Home > Finance and Stocks > When to buy or sell a stock. Valuation in more detail

When to buy or sell a stock. Valuation in more detail

Valuation is the cornerstone of long term gains in stocks and investing.  As I said in my first blog post a companies earnings are going to drive their stock price over long periods of time.  In the short term they will “dance” around some fair value.

In valuation investors use various methods which is one reasons you might see different pundits be bullish or bearish on a company.  Ultimately though we want to stick with what we believe to be a true and simple valuation methodology and let the others deal with complexity that is not necessary and often not conducive to beating the market.

Imagine if had $1,000 and wanted to get some return on that each year.  Maybe you look at a CD that pays 4% and has a 1 year term.  At another bank you can get 6% with a 1 year term.  Which would you put your money in?  The answer is the 6% CD. There is no trick question.  This is simple.  Well investing in companies is all about figuring out what their return is (remember earnings from above), what earnings are likely to be going forward and last how the current plus future earnings compare to your alternatives like that one year 4% CD for example.  Additional considerations such as balance sheet health also come into play.

It is believed there is some simple fast math that Warren Buffett can do on the back of a cocktail napkin or in his head in a minute or so to get the value of a company and see if he might want to invest.   What I use for a short form of valuation is to take the companies earnings per share or EPS and multiply it by their growth rate.  I throw in cash on the balance sheet and deduct any debt.

Let’s use Apple as a simple example.  Apple is growing about 18% and is expected to earn around $6/share next year.  18 x 6 = $108.  Add in $30/share in cash and you get 138 as fair value.  Now here is where assumptions and understanding of a business, the economy in general and an industry matter.  If you change the EPS or growth you can dramatically change the fair value.  For example let’s say Apple makes $6.50/share and grows at 20% instead of 18%.  $6.50 x 20 = $130.  You then add the $30 in cash per share and you get fair value of $160 or about $10 higher then it is today.

In this example would you want to buy, sell or hold Apple?  If it was Buffett he probably would not be buying or selling (aside from the fact he does not invest in tech because he does not understand the sector. he sticks with what he knows).  There is no great margin of safety here for the buyer.  Should Apple’s growth slow just a touch or EPS fall short the stock would likely move down.  Even if they just hit their numbers the day traders, economic news of the day, short term trading, investors with different models (i.e. tech analysis, value investors, momentum), could swing the stock up or down in a wide range.

Assume growth slows to 10% or sentiment falls in general for the markets like it did recently.  You could see Apple trade with a 10 multiple on $6 which is $60 plus the $30 in cash giving you 90/share price target.  A huge drop from todays $150 price!  So in retrospect Apple was a great buy under $100 which is where I bought some and wrote Put option contracts.  The margin of safety though is gone completely on the buy side.   On a valuation basis I would not sell here because it has not exceeded fair value by 20%.  I start to look at selling some or all of a position as it blows past fair value in excess of 20%.  We can use the same volatility to sell over fair value that we can use to buy under fair value.  THIS IS THE ONLY WAY YOU CAN BEAT THE MARKET.  You have to take advantage of the many factors that let you buy when others are fearful and sell when others are greedy.

So on a valuation basis Apple was a good buy, today is a hold if you own it and a sell if it starts to pass the $180/share range in the near term.  If it does not hit $180 until the end of the year we’ll be looking forward at 2011 earnings and those should sustain the price valuation if analyst and my estimates are close.  The thing to be aware of is that prices can get ahead or behind themselves in the near term.  I consider near term one to two years.

Now that we have some basic quick valuation understanding the next question is whether a company is a good buy relative to other investments.  For example I can get some 4% tax free municipal bonds which yield an after tax yield of around 6% plus since they are state and federal tax free and do it with very little risk.  So how does my investment in XYZ company compare to other companies or more “stable” risk investments like bonds or munis?

Taking the Apple example we want to pretend for a moment we are actually owners of the company (which we are when we own stock but most people don’t make the connect).  So pretend you just literally bought Apple!  You would want to get a return on your money invested.  So how could apple pay you back?  Would it be better then the 4% muni bond or some other alternative?

Estimates for Apple are around $5 for FY 2009 and $6 in FY 2010.  Today you would have to pay $150/share and assume they make their $6 estimate.  Then assume they pay you 100% of their profits in 2010 in dividend.  $6/$150 is a 4% yield.  Corporate dividends are 85% tax free for now if qualified so you would have an after tax yield of .85 x 4% = 3.4%.  So not quite as good as that 4% free and clear muni but we do, in Apple’s case, have to take $30/share in cash into account.  With that in mind let’s assume as owners that is our money so when we pay 150/share we pay $120/share for the business and get 30/share in cash.  So 6/120 = 5% yield.  85% tax free on the 5% is 4.25% so now we are looking better.

Now in the real world few companies are paying out 100% of their profits as dividend.  However, this example shows you what they could do if they did not want or need to retain any earnings.  Now a 4% muni would always pay you that 4%.  In our example using Apple again we are assuming they will grow 20% per year.  If they do this then you should see that potential dividend percentage increase.  At 20% they make $7.20/share in 2011 and your 7.20/120 is a yield of 6%.  2012 would be $8.64/share in earnings and yield 7.2%.  You get the idea.  If Apple keeps growing the returns potentially payable as dividend increasingly exceed the other investment alternatives perhaps.

Here is another interesting aside…if a company NEVER pays a dividend your shares in that company are only worth what somebody is willing to pay you for them on a given day, period.  If a company were to never pay a dime in dividends to shareholders there really is no reason to hold the stock.  The ultimate payoff at some point has to be a dividend.  Stock certificates are only worth the paper they are printed on.  Every investor waits for that day where a business does not need to reinvest capital and starts to pay out their cash horde and dividends on profits.  If a company never does you can use the stock certs for toilet paper because that is what they are worth.

This is my Buffett back of the cocktail napkin in my head type of calculation I do to determine fair value and where to get the margin of safety to purchase a stock.  The more you are below fair value the better your margin. You can never have too much.  There is much more to beating the market but earnings and how to value them in the real world is the final arbiter of a stock price over time.

In upcoming posts I’ll expand more on valuations, how to decide if you should trust analyst estimates and when to use your own knowledge to adjust for your own beliefs.  It will be your own understanding of a business that will allow you to get the edge over other investors.  Without this you are swimming against the tide.

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