## Sunday, March 27, 2011

### How to Determine the Value of a Stock

For the past several years I've used Morningstar's Premium service for stock valuation. Morningstar uses a Discounted Cash Flow model to determine Fair Value (i.e. intrinsic value), which can get quite complex. In his book, The Intelligent Investor, Benjamin Graham describes a simpler formula to determine intrinsic value.

Formula: V = EPS x (8.5 + 2G) * (4.4 / Y)

where:

• V: Intrinsic Value
• EPS: the company’s last 12-month earnings per share
• 8.5: the constant represents the appropriate P/E ratio for a no-growth company as proposed by Graham
• G: the company’s future long-term (five years) earnings growth estimate
• 4.4: the average yield of high-grade corporate bonds in 1962, when this model was introduced
• Y: the current yield on AAA corporate bonds

I use the modified formula from Old School Value, which uses a P/E of 7 for a no-growth company and a multiplier of 1.5G rather than 2G, since these are more conservative.

Modified Formula: V = EPS x (7 + 1.5G) * (4.4 / Y)

The original formula uses the last 12-month EPS (TTM), however, like Old School Value, I normalize EPS over a 10 year period, which estimates future EPS for the next 5 years, using a linear forecast based on the previous 10 years, and then takes the median of the previous 5 years and next 5 years to arrive at a normalized EPS. For estimated future 5yr growth rate I use 3 different sources, 1) Yahoo Finance, 2) Morningstar, and 3) MSN Money. I found that each site has a different 5yr estimate, so I use an average of these estimates.

Determining intrinsic value, no matter which method/formula is used, relies on estimating earnings and earnings growth, which is nothing more than an educated guess, so it's important to discount whatever valuation you determine. This is a Graham concept known as Margin of Safety. Purchasing stocks with a sufficient Margin of Safety below Fair Value helps to protect against being wrong on the earnings estimates/growth. How much of a Margin of Safety to require depends on your confidence level in the company and the estimates you use. I typically use a Margin of Safety range between 20%-40% below Fair Value.

Once I have all the input parameters I plug them into my spreadsheet, which is a modified version of the one at Old School Value, and calculate the Fair Value and Target Buy Price. I then compare the results to Morningstar's valuation.

Let's look at an example for Abbott Laboratories (ABT) using the modified Graham Formula:

InputValue
10yr Normalized Earnings\$3.75
Average 5yr Growth Rate9.29%
20yr AAA Corp Bond Rate5.44%
Desired Margin of Safety20%
ResultsValue
Fair Value\$64.00

To compare the Graham Formula to Morningstar's valuation I input Morningstar's Fair Value and Target Buy Price and solve for the implied 5yr growth rate. Here's the same example using Morningstar's Fair Value:

InputValue
M* Fair Value\$68.00
M* Margin of Safety20%
10yr Normalized Earnings\$3.75
20yr AAA Corp Bond Rate5.44%
ResultsValue
Implied 5yr Growth Rate10.28%

As you can see, both valuations are very close, with only a 1% difference in the 5yr growth rate.

Let's do another example, this time for Lowes (LOW) using the modified Graham Formula:

InputValue
10yr Normalized Earnings\$1.94
Average 5yr Growth Rate14.60%
20yr AAA Corp Bond Rate5.44%
Desired Margin of Safety30%
ResultsValue
Fair Value\$45.00

Here's the same example using the Morningstar's Fair Value:

InputValue
M* Fair Value\$36.00
M* Margin of Safety30%
10yr Normalized Earnings\$3.75
20yr AAA Corp Bond Rate5.44%
ResultsValue
Implied 5yr Growth Rate10.68%

Here you can see that there's almost a \$10 difference in Fair Value and a 4% difference in the 5yr growth rate. That's still pretty close. One way to deal with differences is to use an average of both results which would be:

ResultsValue
Average Fair Value\$41.00
Average 5yr Growth Rate12.64%

Now let's look at Pfizer (PFE), where the valuations are very different. Here's the modified Graham Formula:

InputValue
10yr Normalized Earnings\$1.22
Average 5yr Growth Rate2.38%
20yr AAA Corp Bond Rate5.44%
Desired Margin of Safety30%
ResultsValue
Fair Value\$10.00

Here's the same example using the Morningstar's Fair Value:

InputValue
M* Fair Value\$26.00
M* Margin of Safety30%
10yr Normalized Earnings\$1.22
20yr AAA Corp Bond Rate5.44%
ResultsValue
Implied 5yr Growth Rate12.84%

Morningstar's implied 5yr growth rate is about 10 times greater than the average 5yr estimates. That's a very big difference. Either Morningstar overestimated the growth rate or the analysts underestimated it. Again, you can use the average of both results:

ResultsValue
Average Fair Value\$18.00