfident.
I then leave the post-5 year growth rate at zero to be conservative (can any of us really say what will happen to a company after 5 years?). Lastly, I change the market return to 10% as this is the average annual return for the S&P 500 from 1928 to 2014. This includes inflation so it is a conservative figure (increasing the market return rate will result in a lower stock price value in the calculator).
And that’s it! You’ve just done your first EPS DCF stock price valuation! This, however, is just one step in many to properly research a stock. On Thursday morning, I will go over a couple stocks on my radar in the Tech sector. As of right now, I plan on posting every Tuesday and Thursday morning at 8am (sharp!). This may change, but that’s the plan. Please feel free to leave me any questions or comments. I would be happy to address great questions in future articles.
Disclosure: I am not a financial advisor. Do not make any decision solely based upon what you read here. It’s your money, invest it wisely.