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Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

The Mosaic of Stock Analysis
Part 2: Basic valuation
Based on Warren Buffett’s four rules

David J. Moore, Ph.D.
www.efficientminds.com

May 14, 2013

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

The four rules

The company under consideration must...
1 2 3 4

be managed by vigilant leaders, have long term prospects, be stable and understandable, and be currently undervalued.

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

Indicators of vigilant management

vigilant: keeping careful watch for possible danger or difficulties Too much debt → possible danger or difficulty Debt < 0.5 Equity For every $1 of equity there is no more than $0.50 of debt. Unable to meet short term obligations → possible danger or difficulty Current assets current ratio = > 1.5 Current liability

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

Why hold for the long term?

Sustained earnings. Wouldn’t you like to receive dividends year after year? Taxes. Take a look at tax rates vs. holding periods1 : Ordinary income rate ST gains LT gains 5yr gains 15% 15% 10% 8% 28% 28% 20% 18% 31% 31% 20% 18% 36% 36% 20% 18% 39.6% 39.6% 20% 18% Also note that selling every 5 years reduces the amount reinvested and therefore long-run returns.

1 Source:

www.buffettsbooks.com

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

How to assess long term prospects

Do you see the products being used 30 years from now?
iPhones 30 years from now? No. Some type of communication device, Yes. Apps 30 years from now? The app itself no. Programming skills, yes. Candy 30 years from now? Yes. Fans 30 years from now? Yes.

This is perhaps one of the most subjective of the rules. I have no metrics. Perhaps R&D as a percent of sales? What makes you believe this company is going to be around 30 years from now?

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

Indicators of stability

Equity: Steady or growing equity. BVPS Earnings: Steady or steadily growing EPS . Debt: Steady Debt-to-Equity ratio averaging 0.5 or less. The more volatility the more difficult it is to forecast and value.

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

Understandability

Not understandable to me
Facebook: falsified accounting statements, very likely that no one reading this has spent a dime there, not sure how they are going to make money. XM Radio: with MP3 players, iPods, Pandora, etc., who would pay for XM service?

Understandable to me
Chevron: people drive to work and buy gas. Kraft: people must eat. Cisco: this presentation once converted to ones and zeroes passes through Cisco equipment.

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

How to calculate intrinsic value
Determine growth and discount rates. More on this subject in the next slide.
Use LOGEST to compute BVPS growth rate g . Compare to IGR and SGR . Use the 10 year treasury rate for i .

Compute value of BVPS 10 years from now. BV10 = BV0 × (1 + g )10 Compute present value of 10 years of dividends. DPStot = Compute intrinsic value IV = BV10 (1 + i )10 + DPStot DPS0 i 1− 1 (1 + i )n

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

Growth and discount rates
The two most critical factors are also the most difficult to estimate: g and i . Your value add will be in the justification of g and i . Growth rate g
Will BVPS continue to grow at the same rate g over the next 10 years? If yes, why? If higher or lower, why?

Discount rate i
In the previous slide the 10 year treasury was used to establish a maximum price. At that price or above you are better off purchasing a 10 year treasury for the same return with no risk. The discount rate should be commensurate with the companies risk and your required return. Could just use 10% or an industry specific number from my research.

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

The whole presentation on one slide

Rule 1 2 3 4

Description Vigilant leadership Long term prospects Stable and understandable Undervalued

Metrics D /E < 0.5, CR > 1.5 ? BVPS , EPS , D /E MV < PV [BV10 ] + PV [Div]

The stock analyst adds value (pun intended) by determining long term growth prospects, growth rates g , and discount rates i . The intrinsic value model presumes book grate will grow at g over the next 10 years, dividends will remain constant, and P/B = 1 10 years from now.

Overview

Vigilant management

Long term prospects

Stable and understandable

Undervalued

Summary

Future enhancements

Incorporate risk σ .
The resulting E [R ] must have risk associated with it. The model is highly sensitive to g . Perhaps use LOGEST to produce σg as well.

Include P/B multipliers
The model currently presumes stock will/could be sold in 10 years at the then-current book value, i.e., P/B = 1. However, some stocks trade at P/B multiples way over 1. Could combine E [P/B ] and σ [P/B ] to arrive at E [R ] and σ [R ].

Incorporate VAR-type analysis
What is the 5% worst case P/B over the past 10 years? What is the 5% worst case g over the past 10 years?