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The Ultimate Guide to

by Jae Jun
Learn and Profit using 8 Valuation
Techniques to Value Any Stock
03. How to Use and What to Expect
04. Introduction to Stock Valuation
05. Taking a Bird's Eye View
08. Benjamin Graham's "Net Net" Stocks
12. Graham's Growth Formula for Value
18. Intrinsic Value of a Business
20. How to Value Stocks Using DCF
26. How to Value a Stock with Reverse DCF
28. Katsenelson's Absolute PE Model
Table of Contents
35. Valuing Stocks with EBIT Multiples
38. What is Asset Reproduction Value?
45. The Full Earnings Power Value (EPV)
51. Your Valuation, Your Art, Your Way
52. Bonus: Top 7 Books on Valuation and
56. About the Author
57. Get Started with Old School Value
The Ultimate Guide to Stock Valuation
How to Use & What to Expect
The Ultimate Guide to Stock Valuation
Thank you for your interest in this book.
This book is best served as a companion to the Old
School Value Stock Analyzer and its sole focus is
to guide you through a variety of ways to value
It assumes that you already have a working
knowledge of accounting and understanding of
financial numbers.
Throughout the book, you will see examples and
screenshots that were taken from various parts of
the Stock Analyzer to help you visualize and
Even if you are not a user of the Stock Analyzer, you
will find it easy to follow along and apply yourself.
Click on images that look too small. It will open up a
bigger version in your browser.
Links you come across will take you to various
helpful resources for further reading and
Feel free to distribute this to your family, friends and
anyone else interested in the art of valuing stocks.
The stock market is filled
with individuals who know
the price of everything, but
the value of nothing.
- Philip Fisher
Introduction to Stock Valuation
Valuation Matters
You can purchase the best stock in the world, but if
you buy it at a lofty premium, it is a bad investment.
Vice versa, the stock could be the worst company in
the world, but if you buy it at such a cheap price that
it cannot go down any further, it may just turn out to
be your best investment.
That is why valuation is a huge part of the game.
The problem I fell into as I started my investing
journey was trying to value every stock the same
If you play golf, do you use the same club to hit
every shot? It is the same with valuation. Just
because you know how to do a DCF, it does not
mean you should apply it to every company you
come across.
You must use the right tool in the right situation.
Valuation is an Art
Valuation is important, but it is not black and white.
It is an art.
Every valuation method requires assumptions and
inputs because valuation itself is a forward looking
calculation. A stock price is made up of an asset
value and a growth value. Without considering the
growth value, you end up with just half the equation.
Make realistic assumptions and the inputs will be
acceptable. Do not use numbers to match what you
want the output to be.
Your role as an investor is to be a realist. Not an
optimist or a pessimist or to have your views
There will be people who disagree with the methods
used in this book and with how you end up valuing
stocks. Who cares? Stocks are valued in all sorts of
ways and you will learn 8 valuation techniques from
this book.
It is time to let your art shine.
The Ultimate Guide to Stock Valuation
Hold up.
Before you go off racing, let's go through a brief
overview of each valuation method.
8 Valuation Techniques That Will Help
You Value Any Stock
1. Net Net Working Capital and Net Current Asset
Type: Balance sheet and tangible asset valuation
When to Use: Liquidation valuation, net net stocks,
and when trying to determine the stock price relative
to a stock's net assets. Does not work well for
service or low asset companies such as software.
Description: When Ben Graham was around, the
main types of businesses that existed were industrial
businesses. Mainly factories, manufacturers and
retailers. There were no consulting, software, or
high tech companies you see today. He would
analyze the balance sheet and invest in stocks with
high tangible assets as it protected the downside.
2. Benjamin Graham Valuation Formula
Type: Earnings and growth stock valuation method
When to Use: Cyclical companies, volatile cash
flows, growth stocks, and young companies
investing in growth.
Description: Ben Graham was a balance sheet
investor first and foremost, but he created this
formula to simulate growth investing with value
investing principles.
Since the companies that existed back in Graham's
day did not have the growth of today's environment,
I have made adjustments to the final formula to
make it more applicable to today.
3. Discounted Cash Flow (DCF) Stock Valuation
Type: Cash flow valuation
When to Use: Companies with consistent free cash
flow, predictable companies.
Taking a Bird's Eye View
The Ultimate Guide to Stock Valuation
version. Instead of using whatever a competitor is
being valued as the benchmark for the valuation,
the multiple is calculated based on the business
fundamentals. Created by Vitaliy Katsenelson,
author of Active Value Investing.
6. EBIT Multiple Valuation
Type: Multiples method
When to Use: Capable of valuing all companies
Description: Used by many on Wall Street and a
good back of the envelope calculation method. It
has the advantage of being simple and concise.
EBIT is the main driver of the valuation which
makes it applicable for all companies.
7. Asset Reproduction Value
Type: Balance sheet valuation
When to Use: Calculate asset value by making
adjustments to the balance sheet. Also used to see
how much a competitor would have to spend in
order to replicate the company's business.
Description: In a way, this is a health and moat
test. If the value of the balance sheet after making
Description: No need for any introductions to the
DCF method.
It has its weaknesses and advantages which I will
discuss, but overall, it is a highly effective tool for
calculating predictable companies or with realistic
projections and to test scenarios.
The DCF I use is derived from F Wall Street which
is a practical real world version and great for small
4. Reverse DCF
Type: Cash flow valuation of market expectation
When to Use: Any situation to figure out what the
market is expecting from the stock.
Description: A backwards valuation to find what the
market is expecting from the stock. Instead of
entering the future growth rate, the goal is to find out
what the market is expecting the stock to achieve.
5. Katsenelson Absolute PE Model
Type: Fundamentals based multiples
When to Use: Companies with positive earnings
Description: When you think of multiples for valuing
stocks, it is relative. This version is an absolute
The Ultimate Guide to Stock Valuation
adjustments to its line items are strong, the
company is protected by its assets and it is easy to
identify the floor for the stock price.
The way it acts as a moat test is that if the asset
reproduction value is high relative to its stock price,
then new entrants will have difficulty entering the
8. Earnings Power Value (EPV)
Type: Adjusted earnings valuation
When to Use: For all companies but even better for
cyclical, volatile, and young companies.
Description: It is best to use EPV in conjunction
with the Asset Reproduction Value method. It is a
technique for valuing stocks by making an
assumption about the sustainability of current
earnings, and the cost of capital but assuming no
further growth.
Sound complicated? It is at first, but you will get it.
Important Note as You Value Stocks
As you learn about each method and start to
perform these valuations, get in the habit of finding
values based on different scenarios.
This will give you a range of valuations instead of
anchoring on a single absolute fair value.
Think about the low end, high end, and market
expected scenario to form a rounded conclusion
about what the stock is worth.
Key Old School Value Subscriber Tips
Each of the valuation techniques and ratios
mentioned in this book is included in the Old
School Value Stock Analyzer.
Follow the examples with the Stock Analyzer and
maximize your time by quickly identifying and
valuing profitable stock ideas.
The Ultimate Guide to Stock Valuation
Benjamin Graham's "Net Net" Stocks
In 1932 at the bottom of the Great Crash, Ben
Graham's fund had lost 70% of its value.
It was precisely at this time when he wrote a Forbes
article stating how cheap the market was. In fact,
Graham remarked about how the market was selling
the United States for free.
What made Graham make this claim?
Deep Value Companies
It all came down to the way Graham looked at
Stocks were being quoted in the market for much
less than its liquidating value, priced as if they were
destined to be doomed.
This still happens today.
But does it make sense to be quoted for less than
the cash in your hand?
Such deep value stocks are referred to as "net nets"
and the idea is to calculate the liquidation value.
The common definition used is Net Current Asset
NCAV = Current Assets - Total Liabilities
You can see how conservative the above definition
But the term current assets is rather broad. It
consists of cash, accounts receivables, inventory,
and other assets easily convertible to cash. A
company with 100% cash is much better off than a
company with 100% in prepaid assets.
And so, to define it clearer, I use a variation of
NCAV which is stricter, but makes more sense and
offers extra security when valuing and selecting net
net stocks.
That variation is called Net Net Working Capital.
Liquidation Value
Graham defined liquidating value
very conservatively.
The Ultimate Guide to Stock Valuation
Net Net Working Capital
The formula for NNWC is
Net Net Working Capital =
Cash and Short-term Investments
+ (75% x Accounts Receivable)
+ (50% x Inventory)
- Total Liabilities
The formula states that
cash and short term investments are worth
100% of its value
accounts receivables should be taken at 75%
of its stated value because some might not
be collectible
inventories should be discounted by 50% in
the event a close out sale occurs
NNWC places importance on the main parts that
make up current assets; cash, accounts receivables
and inventory.
When it comes to valuing net nets, you want to find
high quality ones. This is an oxymoron because net
nets are trading at deep value ranges for a reason,
but out of the dump, you can find a few stocks that
shine brighter than the rest.
Let's look at a couple of examples.
ADDvantage Technologies (AEY) is a net net with
Cash and equivalents: $7.54m
Accounts receivables: $3.42m
Total inventory: $21.54m
Total Current assets: $33.63m
Total liabilities: $4.62m
Shares outstanding: 10.03m
NCAV = $2.89 per share | NNWC = $1.62 per share
The Ultimate Guide to Stock Valuation
iGo Inc (IGOI) is a company that is extremely
Cash and equivalents: $8.21m
Accounts receivables: $3.53m
Total inventory: $6.03m
Total Current assets: $20.35m
Total liabilities: $3.04m
Shares outstanding: 2.91m
NCAV = $5.95 per share | NNWC = $4.46 per share
iGo is a typical net net selling well below its net net
value. Numbers look good, but always consider the
history of losses and business model.
The key to valuing and investing in net nets is to
purchase a basket of them.
A few days after writing this, iGo was bought out at
a 50% premium to its stock price.
This is the way net nets make you money.
By buying a basket of them at dirt cheap prices, you
protect the downside even though the company has
a horrible business model and operational issues.
There are always bigger companies who may see
value in acquiring such companies. For bigger
companies, it is easy because they can strip out
money losing divisions and merge it into their
existing lines or distribution networks. This will
immediately return results whereas the acquired
company may never have been able to achieve
such returns on its own.
You can calculate the NNWC of any stock. For
some stocks, the NNWC will be negative and that
just means that the company has more liabilities
than the net net value. A negative NNWC does not
indicate a bad business. Apple currently has one of
the strongest balance sheets in the world but it has
a NNWC of -$24. It just means that referencing
NNWC is unimportant for such companies.
"Normal" companies like MIcrosoft have stock
prices far higher than its NNWC. Compare the
The Ultimate Guide to Stock Valuation
Key Old School Value Subscriber Tips
The Net Net section of the Stock Analyzer will
import the necessary balance sheet items
automatically to make it easy to calculate.
Experiment with the percentage multipliers. You
can increase or decrease the values depending
on your situation. There is no hard rule that it has
to be 75% of receivables and 50% of inventory.
numbers for Microsoft with ADDvantage or iGo and
you will get a good idea of how cheap a stock can
really get.
Microsoft has a NNWC and NCAV of $3.24 and
$4.32 respectively. The total stock price is always
made up of two parts, the asset value and the
growth value.
$3.24 is the asset value which means that $31.57 of
the stock price is attributable to growth and future
The Ultimate Guide to Stock Valuation
NCAV or NNWC is not a pure valuation. It is
designed to be used as a measuring stick for
cheapness and show you what the assets of a
company is worth.
Benjamin Graham liked cheap net net stocks. What
you may not have known is that Graham also came
up with an intrinsic value formula to simulate growth
investing valuation but applied a value investing
The Graham Growth Valuation Formula
This is the formula that Benjamin Graham published
in The Intelligent Investor.
V = EPS x (8.5 + 2g)
V is the intrinsic value
EPS is the trailing 12 month (TTM) Earnings
Per Share
8.5 is the PE ratio of a stock with 0% growth
g is the expected growth rate for the next 7-
10 years
The formula was later revised as Graham included a
required rate of return.
Graham's Growth Formula for Value Stocks
The Corporate Bond Rate
The 4.4 was the average yield of high-grade
corporate bonds in 1962 when this model was
The entire formula is then divided by Y which is the
current AAA corporate bond rate, which you find it
on Bloomberg or Yahoo. Dividing by the AAA rate
normalizes the 4.4% bond rate to today's
The reason for the inclusion is that Graham wanted
a minimum required rate of return for investing in
You see, Graham knew that intrinsic value was more
than just growth rates and EPS estimates. He knew
that intrinsic value was related to fixed income rates
or bond rates and that stocks and bonds compete
with each other and are therefore related.
Graham wrote a lot about how the stock PE ratios
were affected by the bond yield levels as well as the
Here is a quote from Graham that talks about this.
The Ultimate Guide to Stock Valuation
The common consensus is that you should use
forward estimates of EPS. However, Graham did
not intend the formula to be used in this way.
Use a 5 to 7 year average of EPS to normalize the
value. If the company is a high growth company,
then the EPS should be calculated by using rolling
Remember that if you use analyst EPS estimates, it
tends to be on the optimistic side and will result in a
valuation at the upper range.
What To Do About Growth?
Growth for a value investor?
Yes, and that is what Graham wanted to mimic.
Although trying to estimate growth in general is a
drawback, it is a big element of the whole valuation
There are two parts that make up the growth
The PE of 8.5
and the growth rate, g
Graham defined 8.5 as the PE for a company with
zero growth. There is no clear indication of how this
number was derived, so I will have to take Graham's
word and his research.
As you test the formula yourself, you will notice that
bond rates affect valuation.
The lower the yield the higher the price. This goes
back to bond basics. If the yield is low, the price is
high. If the yield is high, the price is low.
Graham designed the formula to replicate this line
of thought. Think of it as inflation adjusting.
So it is important to understand the current bond
environment as you value stocks with the Graham
Adjust Earnings Per Share
Further discussion on how to use the EPS value of
the formula is required.
It seems logical to me that the
earnings/price ratio of stocks generally
should bear a relationship to bond
interest rates.
Viewing the matter from another angle, I should
want the Dow or Standard & Poor's to return an
earnings yield of at least four-thirds that on AAA
bonds to give them competitive attractiveness with
bond investments. - Ben Graham
The Ultimate Guide to Stock Valuation
Final Adjusted Graham Formula
Here is what the final formula looks like.
Time for some examples.
The Graham Formula in Action
Let's run this formula through a couple of stocks.
Microsoft (MSFT) is up first.
I am going break the rules of what I wrote already,
but follow along to see why.
First, here are the inputs that I will be using for the
EPS = $2.51
g = 13.9%
Y = 4%
For a company like Microsoft with a huge moat and
good predictability, you do not need to worry so
much about using the past 5 - 7 year averages.
But instead of using 8.5 as the no growth PE, I have
reduced it to a PE of 7 in my version of the formula.
Nowadays, even if a company has zero growth
prospects, if it is able to maintain cash flows and
distribute dividends, the PE is easily higher than
And I prefer to err on the side of conservatism.
Choosing the growth rate is very much the same as
how you find the EPS.
Instead of using a single forward estimate, calculate
the average 5-6 years of growth experienced by the
company. If a company has 3 years of operating
history, then take the average of the three years.
Next is the "2" multiplier which I find to be too
aggressive. This is understandable if you take
things into context. Graham never experienced
companies with growth rates of 20-30% which is
common today. There was no Amazon or Facebook
in Graham's time.
Instead of 2, you can reduce the multiplier to 1.5 or
1. From all the valuations I have performed using
the Graham formula, I have found that using 1 is
completely satisfactory and still yields an optimistic
The Ultimate Guide to Stock Valuation
Applying it to Slow Growth Companies
Although the Graham formula is meant for growth
stocks, it works even better for low growth stocks.
Take a look at American States Water Company
(AWR). It is a utility stock with low growth prospects
but pays regular dividends.
The inputs used are:
Companies like MSFT do not grow or die overnight.
In this case, I like to average the past 2-3 years
That is how I get the EPS of $2.51.
To find growth, I looked at the 5 year and 10 year
rolling median. Surprisingly, the growth rate
between the 5 year and 10 year rolling periods are
identical at 13.9%, which is what I will stick with.
Get the 20 year AAA corporate bond from Yahoo. It
is currently 3.2%. About one to two years ago, the
bond rate was in the 5% range. As discussed in the
previous section on bond rates, the low yield is
going to give a high valuation.
So do you use the 3.2% yield or something else?
Since the other inputs use averages and the bond
rate is bound to go up, the long term bond rate
comes out to be 4%, which is why I have chosen to
use it for the basis of this valuation.
Current Price: $33.49
Graham Formula @ 3.2%: $72.31
Graham Formula @ 4%: $57.70
See the difference in the values when different bond
rates are used?
Click to enlarge the screenshot and view in your
The Ultimate Guide to Stock Valuation
EPS = $2.63
g = 7.8%
Y = 4%
Refer to the calculations in the screenshot below.
Current Price: $53.05
Graham Formula @ 3.2%: $53.31
Graham Formula @ 4%: $42.65
If the valuation in today's environment was most
important, then 3.2% bond rate shows that AWR is
fairly valued at the moment.
However, if you consider what bonds might do in
the future, it is overpriced.
Super Duper Growth Stocks
For a company to grow at rapid speeds, what does
the Graham formula show?
A hot stock like Netflix (NFLX) with an expected
growth rate of 36%.
Since Netflix has such high growth expectations, it
is impossible to use an average.
This is where you have no choice but to use the
analyst estimates.
The inputs are:
EPS = $1.41
g = 36.1%
Y = 4%
The Ultimate Guide to Stock Valuation
Current Price: $223.52
Graham Formula @ 3.2%: $83.65
Graham Formula @ 4%: $66.92
Regardless of whether I value Netflix for the present
or for the future, the Ben Graham model has
decided that Netflix is extremely overvalued.
Out of curiosity, I wanted to see what growth rate
the market is expecting from Netflix.
I will get into the details of this later, but by
performing a reverse Graham valuation, using an
EPS of $1.41 and bond rate of 3.2%, the expected
growth comes out to be 108%!
In other words, Netflix must be able to grow by
108% for the current stock price to be justified.
Download this free excel spreadsheet of the
Graham formula valuation and try it.
Now go find three stocks. One that you believe is
undervalued, fairly valued and over valued and test
it out for yourself.
Key Old School Value Subscriber Tips
Practice makes perfect.
Load different types of companies and look at
how the valuation is affected based on the inputs
you enter.
Understanding the inputs is the key to valuation
The Ultimate Guide to Stock Valuation
So far, you have been introduced to two valuation
methods. I want to break it up here with some
background before diving into the more complicated
valuation models.
This discussion ties in with how you should value
stocks using the DCF model.
Valuing a Business, not a Stock
Learning to use all the valuation methods laid out in
this book is fine and dandy, but there is one big
theme I want you to recognize.
Each method focuses on finding the intrinsic value
as if it were a business and not just a stock.
As an example, let's say McDonalds' earnings
tanked. Immediately, Wall Street will publish sell
reports and how the company is doing horribly.
But for the value investor, if the fundamental core of
the business is operating strongly, then why worry?
One bad quarter does not change the outlook of a
A business does not survive from quarter to quarter.
Small companies can witness events occurring
quickly, but for bigger companies like McDonalds, a
Big Mac will taste like a Big Mac even if earnings
come in lower or higher than expected.
How to Value a Business
When it comes to the idea of valuing businesses,
there is no one better to ask than Warren Buffett.
What is the Intrinsic Value of a Business?
Intrinsic value can be defined simply: It
is the discounted value of the cash that
can be taken out of a business during
its remaining life. - Warren Buffett
This brings me to the discussion of the DCF
valuation method used at Old School Value. The
method is derived from F Wall Street with some
The main components to valuing a business using a
DCF centers on:
1. Finding the sum of the future cash flows
2. Adding the excess cash
3. Subtracting interest bearing debt
The Ultimate Guide to Stock Valuation
The intrinsic value as defined by the seller is very
You have gross income to show how much the
business makes in a year, net cash flow, inventory,
real estate and FF&E (Furniture Fixtures &
Equipment) aka PPE.
These are assets that produce cash flow and
anything remaining will then be added to the
intrinsic value. Subtract any debt like bank loans
and you get the formula highlighted previously.
In business school, where valuation is taught as an
absolute measure, you will fail if you value stocks
like this, but valuation is an art and in the real world,
this is how it is done. The next chapter will show you
how this comes together.
The intrinsic value of a
business in a broad
sense becomes:
Intrinsic Value =
Present Value of Future
Cash Flow
- Excess Cash
- Interest Bearing Debt
A Real Life Small Business Example
To put it into perspective, toss aside the modern
financial modeling hat for a second and think of
yourself as a small business owner.
The truth is that most small business owners do not
understand financial statements or much about
accounting beyond the basics.
However, what the small business owner does
understand is how much cash the business
generates and what their business is worth.
If you look in the local papers or do a quick search
for businesses on sale on the internet, you will find a
common theme in the asking price.
Take a look at this example of a B&B in the state of
Washington where I live.
The Ultimate Guide to Stock Valuation
How to Value Stocks Using DCF
Now let's dive into the technical side of a DCF
model. There are many people against the use of
DCF's. The main argument is that it requires too
many input assumptions.
This is only true if you do not understand the
components and the makeup of a DCF.
Do not do blind DCF's. By understanding each
component of a DCF, you will be able to make
accurate valuations and test ranges of values based
on different scenario assumptions.
Disadvantages of the DCF
1. Projecting Future Cash Flow
The main weakness with the DCF is that you have to
project the future cash flows far into the future.
How do you know whether a business will still exist 5
years later?
How can you predict the cash flow figure 10 years or
20 years out?
With such forecasting, a small error can result in big
differences in the final DCF valuation.
2. Sensitive to Discount Rates
The discount rate you use has a great impact on the
final valuation.
If you are unfamiliar with discount rates, it is a rate of
return you desire by quantifying the importance of
current value of cash versus the future value of
cash. I encourage you to read this full explanation
on discount rates.
A discount rate of 6% could value a company at
$114 per share. Increase it to 9% and it drops to
$88.17. That is a big range and shows you that the
higher the discount rate, the cheaper you want to
buy tomorrows cash flow today.
3. Choosing a Growth Rate
There is no way to accurately predict the growth rate
of a company.
In fact, it is impossible and the same points made for
projecting future cash flows applies here.
Nevertheless, you still need to determine a growth
rate to project future cash and to make the DCF
The Ultimate Guide to Stock Valuation
But there are Advantages
It is not all doom and gloom for DCF.
There is some art required to get good inputs, but
the benefit is that it will give you a good estimate of
intrinsic value.
Remember the Buffett quote?
The intrinsic value of a business is the sum of its
future cash flows.
That is exactly what a DCF model does.
You can also use it as a quick sanity check because
you can work backwards to figure out what the
market is expecting. This is known as reverse DCF
which you will get to in the next section.
The Real DCF Formula
This is the discounted cash flow formula.
Getting That Discount Rate
You need to know what discount rate you want to
use. After all, the word "discount" is in the name of
the valuation method for a reason.
Find the sum of the future cash flow of the business
and discount it back to the present value.
When a bank lends out money, the interest rate it
receives is the discount rate. Remember that
discount rate is another way of saying rate of return.
How much do you want to earn off your
If the bank and fed are risk free investments at 3%,
then would you use 3% as the discount rate? No
you would not because it would be safer and easier
to buy treasury bills for a risk free return of 3%.
Instead of trying to calculate it, here is a quick way
of quantifying a discount rate.
Discount Rate = Risk Free Rate + Risk Premium
The long term risk free rate is around 4% which is
what I prefer to use. Then decide how much you
want to be compensated for investing in the stock
For most situations, the risk premium is around 5%
which makes the discount rate 9%. However, for
Don't worry. It is easier than it looks. I will break it
down to the following formula.
DCF = Present Value of Future Cash Flow + Non
Operating Assets + Excess Cash - Interest Bearing
The Ultimate Guide to Stock Valuation
small and micro cap companies, I prefer to increase
the risk premium to around 8%.
This means that I use 9% as a minimum for stable
and predictable companies like Coca Cola (KO),
while 12% is a good return for smaller and less
predictable companies.
What about WACC?
I do not use WACC and other modern finance
theories because it over complicates things.
The approach I take is from a real world point of
view. When you think of discount rates in terms of
how real businesses operate, it is simple and it
makes sense. That is all you need to get good
valuation results.
Remember it is all about finding the valuation range.
Not whether your discount rate is accurate to the
second decimal place.
Choosing a Growth Rate
When it comes to growth, I err on the side of
conservatism and place more emphasis on the
present data rather than what will happen in the
Do not purely rely on analyst growth rates for one
year estimates. Wall Street and the reports they put
out are too short term focused.
To find a growth rate based on past performance,
calculate the CAGR over multiple short term periods and
then calculate the median of all those values. This will
smooth out the data and eliminate any one time years
that are either great or horrible.
For example, in the OSV Stock Analyzer, the growth
rate is calculated by taking the median over 5 years and
10 years.
For the 5 year period, the CAGR rolling periods are
2007-2011 (4 year period)
2008-2012 (4 year period)
2007-2010 (3 year period)
2008-2011 (3 year period)
2009-2012 (3 year period)
2007-2009 (2 year period)
2008-2010 (2 year period)
2009-2011 (2 year period)
2010-2012 (2 year period)
Then take the median of all these values to get the
median growth rate over the five year span. Apply the
same concept over 10 years. This growth rate is then
used to calculate the projected free cash flow.
In the business world, the rearview
mirror is always clearer than the
windshield. - Warren Buffett
The Ultimate Guide to Stock Valuation
Terminal Value
Once the FCF has been projected, you need to calculate
the company's cash flows when the company enters
its mature stage grows at a slower pace.
Since the terminal value is so far out in the future, it
does not affect the final valuation by large amounts
since the present value of cash 20 or even 30 years
away is worth very little today.
Keep it easy and use 2% or 3% for the terminal
Include Non Operating Assets
For the final piece of the DCF, you want to find out
what the public stock is worth by including non-
operating assets and subtracting the debt that bears
interest. In other words, you are finding the equity
value of the shares.
A company uses assets to generate FCF. This can
include buildings, equipment, chairs, phones and
However, there are assets that do not generate any
cash flow. For example, a company may own a car
park that is sitting in the middle of nowhere doing
nothing. The property has value though. Such
assets are referred to as non-operating and should
be added back to the DCF calculation.
Determining the value of non-operating assets is
time intensive. Consider looking for this information
once you find a company worth digging into and not
right away.
Add Excess Cash and Subtract Debt
Same with cash. There is cash that you need to run
the business and cash that exceeds what the
business needs. This non-operating cash does not
help create cash flow and so it is classified as a
non-operating cash, aka excess cash.
Use the following formula to calculate excess cash.
Excess Cash = Total Cash MAX(0,Current
Liabilities-Current Assets)
Subtracting debt is tricky because you need to use
the market value of debt which is rarely available.
Instead, calculate the present value of any long
term debt.
Optional Additions to the DCF
A more advanced DCF model involves a multi-stage
approach. This is where several growth rates are
used, instead of a single growth rate. The benefit in
using a multi-stage DCF is that you can simulate the
business cycle better.
The Ultimate Guide to Stock Valuation
The OSV Stock Analyzer is a powerful 3-stage
DCF and the inputs have been simplified for ease of
Instead of guessing what the future performance will
be, the model starts off with the default value for
growth and then reduces it by 10% in years 4-7 and
then reduces the growth rate further by another 10%
in years 8-10. Thus the 3-stage approach.
The idea is to simulate the business cycle.
The last optional piece to include in the DCF is
related to intangibles.
If a discounted cash flow is designed to calculate
the value of a stock based on cash producing
assets, certain companies must have their
intangibles added to get the fair value.
Coca Cola (KO) outsells all other cola due to its
brand recognition. By leaving out the intangibles,
you will be missing out on one of the biggest cash
generating assets.
Here is the formula again with intangibles added.
The brackets around intangibles is to show that it is
Present Value of Future Cash Flow
+ Non Operating Assets
+ Excess Cash
- Interest Bearing Debt
- [intangibles]
Discounted Cash Flow in Action
Using the Stock Analyzer to load Microsoft (MSFT),
the assumptions used for the DCF are as follows:
Discount rate: 9%
Growth rate: 10%
Starting FCF: $27,522m
Terminal rate: 2%
Intangibles to add back: 10%
Microsoft is a very predictable cash flow generator.
It is in the mature stage of its business cycle, so
growth above 15% is unlikely.
In fact, the growth rate over the past 5 years is
12.3% compared to a growth rate of 7.8% in the
past 10 year period.
By taking the average of the 5 and 10 year periods,
I get my 10% growth rate.
The Ultimate Guide to Stock Valuation
The FCF to end 2012 was $29,321m but the TTM
number is $27,522m which is what I use as the
starting point of the DCF.
If the numbers were reversed, I would still start with
the smaller number.
The projected future cash flows looks like this.
click to enlarge
For intangibles, I like to add 10%. You may think it
is too little considering Microsoft is synonymous
with Windows and Office, but even if I increase it to
50%, the difference in the stock valuation comes
out to be a mere $0.15.
The final DCF calculation shows the following:
Present value of future cash is $477,429m
Excess cash of $74,483m
Interest bearing debt of $8,701m
Total Present Value of $543,534m
Divide the Total Present Value by the shares
outstanding to get the final per share value.
Key Old School Value Subscriber Tips
Download and follow along with this Stock
Analyzer PDF report on Microsoft (MSFT).
Look at the numbers and see how I use it in this
Download this Free DCF Excel template here.
The fair value is $65. Compared to the stock
price of $33.67, the margin of safety then
becomes 48%.
The Ultimate Guide to Stock Valuation
How to Value A Stock with Reverse DCF
The advantage of a reverse DCF is that it eliminates
a lot of the inputs required in a DCF.
Instead of starting with a given FCF, and then
projecting towards an unknown, the purpose of the
reverse DCF is to calculate what growth rate the
market is applying to the current stock price.
By taking this backwards approach, it simplifies the
DCF thought process and output from what is the
future growth rate?, to is the expected growth rate
Take Lumber Liquidators (LL).
The current stock price is $80 and has climbed
dramatically on the tailwinds of a housing market
"recovery". Using a discount rate of 9% with the TTM
FCF number of $35.2m, the required growth rate to
come to a valuation equal to the stock price of $80 is
Is 30% a sustainable growth rate? In this particular
industry? At the current lofty valuations, is there
more upside or downside?
Such questions are much easier to answer with the
reverse DCF.
Application of Reverse DCF
Here are the details of the Lumber Liquidators
reverse DCF valuation. Click the image to see the
full size with notes.
1. Start with the TTM FCF number
Enter the TTM value because you want to work
backwards from today's valuation.
The current valuation is best represented by the
TTM figures because the market is short term
2. Change discount rate to 9%
You are looking for market expectations and a 9%
discount rate best represents the historical average.
The Ultimate Guide to Stock Valuation
3. Adjust growth rate
Change the growth rate so that the fair value
number matches the current price.
This will show you what the market expectation for
growth is. Remember that this is an approximation
and a measuring stick to quickly see whether a
stock is cheap or expensive.
In the case of Lumber Liquidators, a 30% growth
rate is unsustainable for a cyclical company.
Lumber Liquidators could continue to go up but from
a value investor's point of view, the current numbers
and expectations are too lofty to merit an
The Temperature Test
When you walk into a room, it is obvious whether it
is hot, cold, or comfortable. You do not need to
concern yourself with knowing the exact
Stock valuation is the same concept. The reverse
DCF will help you with this as you can see in the
next example.
Identifying Cheap Stocks
Lumber Liquidators is an example with high market
expectations. Take a look at Cisco for an example
of a company with low market expectations.
Cisco shows that with the TTM FCF and 9%
discount rate, the expected growth priced into the
stock price is -1%. Back in 2011, I calculated a
growth rate of -9.6%.
Although the market has eased up a little on Cisco,
there is still pessimism and uncertainty surrounding
the company.
Is Cisco still cheap and worth further investigation?
You bet, and the reverse DCF method will help you
identify such stocks quickly so that you can focus on
research instead of wandering around looking for
companies to analyze.
Key Old School Value Subscriber Tips
The reverse valuation section is the same as the
DCF valuation section in the Stock Analyzer.
The only difference is how you enter the inputs.
The Ultimate Guide to Stock Valuation
Katsenelson's Absolute PE Model
This model is named after Vitaliy Katsenelson, Chief
Investment Officer of Investment Management
Associates, based in Denver.
In his book, Active Value Investing, Katsenelson lays
out a valuation model using absolute measurements
instead of relative numbers.
A relative valuation is where you value a stock by
comparing it to other stocks. E.g. if company A has a
multiple of 15x but a competitor has a multiple of 20x
then company A is cheap.
The problem with this is that it depends on the
market conditions. In a recession, a company could
have a multiple of 10x and be considered fairly
valued or expensive just because a bear market
pushes down all stocks.
The Katsenelson approach assigns a company with
PE "points" and then calculates the fair value by
multiplying it with a final multiple factor. This is an
absolute approach to remove the effects of market
dependency and competitor bias.
Katsenelson's Absolute PE Model
The model derives the intrinsic value of the stock
based on the following five conditions.
1. Earnings growth rate
2. Dividend yield
3. Business risk
4. Financial risk
5. and earnings visibility
Like all valuation models, there is some subjectivity
involved. In this case, you are required to grasp an
understanding of the business to identify the level of
risk involved for points 3, 4 and 5.
Core Idea of the Absolute PE Model
No Growth PE
Part of the reason why I created the no growth PE
screen was for the purpose of this valuation method.
I needed to know whether my conservative nature of
using a PE of 7 for no growth was factually correct.
My results show that a PE range of 7 to 8.5 is
perfectly acceptable so you are free to use whatever
suits you.
The Ultimate Guide to Stock Valuation
Graham used 8.5 in his growth formula, and
Katsenelson uses a PE of 8 in the book.
I will stick to a PE of 7 because if you flip the PE
over, the earnings yield is 14.2% compared to
11.8% and 12.5% for Graham and Katsenelson
With the small caps I analyze, demanding an
earnings yield of 14.2% is better than 11.8%.
However, if I analyze large blue chips such as
Microsoft, I am content to adjust the PE to 8.5.
Earnings Growth and PE Relationship
Instead of calculating growth projections,
Katsenelson's Absolute PE method reverse
engineers the PE ratio to come up with a growth
rate according to the table on the right.
The table has been adjusted to have 0% growth for
stocks with a PE of 7 and below. The "Original PE"
column is what is used in the book.
For every percentage of earnings growth from 0% to
16%, the PE increases by 0.65 points.
Once the growth rate reaches a certain level, in this
case 17%, the PE value increases by 0.5 points and
maxes out at 25% growth. So any stock with a PE
higher than 21.9 is capped to a 25% growth rate.
The Value of Dividends
Dividends are tangible to the investor whereas
earnings are not. Dividends provide you with a hard
return whereas you may never get to see earnings.
The Ultimate Guide to Stock Valuation
In contrast to the non-linear points relationship
between earnings growth and PE in the table, the
dividend yield and PE has a linear point system.
Every dividend yield percentage receives an
equivalent PE point. If the dividend yield is below
1%, give a bonus of 0.5 points.
PE Factors for Business, Financial Risk
and Earnings Visibility
This is where some subjectivity is involved as it
requires you to come up with a single number to
summarize the risks and earnings visibility.
For business risk, you want to consider the industry
the company is in, the products, the life cycle,
concentration of products and customers,
environmental risks, and anything else related to
the operations of the business.
The level of financial risk can be determined by
examining the capital structure of the business as
well as the strength of the cash flow in relation to
debt and interest payments.
Earnings visibility is analyzed in much the same
How Business Risk is Quantified
In order to quantify business risk, I went through
various ratios and numbers to identify what makes a
business good.
Everybody has a different definition of business risk,
but what I have tried to do is come up with four
items that the majority of investors would agree to.
The four are:
1. Return on Equity
2. Return on Assets
3. Cash Return on Invested Capital
4. Intangibles % of Book Value
The first three are self explanatory. Businesses
capable of sustaining above average returns or
increasing returns each year has a good business
model, moat, and capable management.
The fourth needs some explaining.
I have added intangibles as a percentage of book
value because I do not want businesses to grow by
acquisition which could lead to issues later on.
Growth through intangibles is not a good business
model and has no competitive advantage.
High intangibles do not reflect business risk, but
The Ultimate Guide to Stock Valuation
continually growing intangibles is a red flag.
How Financial Risk is Quantified
The four factors that make up financial risk are:
1. Current Ratio
2. Total Debt/Equity Ratio
3. Short Term Debt/Equity Ratio
4. FCF to Total Debt
A company with a strong current ratio does not run
the risk of going under.
Total debt/equity and short term debt/equity is
included because total debt may not give the whole
picture. A large upcoming debt payment is much
more worrisome than a low interest, long term debt
due in 10 years.
FCF/Total Debt displays the financial strength
because it shows whether the company is able to
pay back its debt through FCF instead of taking on
new debt.
Earnings Predictability
Trying to quantify earnings predictability is more
difficult, so it is best to keep it as simple as possible.
1. Gross Margin
2. Net Margin
3. Earnings
4. Cash from Operations
For a company to be predictable, it has to have
stable margins, stable or increasing earnings and
cash from operations.
As much as I like FCF or owner earnings, I do not
use it for this valuation model as it is volatile and not
a good measurement for predictability.
The Absolute PE Formula
The formula to calculate the fair value PE is
Fair Value PE =
Basic PE
x [1 + (1 - Business Risk)]
x [1 + (1 - Financial Risk)]
x [1 + (1 - Earnings Visibility)]
where the Basic PE is the starting PE from the
Business risk, financial risk, and earnings visibility
scores are calculated automatically in the Stock
Analyzer. However, to do it manually, follow these
quick hand instructions.
The Ultimate Guide to Stock Valuation
For any stock you look at, it will fall into one of three
categories. Average, above average, or below
For each of the three business quality factors,
if the company is an average company, give
it a value of 1.
if the company is a market leader, select a
number less than 1. If you believe a market
leader deserves a 10% premium, then use a
value of 0.9. If a 15% premium is deserved,
then 0.85 is the number to use.
if the company is a market lagger, select a
number greater than 1. Poor companies
should be discounted and so by giving it a
higher number, it will minus some points in
the final calculation. E.g. a stock is in horrible
shape and cannot pay its bills, then you may
want to give it a 20% penalty for financial
risk. For this, you would assign a value of
Checking Out Wal-Mart
Starting with Wal-Mart (WMT), the company rules
retail and its competitors. Strong balance sheet,
huge competitive advantage capable of swallowing
any small competitor.
Consistent dividend payouts, FCF cow, stable
margins, CROIC of 9% with ROE of 20+% makes
this one of the best retailers in the world. Debt is not
an issue as FCF can cover all interest payments. It
also makes earnings growth and visibility easier to
Based on the past 5 year median EPS growth, Wal-
Mart achieved 11% earnings growth which sounds
about right. Although WMT is the best of breed, it
only gets a 6% premium for the business as retail is
still a tough industry to be in regardless of who you
are competing against.
The financials are wonderful. The balance sheet is
powerful and extremely efficient. Wal-Mart leads the
competitors easily and deserves a 10% premium
over its competitors.
For earnings visibility, Wal-Mart scores an 8%
premium to competitors. It loses a couple of points
from down years, but other than that, the company
is very easy to predict.
Combine all this together and the inputs for the
Absolute PE valuation become:
Expected Earnings Growth: 11%
Dividend Yield: 2.5%
Business Risk: 6% premium = 0.94
Financial Risk: 10% premium = 0.90
Earnings Visibility: 8% premium = 0.92
The Ultimate Guide to Stock Valuation
For a great business such as WMT, the fair value
PE comes out to 21.65. However, since WMT is in
the retailing business, a business risk of 1.00 could
have been applied due to the competitive nature of
the industry. As a rule, apply a maximum premium
of 30% to the basic PE which means that the final
fair value PE should be capped at 22.35.
According to this calculation, Wal-Mart is priced
attractively with its current PE of 14.69 with room to
move up if the business continues to operate
Comparing with Target
Target (TGT) is number two behind Wal-Mart.
Margins are solid and consistent, with a sub par
CROIC average of 6%. ROE of 18% and no issues
with debt or financial risks. Earnings growth has
been a lackluster 5% and likely will be the same.
Expected Earnings Growth: 14%
Dividend Yield: 2.50%
Business Risk: 3% premium
Financial Risk: 5% premium
Earnings Visibility: 5% premium
The fair value PE of 21.2 gives an expected
future growth rate of 23% compared to the
current expected growth of 14% and adjusted PE
of 18.7.
Some room to move, but the margin of safety is
The Ultimate Guide to Stock Valuation
An Example of a Bad Company
Both Wal-Mart and Target are great companies. On
the other side of the spectrum is RadioShack
Unlike Wal-Mart and Target, RadioShack is a
consumer electronics goods and services retailer
struggling to turn a profit. It is loaded with debt and
does not have a PE as earnings is negative.
In a situation like this, the Katsenelson model will
not work because the adjusted base PE is zero to
begin with.
See the image below to see why.
Summing Up
The advantage of using this method is that you do
not have to value the company based on another
company's multiple.
The disadvantage is that the calculation uses the
current PE as the anchoring and starting point of the
valuation. If the PE is already high, and the
business fundamentals are strong, it will add on
more points to the already overvalued PE.
To improve on this and to be able to apply it for
companies with negative earnings, you can try
substituting PE for EV/EBIT, EV/EBITDA or another
One important point to end with is that you need to
have a systematic way of quantifying the business
risk, financial risk and earnings predictability. It is
too easy to randomly apply a premium based on
what you feel the company deserves. Having a set
of rules and systems will keep the way you value
companies consistent and prevent bias.
Key Old School Value Subscriber Tips
If the starting growth rate is too high, don't be
afraid to adjust the "Expected PE" box for a value
more inline with what is expected.
The Ultimate Guide to Stock Valuation
Although the downside of relative valuation was
described in the previous chapter, there are times
where it is useful for valuing stocks.
The important part is to know how to perform a
relative valuation properly, and not just slapping on a
multiple to come up with a fair value.
PE multiples are thrown around a lot when talking
about stocks, but the better way to value stocks is to
use EBIT multiples.
EBIT: Earnings Before Interest and Tax.
Difference between EBIT and EBITDA? EBIT
recognizes that depreciation and amortization are
real expenses related to the use and wear of assets.
How People Perform Multiples Valuation
The All Too Common Way
Have you heard or read something like this?
DELL is trading at a PE of 10.6x with a
Forward PE of 8.7x. Its competitors are
trading between 9x to 14x.
If DELL corrects their problems, it should
trade at similar multiples to its competitors.
Therefore DELL is worth $18.
Keeping things simple is important, but it should not
be simplified to the point where it becomes garbage
in, garbage out.
Problems Doing it This Way
The problem is that PE is a broad metric which can
vary greatly depending on adjustments to the
income statement.
Such adjustments are:
goodwill charges: this can reduce earnings
drastically even though it does not affect the
business operation
income from discontinued operations can
inflate PE
share repurchases: reduces the number of
shares outstanding which increases the EPS
Valuing Stocks with EBIT Multiples
The Ultimate Guide to Stock Valuation
Doing it the EBIT Way
First, start with a normalized revenue estimate. To
get a normalized revenue value, take the average
revenue over anywhere from 3 to 5 years,
depending on the history of the company.
Multiply revenue with a conservative, normal and
aggressive operating margin to get the range of
EBIT values.
Then decide what multiplier you want to multiply the
EBIT value by. A normal case multiplier is
considered to be between 8-10.
Now add cash and subtract debt to get the total
equity value.
It is that easy, and that is the attractiveness of the
multiples method.
Use the online EBIT calculator to see the details of
what inputs are required in the calculation.
The EBIT multiple valuation also makes it easy to
perform a sum of the parts analysis. If a company
has several subsidiaries or operating segments, you
can perform a EBIT valuation for each segment and
then add it up to get the total equity value.
Valuing DELL with EBIT Multiples
DELL makes for an interesting case study because
it is in the middle of a buyout with several big
investors coming up with their own valuation targets.
Michael Dell will buy out DELL at $13.36
Carl Icahn has come out and said that he
wants DELL to issue a $9 special dividend
because he values it at $22.81
Jim Chanos has revealed that he is short
DELL going into the deal citing issues with
the balance sheet and cash flow. (In other
words, he does not think it was worth $13.65)
Three different valuations. Three different scenarios.
Lets jump straight into the numbers and see how
this works.
The numbers and assumptions used for the
normalized case are:
normalized revenue over 5-6 years is $59b
normalized operating margin of 5.3%
fair value EBIT multiple of 8x
add cash and subtract debt
These numbers result in the following valuation.
The Ultimate Guide to Stock Valuation
The three fair value targets are:
conservative fair value of $10.87
normal case fair value of $16.51
aggressive fair value of $21.12
Although Jim Chanos has not revealed his target
price, it will likely be closer to $10 which is the lower
end of the range.
Michael Dell is hovering below the normalized value
to get a cheaper deal than the fair value. Current
news has Michael Dell not budging on his buy out
Carl Icahn is the optimistic and aggressive investor
of the group.
But this example should give you an idea of how to
value a business using EBIT multiples.
Coming up with the EBIT multiple is the hardest part
and this is where you will want to compare to a
competitor to find a fair EBIT multiple.
The numbers for cash and debt came from the
Stock Analyzer and verified against the latest 10-K.
Free EBIT Multiple Calculator
Use the EBIT Multiple Calculator for free today.
The Ultimate Guide to Stock Valuation
What is Asset Reproduction Value?
Calculating the reproduction value of a company's
assets is the first part of the Earnings Power
But what does it mean to find the cost of reproducing
an asset?
Reproduction value looks at how much it will cost a
competitor to purchase the assets required to run a
competing company.
As an example, based on book value, machinery
and equipment could have been depreciated over 5
years and is now worth $1m on the books compared
to the purchase price of $2m.
However, a competitor will have to pay $2m to
purchase the same equipment. Not $1m.
There are several items like this in the balance sheet
where the current value may be more or less than
what is required for a new entrant.
Another quick example is brand recognition. For a
new cola beverage company to compete with Coca-
Cola, a huge amount of money must be spent to
replicate the brand recognition. Coca-Cola's
intangible value may be listed as $1b on the balance
sheet, but for any new competitor, it will have to
spend in excess of that to build momentum and
market penetration.
To really understand the details of asset
reproduction, let's dig into National Presto's (NPK)
2010 annual report.
Key Old School Value Subscriber Tips
You can adjust values in the balance sheet by
going to the EPV valuation and using the
"Adjustment" section.
There is an adjustment section for both assets
and liabilities.
The Ultimate Guide to Stock Valuation
1. Make Adjustments to Current Assets
Start by grabbing a copy of National Presto's 2010
annual report or load the latest numbers for National
Presto into the OSV Stock Analyzer.
Using National Presto's numbers, I have organized
the data into the following format showing the book
value and the adjustment amount.
Cash and market securities will always be 100%.
Cash is what it is. No more, no less.
You need to add the doubtful reserve to accounts
receivables. A competitor will not have the luxury of
being able to perform at the same level without a
doubtful account for A/R.
Inventory is increased by $4.2 million because
National Presto uses the LIFO inventory method.
Restating it in terms of FIFO results in an increase
of $4.2m.
The only adjustments made were to accounts
receivables, finished inventory and deferred tax
Quick Tip
To see whether LIFO or FIFO is used, do a search
in the 10-K using CTRL+F and type in "LIFO" or
Deferred taxes. National Presto expects to receive
$6.3m from overpaying taxes. This 2010 report was
released at the end of its fiscal year so at the time
this report came out, I am assuming that the
company received a quarter's worth of deferred
$1.6m is a quarter of the deferred taxes ($6.3m/4),
so subtract $1.6 from the original amount to
represent the adjusted value of $4.7m
No adjustments to other current assets.
The Ultimate Guide to Stock Valuation
2. Make Adjustments to PP&E
Basic PP&E is $58m but as you go through the
report, you will realize that it is worth more.
Qualitative research is required to properly identify
whether assets are over or undervalued.
Thankfully, National Presto is very easy to analyze
because the company provides all the stated and
adjusted values in its report.
The 2010 value of PP&E was $58m, however, $49m
was deducted for accumulated depreciation.
Depreciation is a non-cash expense so when you
add it back in, the adjusted value is $107m.
National Presto is over 100 years old. This means
that they have assets that have been written off to
zero. However, it will cost a competitor to own those
same assets.
National Presto owns land and buildings and uses a
straight line depreciation method giving 15-40 years
of depreciation to buildings and it will be worth more
than what is stated on the balance sheet.
To take your analysis one step further, you could
get an appraiser to value surrounding land and
property to determine how much you should adjust
the value.
A quicker and cheaper way is to perform online
searches on real estate services like Zillow to get
According to the 2010 report, NPK has a facility
where 314,000 sq ft is used for industrial purposes,
and 140,000 sq ft is used for offices.
Commercial property searches show that value of
industrial buildings are much cheaper than offices.
In Wisconsin, where its building is located, industrial
buildings go for a range of $2 $5 per sq ft
compared to $7 $12 per sq ft for office buildings.
So you can do something like 314,000 x $5 +
140,000 x $12 = $3.25m for this facility.
Repeat for other buildings and land values and then
continue making those adjustments.
Machinery and equipment in National Presto's
business is very specialized. In a liquidation event,
highly specialized equipment will be discounted as
the number of buyers are limited.
The Ultimate Guide to Stock Valuation
The demand will also be much lower compared to
common high end equipment like photocopiers.
But as an ongoing asset, National Presto's
equipment is expensive and requires a competitor to
pay the full price in order to do business.
3. Make Adjustments to Goodwill
For National Presto, R&D is negligible but it does
have important patents for its housewares/small
appliance business. The housewares segment
make up 30% of revenue and its patents protect that
revenue to a certain degree. I have assigned a
value of $2m for its patents which is a conservative
amount compared to the revenue.
National Presto sells its products through
distributors and there are no long term contracts set
with any of their buyers. I do not see any monetary
value here. If you are a big company and you have
good products, it is easy to get distribution.
Competitors can replicate their distribution channel
The Absorbent Segment requires in-depth know
how and special training to operate the machines
and to maintain quality. It costs money and time to
train employees to ensure that product quality
meets specifications and orders.
The next move is to adjust for goodwill which is
trickier. To do it properly, it is important that you
learn and understand the business.
Goodwill means that a company has overpaid to
buy another company. What the additional cost
does not specify is the relationship with customers,
the brand image, network effect, patents and other
skills that cannot be valued on the balance sheet.
This is why you need to know the business. It is up
to you to think things through and adjust for special
$2m in value for this
skill is a small yet fair
The Ultimate Guide to Stock Valuation
4. Complete Asset Side Adjustments
After completing steps 1-3, the total adjusted asset
side of the balance sheet is shown below.
By going through the line items of the balance
sheet, it forces you to think about all aspects of the
business. You start with a broad view and then with
each line item, you try to break it into smaller
pieces. The end result of doing this exercise is to
find hidden value the market may be overlooking.
The process is quite long, but once you practice and
find yourself in a rhythm, it will become quicker and
easier. The Stock Analyzer will also help with this.
Now let's move on to the liabilities side.
Adjusting the Liabilities
The accounting definition of the balance sheet is
Assets = Liabilities + Equity
but the business definition of a balance sheet is
Liabilities and Equity are the sources of funds that
support the assets.
You have the asset reproduction value, but a new
business will not pay the same amount. That is
because a business has debt. Just like what you
saw on the asset side, the same adjustments have
to be applied to the liabilities side. Do not subtract
total liabilities because you only need to exclude the
liabilities that do not support the assets.
The Ultimate Guide to Stock Valuation
Bruce Greenwald, calls these types of liabilities
"spontaneous" and "circumstantial liabilities" as a
new entrant is not subject to the same cost.
Spontaneous Liabilities or Non Interest
Bearing Debt
Circumstantial Liabilities
As the name implies, circumstantial liabilities are
incurred by circumstances in the past.
Examples include
paying penalties for insider trading
lawsuits from former employees
inventory catching on fire
Remove these liabilities as it adds no value to
assets. A competitor is not required to pay for these
circumstances to start a competing business.
Subtract Cash not Required to Run the
The final step to calculate the reproduction value is
to subtract cash that is not required in the business
because you want to value the assets based on how
much a competitor will pay for the same things
As a rule of thumb, it costs about 1% of sales to run
one year of operations so the remaining 99% of
cash can be subtracted.
Other examples include accounts payable, deferred
taxes and accrued expenses.
Liabilities of a company that are
accumulated automatically as a result
of the firms day-to-day business.
Spontaneous liabilities can be tied to
changes in sales - such as the cost of
goods sold and accounts payable. These liabilities
can also be fixed, as seen with regular payments
on long-term debt. - Investopedia
Such liabilities that occur due
to day to day operations is
not required by a new
entrant. Remove such values
from the reproduction value
to get an accurate picture of
the final value.
The Ultimate Guide to Stock Valuation
Final Net Reproduction Value
Net Reproduction Value =
Adjusted Asset Value
- Spontaneous & Circumstantial Liabilities
- Cash not Required in Business
The final value comes out to
- $66.7m (spontaneous)
- $4.5m (deferred tax liability)
- $4.8m (1% of sales)
= $593.2m (Net Asset Reproduction Value)
National Presto's asset reproduction value comes
out to be $593.2m compared to its book value of
Putting it Together
On Dec 31, 2010 at the time of the annual report,
the stock price was $130 with 6.86m shares
Market valuation of equity: $889m
Enterprise value: $955.7m
Both book value and net reproduction value made
up about half the market value. This means that half
the stock price was supported by the assets. The
remaining half of the stock price was made up of
growth expectations, which you can consider as the
speculative value making up the stock price.
So far, National Presto was a very straightforward
example. The company is shareholder friendly
which is evident in the way the financial data is
presented. Other companies will be more difficult
because the required information may be buried
deep in the report.
If you try the same exercise for a company like
Groupon (GRPN), you will see that the adjusted
balance sheet will be considerably lower than what
is stated on the books. This will be the same for
companies that are asset light such as software and
services companies.
As a final tip, compare the net reproduction value to
the market cap and enterprise value. If the
reproduction value is close to the market cap, the
market is pessimistic towards the stock and that is
where you can find hidden value.
Further Reading
Liz Claiborne Asset Reproduction
Sealed Air Valuation Case Study
The Ultimate Guide to Stock Valuation
The Full Earnings Power Value (EPV)
There are really two parts to Earnings Power Value.
Asset reproduction and the EPV itself. To fully grasp
the entire method and concept, be sure to have a
good understanding of the asset reproduction
To help you see how both net asset reproduction
and earnings power value go together, let's go
through the asset reproduction of Microsoft and then
follow that up with the EPV calculation. This way you
can see how the numbers relate to each other and
how you should interpret the calculations.
If you feel this is too much repetition and wish to skip
it, jump to the EPV calculation section.
Reproducing the Assets of Microsoft
Company PrintyInk is in the business of selling ink
for printers and has a market value of $1m. But
when you look at the assets, the company assets
are worth around $500k.
By performing the asset reproduction, you should be
able to determine what it will cost you to do business
competing with PrintyInk. That cost is going to be
Now look at Microsoft. Take a step back and think
about its products, brand, moat, scale, marketing
and more.
How much will a competitor have to realistically pay
in order to enter Microsoft's market?
It has a huge OS market share, Office suite, internet
explorer, the name Microsoft is synonymous with the
term PC, they have MSN, Bing, Skype and more.
Microsoft has huge names and a huge moat.
Because there are so many strong assets, in the
balance sheet adjustment, there is no need to
subtract anything from Microsoft's balance sheet.
Key Old School Value Subscriber Tips
Load MSFT into the Stock Analyzer and go to the
EPV section.
Follow along with the latest numbers because the
process is still the same.
The Ultimate Guide to Stock Valuation
The only adjustment I made was to reduce goodwill
by 50% because I know that Microsoft have not
made the best decisions regarding prices paid for
Include Marketing and R&D
The next step is to realize that Microsoft has value
coming from its marketing and R&D.
No competitor will be able to compete if it does not
try to spend money to increase brand awareness or
on R&D. The competition has to acquire the best
talent to develop world class software products and
that costs money.
The amount of marketing added back to the asset
value is calculated by:
Taking the 5 year average of SG&A as a % of sales
and then multiply that number to the current sales
Do the same thing with R&D but for Microsoft, more
weight is given to their R&D capabilities as a
valuable asset.
The easy way to do it for R&D:
Take the sum of the past 3 years of R&D and then
take 80%.
These are rules of thumbs applied for Old School
Value subscribers but I recommend testing your
own rules.
The adjusted total asset is now $126,764m.
The Ultimate Guide to Stock Valuation
Add the marketing and R&D value of $20,290.4m
and $21,413.6m to the adjusted asset value of
This equals $168,468m.
Another note to remember is that off balance sheet
liabilities are liabilities, but a significant part of that
will also have to be reproduced by a new entrant in
order to start business.
Take home shopping company, HSN, as an
example. On the surface, it may be a another home
shopping channel, but for a new competitor to enter
the market the company will have to spend money
on carriage licenses and other network equipment
and licenses that will not appear on the balance
sheet. Such costs may be a liability when valuing
the business as a standalone, but when considering
what a competitor will have to pay, it should be
Subtract Non Interest Bearing Debt and
Unneeded Cash
To calculate cash not required in the business, you
can use the excess cash formula from the DCF
valuation chapter.
The other alternative is to follow the rule of thumb
from the book Value Investing from Benjamin
Graham to Warren Buffett and Beyond.
Unnecessary Cash =
Cash and cash equivalents - 1% of sales
If 1% of sales is greater than cash and equivalent,
use a value of zero.
The Ultimate Guide to Stock Valuation
Subtract non-interest bearing debt and excess cash
to get the net reproduction cost of $68,748m which
is equal to $8.22 per share.
Step 1: Start with EBIT from the income statement.
The year ending 2012 EBIT is $22,647m.
Look to see if there are any one time charges that
you need to add back. From the financial report,
there is a one time goodwill impairment of $6,193m
which needs to be added back.
This makes it $28,840m so far.
Step 2: Add a certain percentage of SG&A and
R&D back to earnings. Keep it simple by adding
back 25% for both.
25% of SG&A: $4,606.5m
25% of R&D: $2,452.8m
The Adjusted EBIT is now $35,899.3m.
Earnings Power Value Calculation
What is EPV?
EPV is a technique for valuing stocks by making an
assumption about the sustainability of current
earnings and the cost of capital with zero growth
The formula is simple. The tricky part is performing
the income statement adjustments.
EPV = Adjusted Income / Cost of Capital
To get the adjusted income, the best way is to use
averages, but for the sake of keeping this simple, I
will use the latest numbers.
Key Old School Value Subscriber Tips
You can view all the details and formulas for every
valuation model and metric.
To view the EPV details, right click any of the tabs
and select unhide. Then select "EPVData" from
the list to see the behind the scenes of the EPV
The Ultimate Guide to Stock Valuation
Step 3: Apply a tax rate to the adjusted EBIT.
Since EBIT is earnings before interest and taxes,
account for taxes and it simply becomes earnings.
The tax rate in 2012 was 23.8%.
Multiply the tax rate to the Adjusted EBIT and the
Adjusted Earnings After Tax is $27,3553m.
Step 4: Add back a percentage of Depreciation and
The best way to do this is to be familiar with the
business and industry to accurately assess the
equipment needed and how fast it loses value.
The rule of thumb here is to add 20% of D&A.
By adding 20% of D&A, the adjusted income is now
Step 5: Subtract maintenance capital expenditures.
Companies rarely give out the details of
maintenance capex, which is what you need. Follow
this link to see how to calculate maintenance capital
Following the steps in the above link, the 2012
maintenance capex comes out to be $1,881m.
Adjusted income is now $26,067.7m.
Step 6: Divide the adjusted income by the cost of
Cost of capital is also another term for discount rate.
In the EPV, since zero growth is assumed, a 9%
cost of capital is a good figure to use.
EPV = $26,067.7 / 9% = $248,964.2m
This number represents the value of the company
based on current earnings and ignoring growth.
Step 7: Add cash and subtract debt.
Cash is the unnecessary cash mentioned
Unnecessary Cash =
Cash and cash equivalents - 1% of sales
Only consider interest bearing debt only because
Key Old School Value Subscriber Tips
Calculating maintenance capital expenditures is
an advanced task.
The Stock Analyzer takes the average
maintenance capex to give you the best possible
The Ultimate Guide to Stock Valuation
other types of debt may not be relevant to a new
competitor as interest bearing debt represents the
debt that is applicable to run the business.
The guide for calculating interest bearing debt is
Interest Bearing Debt =
Notes Payables or Short Term Debt
+ Current Portion of Long Term Debt
+ Long Term Debt
+ Capital Leases
This is just a quick rule of thumb for when you use
the Stock Analyzer or other financial sites such as
When you combine all this, the final EPV numbers
look like this.
Here is a chart that explains how to interpret the
relationship between EPV and reproduction value.
The EPV per share value is $39.25 compared to an
asset reproduction value of $8.22.
What does this mean?
Tying it All Together
When I performed the same valuation in 2009,
Microsoft had an EPV in the $22 range. In 3 years,
the value of Microsoft has doubled thanks to the
large moat identified by the EPV.
By using the EPV, you get an idea of the company's
moat as well as a snapshot valuation of the
company today which is beneficial in helping you
answer what type of expectation the market is
pricing in to the stock price.
The Ultimate Guide to Stock Valuation
Your Valuation, Your Art, Your Way
You now have the tools and knowledge to value and
understand the value of a stock in 8 different ways.
With the new skillset you have access to, go crazy
with stock valuation. The more you apply it, the
better your art becomes.
Just like how a master artist has many techniques
and tools to create his final piece, do not limit
yourself to using just one valuation method. Broaden
your views and value stocks from different angles.
A stock may look horrible from an earnings
basis, but the cash flows could be fantastic
A stock has an asset loaded balance sheet
but zero growth expectations
A stocks earnings growth is exponential but it
is bleeding cash and diluting shareholders
Three different types of stocks, three different views
and three valuations are needed.
My hope is that you will keep this book by your side
and use it as a guide and a tool to value each of
these different scenarios and more.
Key points to remember:
Valuation is an art. There is no single or
perfect way to value stocks.
Be a realist. Not a pessimist or optimist. You
make money by being realistic.
Value the downside and upside. Consider the
range of possibilities.
Value stocks like businesses. Look at cycles,
history, business strength.
Keep it simple. The best ideas are sometimes
the most obvious.
Empower yourself to take control.
The Ultimate Guide to Stock Valuation
Top 7 Books on Valuation and Analysis
For further reading, I have included a list of my top
recommended books on the topic of valuation and
financial analysis.
The type of investment books I really love to read,
recommend and continually reference are books that
are practical and timeless.
They require a slower reading pace to absorb the
information and more thought and attention, but the
stellar lessons contained in these books will launch
your investment prowess to another level.
The books are recommended in order of difficulty.
[Easy] 1. Why Are We So
Clueless About the Stock
A very good primer for new
investors to the world of investing,
accounting and financial analysis.
This is one of the best investing
books that introduces you to what
value investing is all about.
Start off with accounting basics,
how all three statements work and
come together and then look at
the way the stock market works
and how stocks are valued.
Detailed, easy to understand and
well written in plain english.
Definitely a book I recommend to
new investors or anyone wanting
to learn what value investing is all
The Ultimate Guide to Stock Valuation
[Easy] 2. F Wall Street
If you are looking for a book to
take you through the
fundamentals of valuing stocks,
what to look for and a practical
way to understand financial
analysis, F Wall Street is the
right book for you.
The book does a fantastic job of
making difficult concepts easy
to understand. Everyday
examples are used to help you
understand how to value
businesses. After reading the
book, you will appreciate
looking at stocks like a business
There is also a section
dedicated to portfolio
management making this a
solid investment book to keep in
your library.
3. Financial Statements:
Step-by-Step Guide to
Understanding and
Creating Financial
Financial statements, is as the
title suggests; all about financial
statements. It is an accounting
book that takes you through the
Easy to understand and follow.
What more could you ask from
an accounting book?
If you read and understand the
concepts from this book, you can
understand the numbers in the
10-K and pass any accounting
course as a bonus.
In fact, why take an accounting
course for several hundreds or
thousands of dollars, when this
sub $20 book will do more for
The Ultimate Guide to Stock Valuation
[Intermediate] 4. Active
Value Investing
This is the book that describes
the Absolute PE model.
Active Value Investing can be
broken into two parts. The first
section discusses economics
and macro events. The second
part details value investing
concepts, strategies and
As a value investor, the second
part of the book really shines
where you learn about the
authors investing framework of
QVG (Quality, Value, Growth)
and introduces in detail the
Absolute PE valuation method.
Get this book if you want to
learn more on qualitative
research and combining it with
quantitative assessment.
[Difficult] 5. Value
Investing: Graham to
Buffett and Beyond
The book on Earnings Power
To get through it, it requires a lot
of knowledge and confidence in
number crunching, accounting
and working through financial
It is best that you read the easier
books and gain confidence
before tackling this one. It is very
detailed and dry and I do not
want you to give up in frustration.
As difficult as it is, it is still one of
the best investment books on
valuation and how you should
approach the subject from the
qualitative side as well.
The Ultimate Guide to Stock Valuation
[Difficult] 6. Quality of
My favorite investment book to
date. I reference it all the time.
From this book, you will learn
how to interpret the financial
statements from an investors
point of view and learn ways to
determine the true quality of
Instead of relying on what the
income statement says, you can
apply the methods taught in the
book to interpret it in a new light
and discover patterns to
determine earnings quality of a
The book is full of useful and
practical lessons you can start
applying immediately.
The print is quite old so you can
pick up a cheap copy for a few
bucks online.
[Difficult] 7. Financial
Rounding up the list is Financial
This book is a gem. It is very
detailed, thorough and practical.
This book will teach you the ins
and outs of the accounting
games that companies play to
either confuse or trick investors.
The information in this book is so
good that business schools use
it as class text.
You have to have a very good
understanding of accounting and
financial statement analysis for
this book to be worthwhile.
If there is one book that will
immediately take you to another
level in investing, it is this one.
The Ultimate Guide to Stock Valuation
About the Author
I started my investing journey after losing $3,000
due to bad advice from a financial advisor. At the
time, I had just graduated and was starting my first
full time job as an engineer, so it was a lot of money.
Long story short, I found a book called the
"Intelligent Investor" and was introduced to the
school of Graham, Buffett and beyond.
I never looked back.
Value investing was my calling and my goal ever
since has been to provide investors with a
resourceful site containing tools, tutorials, ideas and
offering engaging newsletters.
I'm also an efficiency fanatic and I want to help you
value stocks with efficiency, accuracy and
confidence. Save time and the headache by
automating the valuation process.
Old School Value Services
Would you like to make more money in the stock
Would you like to save time by quickly finding and
valuing stocks?
Would you like to make better decisions and avoid
disaster stocks?
If you answered Yes to any of these questions,
check out Old School Value and see how the Stock
Analyzer can help you.
Email: jae.jun [at]
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My name is Jae Jun, a value
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