You’re IMM (In The Money) ?
The crux of value investing is to buy a stock for less than it’s worth, and make money from the market correction to its true value. But let’s get practical, you can’t work this out in your head. You need a net present value, discounted cash flow model that doesn’t rely on CAPM. I’ve spent about six months building one that’s beginner-friendly, and now it’s like my third arm. £450 gets you the calculator, evergreen and updated annually, with a 30-minute on-boarding call via Skype/Instagram Call if you’d like help with anything. This lesson I demonstrate how to use the model with Facebook as an example. Let’s get cracking!
Quick Instructions ?
|Fill out the green boxes.|
|Click on the little red triangles for help.|
|Use a discount rate higher than 10% for young companies.|
|Use instructions in Lesson 7 to estimate ROIC.|
|Use avg. GDP growth as your terminal growth rate (3% in US).|
|Use Ctrl-F to search for keywords in 10Q/K documentation.|
Quick Wisdom ?
|Apply a 20% margin of safety to your final valuation.|
|Be conservative where possible.|
|Garbage in, garbage out.|
|Ignore three-blind-mice debates about CAPM and WACC.|
|Bother working out maintenance capital expenditures and net working capital (lesson 7).|
|If you’re new to the course, go back and watch it from lesson 5 for context.|
Enter the Company Name ✍️
You’re a natural!
Enter the Industry ✍️
Is it an automotive company? A social media company? A steel manufacturer? A textile mill? Sometimes, it’s hard to pin it down. Use the GICS classifications for help if needed.
Fetch the Effective Tax Rate for The Industry ?
Click on the blue hyperlink and pull the average effective tax rate for your industry (or a close industry) from the table provided. Better yet, download the company’s 10K here and press ctrl+F to search for the keyword ‘tax,’ finding it specifically for your company. Be careful not to mistake the marginal tax rate for the effective tax rate!
Fetch the Long-term Debt ?
This website has all the company documents for free. The 10K is a yearly report about how business is going and it includes three key financial statements. Go to ‘Financial Statements and Supplementary Data’ and then ‘Consolidated Balance Sheet.’ The first half are assets, and the second half are liabilities (debts). Take the total liabilities figure, whether it’s big or small. Type it in to the green box in your model exactly as is!
Fetch the Cost of Debt ?
Click on the blue hyperlink and lookup the average cost of debt for your industry. Enter it into the green box in the model. Nice work!
Pick Your Discount Rate ?
This is your first big input! It doubles up as both risk in the business (one half of your risk/reward matrix), and the annual return you’ll get from the stock.
Don’t set a discount rate below the annual return you’re willing to accept. That should be your floor. On top of that, go up as high necessary to feel compensated for real risk in the business.
The stock market goes up 10% per year on average. If we’re picking stocks, it makes sense to want to beat that. Set your discount rate at a minimum floor of 10%.
Then, look to the business. Is it young? Profitable? Led by conservative managers? Fearsome competitors out there? There are a million and one factors to consider. For some perspective, start-ups looking for a first round of funding from venture capitalists have discount rates of around 25% attached to them. A steady-Eddie freight railroad with reliable profits and 100-year business prospects sits only at a 4-5% discount rate.
Make the call. There’s no right or wrong answer, and you can change this after the stock value is calculated.
It’s your table to project the company’s profit into the future. This is the reward side of your risk/reward matrix.
YR-2 was two years ago. YR-1 was one year ago. YR+1 is next year. YR+2 is the year after that.
Keep your eyes on the green ?. Our job is to fill out operating profit going forward. It’s also great to work out and enter the company’s maintenance capex and net working capital as well. Read the previous lesson‘s transcript to learn how.
Tax and interest obligations for the company are worked out for you. Net income and free cash flow are also calculated automatically based on the numbers you punch in.
Start With This Year’s Operating Profit ℹ️
You need this year’s 10K and financial statements again, but this time look at the income statement. Find operating profit and enter it into the model.
It’s smarter to download the last four quarterly reports (10Qs). If you add the operating profit figures together from the latest four quarters, you have a more accurate overall number.
Then, Estimate Its Growth Rate for 8 Years ?
All your hard work and sacrifice to research the business (taught in lesson 9) will pay dividends here. You work out the profits in the future by working out the growth rate of the current year’s profits. There are three components of that growth rate. First, the company’s “reinvestment rate.” Then this year’s “return on invested capital” (ROIC), and next year’s ROIC as well.
Armed with all three components, put it all together in this formula:
Next year’s ROIC x Reinvestment Rate + (Next year’s ROIC – This year’s ROIC) ÷ This year’s ROIC.
The result will be the percentage change in operating profit from this year to the next, i.e. for the YR+1 box. To fill out the rest of the boxes, either work out a new percentage change after every year and keep filling them out one-by-one, or apply that original growth rate to every box.
And Then Forever After That ∞
It’s hard enough to predict the future in 8 years time, let alone into infinity. That’s why we set a very conservative ‘terminal growth rate’ ensure we’re including perpetual growth in our valuation, but fairly. If the company is growing its profits, set this to average GDP growth. In the US, that’s 3%. If the business is not growing its profits year-to-year, it may need to be negative. I roll my eyes when I see investors set this number at 5% or 6%. To be rewarded with that kind of terminal growth, a company needs very strong and durable competitive advantages.
No-one can escape fate, which in commercial terms is to live around 40 years before becoming obsolete. Bear in mind that your company will need a negative growth rate in its old age, which usually comes sooner than most investors realise. We’re on the home stretch now!
Include The Value of Marketable Securities ?
We’re polishing off loose ends now, such as what investments the business itself holds. Minority ownerships are common, so open the balance sheet again on the 10K. In the assets section, take the value of ‘marketable securities.’ Enter it into the green box in our model.
Include The Value of Dormant Assets ?
Dormant assets aren’t creating any value for us today, but at some point they’ll be put to work or sold. That’s value for us. To find the dormant assets figure, open the 10K, type ctrl-F on your keyboard, and search for the word ‘dormant.’ Mentions of potential dormant assets will appear. The number is likely to be very small in any case.
Plug in The Total Number of Shares Outstanding ?
You now have the value of the business as a whole. To get from here to the value per share, you need to enter the total number of shares out there. You can find that information in the 10K.
You Did It! ?
Of all the stocks you value, buy those which trade at the biggest discounts to their true values. If your inputs to the model have been reasonable, the stock will eventually correct and you’ll make money on the way up. You may need to wait for a moment to pounce, and update your valuation every few months.