Pat Dorsey and Joe Mansueto
Although I love funds, I have an even greater passion for stocks. Funds are great for those who don’t want to spend a lot of time doing research. But if you enjoy analyzing companies—and I think it’s a tremendous amount of fun—you can do perfectly well investing in equities yourself. (Location 223)
minds—Clyde MacGregor, Chuck McQuaid, Bill Nygren, Ralph Wanger, Sherwin Zuckerman, to name a few. They all practiced a rigorous, bottomsup investment style that involved looking for companies selling at a discount to their true worth. (Location 233)
We realized that by looking carefully at the stocks a fund owned, we could understand the manager’s strategy (Location 250)
now, I suggest you begin reading the major business magazines regularly—Barron’s, BusinessWeek, Forbes, Fortune,—as well as The Wall Street Journal daily. You’d be surprised how many investors neglect to do these basic things. Among our own publications, you’ll find Morningstar.com and Morningstar StockInvestor, our monthly newsletter, helpful. I also recommend all the Berkshire Hathaway annual reports and Outstanding Investor Digest for its lengthy interviews with leading money managers. (Location 261)
The basic investment process is simple: Analyze the company and value the stock. (Location 308)
Remember that buying a stock means becoming part owner in a business. By treating your stocks as businesses, you’ll find yourself focusing more on the things (Location 311)
that matter—such as free cash flow—and less on the things that don’t—such as whether the stock went up or down on a given day. Your goal as an investor should be to find wonderful businesses and purchase them at reasonable prices. Great companies create wealth, and as the value of the business grows, so should the stock price in time. In the short term, the market can be a capricious thing—wonderful businesses can sell at fire-sale prices, while money-losing ventures can be valued as if they had the rosiest of futures—but over the long haul, stock prices tend to track the value of the business. (Location 312)
In this book, I want to show you how to focus on a company’s fundamental financial performance. (Location 318)
exceptional managers spend any time at all thinking about what the market will do in the short term. Instead, they all focus on finding undervalued stocks that can be held for an extended time. (Location 335)
First, you need to develop an investment philosophy, which I’ll discuss in Chapter 1. Successful investing is built on five core principles: 1. Doing your homework 2. Finding companies with strong competitive advantages (or economic moats) 3. Having a margin of safety 4. Holding for the long term 5. Knowing when to sell Building a solid stock portfolio should be centered on these five ideas; once you know them, you’ll be ready to start learning how to look at companies. (Location 353)
This sounds obvious, but perhaps the most common mistake that investors make is failing to thoroughly investigate the stocks they purchase. Unless you know the business inside and out, you shouldn’t buy the stock. (Location 400)
Unless you know the business inside and out, you shouldn’t buy the stock. (Location 401)
In Chapters 4 through 7, I’ll show you what you need to know about accounting and how to boil the analysis process down to a manageable level. (Location 405)
Think of the time you spend on research as a cooling-off period. It’s always tempting when you hear about a great investment idea to think you have to act now, before the stock starts moving—but discretion is almost always the better part of valor. After all, your research process might very well uncover facts that make the investment seem less attractive. But if it is a winner and if you’re truly a long-term investor, missing out on the first couple of points of upside won’t make a big difference in the overall performance of your portfolio, especially since the cooling-off period will probably lead you to avoid some investments that would have turned out poorly. (Location 410)
It’s always tempting when you hear about a great investment idea to think you have to act now, before the stock starts moving—but discretion is almost always the better part of valor. (Location 410)
The key to identifying wide economic moats can be found in the answer to a deceptively simple question: How does a company manage to keep competitors at bay and earn consistently fat profits? If you can answer this, you’ve found the source of the firm’s economic moat. (Location 426)
Finding great companies is only half of the investment process—the other half is assessing what the company is worth. You can’t just go out and pay whatever the market is asking for the stock because the market might be demanding too high a price. And if the price you pay is too high, your investment returns will likely be disappointing. (Location 429)
Always include a margin of safety into the price you’re willing to pay for a stock. (Location 441)
The size of your margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictable earnings. For example, a 20 percent margin of safety would be appropriate for a stable firm such as Wal-Mart, but you’d want a substantially larger one for a firm such as Abercrombie & Fitch, which is driven by the whims of teen fashion. (Location 443)
For example, a 20 percent margin of safety would be appropriate for a stable firm such as Wal-Mart, but you’d want a substantially larger one for a firm such as Abercrombie & Fitch, which is driven by the whims of teen fashion. (Location 444)
Sticking to a valuation discipline is tough for many people because they’re worried that if they don’t buy today, they might miss the boat forever on the stock. That’s certainly a possibility—but it’s also a possibility that the company will hit a financial speed bump and send the shares tumbling. (Location 446)
One simple way to get a feel for a stock’s valuation is to look at its historical price/earnings ratio—a measure of how much you’re paying for every dollar of the firm’s earnings—over the past 10 years or more. (Location 451)
To justify paying today’s price, you have to be plenty confident that the company’s outlook is better today than it was over the past 10 years. (Location 455)
Ideally, we’d all hold our investments forever, but the reality is that few companies are worth holding for decades at a stretch—and few investors are savvy enough to buy only those companies. Knowing when it’s appropriate to bail out of a stock is at least as important as knowing when to buy one, yet we often sell our winners too early and hang on to our losers for too long. (Location 498)
our losers for too long. (Location 500)
The key is to constantly monitor the companies you own, rather than the stocks you own. It’s far better to spend some time keeping up on the news surrounding your companies and the industries in which they function than it is to look at the stock price 20 times a day. (Location 504)
Before I discuss when you should sell a stock, I ought to point out when you shouldn’t sell. (Location 506)
So when should you sell? Run through these five questions whenever you think about selling a stock, and you’ll be in good shape. (Location 519)
But even the greatest companies should be sold when their shares sell at egregious values. (Location 534)
The key is to not let greed get in the way of smart portfolio management. If an investment is more than 10 percent to 15 percent of your portfolio, it’s time to think long and hard about trimming it down no matter how solid the company’s prospects may be. (Location 548)
Investor’s Checklist: The Five Rules for Successful Stock Investing • Successful investing depends on personal discipline, not on whether the crowd agrees or disagrees with you. That’s why it’s crucial to have a solid, well-grounded investment philosophy. • Don’t buy a stock unless you understand the business inside and out. Taking the time to investigate a company before you buy the shares will help you avoid the biggest mistakes. • Focus on companies with wide economic moats that can help them fend off competitors. If you can identify why a company keeps competitors at bay and consistently generates above-average profits, you’ve identified the source of its economic moat. • Don’t buy a stock without a margin of safety. Sticking to a strict valuation discipline will help you avoid blowups and improve your investment performance. • The costs of frequent trading can be a huge drag on performance over time. Treat your stock buys like major purchases, and hold on to them for the long term. • Know when to sell. Don’t sell just because the price has gone up or down, but give it some serious thought if one of the following things has happened: You made a mistake buying it in the first place, the fundamentals have deteriorated, the stock has risen well above its intrinsic value, you can find better opportunities, or it takes up too much space in your portfolio. (Location 551)
Know when to sell. Don’t sell just because the price has gone up or down, but give it some serious thought if one of the following things has happened: You made a mistake buying it in the first place, the fundamentals have deteriorated, the stock has risen well above its intrinsic value, you can find better opportunities, or it takes up too much space in your portfolio. (Location 561)
So, before we dive into the company analysis process, I want to introduce you to seven easily avoidable mistakes that many investors frequently make. Resisting these temptations is the first step to reaching your financial goals: 1. Swinging for the fences 2. Believing that it’s different this time 3. Falling in love with products 4. Panicking when the market is down 5. Trying to time the market 6. Ignoring valuation 7. Relying on earnings for the whole story (Location 572)
The only reason you should ever buy a stock is that you think the business is worth more than it’s selling for—not because you think a greater fool will pay more for the shares a few months down the road. (Location 661)
At the end of the day, cash flow is what matters, not earnings. (Location 667)
The first thing we need to do is look for hard evidence that a firm has an economic moat by examining its financial results. (Location 715)
First, look at free cash flow—which is simply cash flow from operations minus capital expenditures. (We’ll go over free cash flow more in Chapter 5. For now, just go to a firm’s statement of cash flows, which you can find in its quarterly and annual financial filings, look for the line item labeled “cash flow from operations,” and subtract the line labeled “capital expenditures.”) Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business. (Location 722)
Next, divide free cash flow by sales (or revenues), which tells you what proportion of each dollar in revenue the firm is able to convert into excess profits. If a firm’s free cash flow as a percentage of sales is around 5 percent or better, you’ve found a cash machine—as of mid-2003, only one-half of the S&P 500 pass this test. Strong free cash flow is an excellent sign that a firm has an economic moat. (Location 727)
net margins look at profitability from another angle. Net margin is simply net income as a percentage of sales, and it tells you how much profit the firm generates per dollar of sales. (You can find sales and net income on a firm’s income statement, which should also be in each of its regular financial filings.) In general, firms that can post net margins above 15 percent are doing something right. (Location 732)
Return on equity (ROE) is net income as a percentage of shareholders’ equity, and it measures profits per dollar of the capital shareholders have invested in a company. Although ROE does have some flaws—which we discuss in Chapter 6—it still works well as one tool for assessing overall profitability. As a rule of thumb, firms that are able to consistently post ROEs above 15 percent are generating solid returns on shareholders’ money, which means they’re likely to have economic moats. (Location 736)
Return on assets (ROA) is net income as a percentage of a firm’s assets, and it measures how efficient a firm is at translating its assets into profits. Use 6 percent to 7 percent as a rough benchmark—if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers. (Location 741)
A firm that has consistently cranked out solid ROEs, good free cash flow, and decent margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results. Consistency is important when evaluating companies, because it’s the ability to keep competitors at bay for an extended period of time—not just for a year or two—that really makes a firm valuable. Five years is the absolute minimum time period for evaluation, and I’d strongly encourage you to go back 10 years if you can. (Location 744)
Next, we need to determine why a firm has done such a great job of holding on to its profits and keeping the competition at arm’s length. (Location 754)
In general, there are five ways that an individual firm can build sustainable competitive advantage: 1. Creating real product differentiation through superior technology or features 2. Creating perceived product differentiation through a trusted brand or reputation 3. Driving costs down and offering a similar product or service at a lower price 4. Locking in customers by creating high switching costs 5. Locking out competitors by creating high barriers to entry or high barriers to success (Location 764)
A great example is Pfizer, which holds patents on some of the top-selling drugs in the world. These patents allow the company to charge high prices for new drugs for years after they hit the market. Competition during the life of the patent is usually limited, so profits and cash flows are huge. That’s one reason Pfizer’s average return on equity over the past decade has been greater than 30 percent and its net profit margins are currently north of 25 percent (compared with around 6 percent for the average S&P 500 company). That’s also why it’s been a great stock to own over the long haul. In fact, many of the major pharmaceutical players have outperformed the market over the past 10 years because of the economic moats inherent in this industry. (Location 885)
Our next topic is assessing the longevity of an economic moat, so we know how long a firm is likely to keep its competitors at bay. Think about an economic moat in two dimensions. There’s depth—how much money the firm can make—and there’s width—how long the firm can sustain above-average profits. Technology firms often have very deep but very narrow moats, so they’re incredibly profitable for a relatively short period of time until a competitor builds a better product. (Location 914)
In general, any competitive advantage based on technological superiority—real product differentiation—is likely to be fairly short. Successful software firms, for example, can generate huge excess returns because they have high profit margins and they don’t need to spend much money on fixed costs such as machinery. However, the duration of those returns is typically very short because of the rapid pace of technological change. In other words, today’s leader can quickly become tomorrow’s loser because the barriers to entry are so low and the potential rewards so high. (Location 922)
First, get a rough sense of the industry so you can classify it. Are sales for firms in the industry generally increasing or shrinking? Are firms consistently profitable or does the industry go through periodic cycles when most firms lose money? Is the industry dominated by a few large players, or is it full of firms that are roughly the same size? How profitable is the average firm—are operating margins fairly high (more than 25 percent) or fairly low (less than 15 percent)? (An operating margin is income from operations as a percentage of sales. I discuss such financial ratios in more detail in Chapter 6.) You can answer some of these questions by looking at aggregate statistics—average growth rates, average margins, and so on. However, averages can’t tell you everything, so be sure that you examine a number of individual companies. An easy way to do this is to look at a list of companies in the industry you’re researching sorted by sales or market cap, and examine a dozen or so to get a feel for the industry. You don’t need to do detailed analysis at this point—just glance over sales and earnings growth rates and margins. The most important thing is to look at a variety of firms over a reasonably long time frame—at least 5 years and, preferably, 10. (Location 989)
To invest successfully means you need to buy great companies at attractive prices. (Location 2461)
Over time, the stock market’s returns come from two key components: investment return and speculative return. As Vanguard founder John Bogle has pointed out, the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio. (Location 2472)
The most basic ratio of all is the P/S ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings. (Location 2515)
However, the P/S ratio has one big flaw: Sales may be worth a little or a lot, depending on a company’s profitability. If a company is posting billions in sales, but it’s losing money on every transaction, we’d have a hard time pinning an appropriate P/S ratio on the shares because we have no idea what level (if any) profits the company will generate. We can see the drawbacks of using sales as a proxy for value in the marketplace every day. (Location 2525)
Another common valuation measure is price-to-book (P/B), which compares a stock’s market value with the book value (also known as shareholder’s equity or net worth) on the company’s most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm’s tangible assets in the here-and-now. Legendary value investor Benjamin Graham, one of Warren Buffett’s mentors, was a big advocate of book value and P/B in valuing stocks. Although P/B still has some utility today, the world has changed since Ben Graham’s day. (Location 2540)
For service firms, in particular, P/B has little meaning. If you used P/B to value eBay, for example, you wouldn’t be according a shred of worth to the firm’s dominant market position, which is the single biggest factor that has made the firm so successful. Price-to-book can also lead you astray for a manufacturing firm such as 3M, which derives much of its value from its brand name and innovative products, not from the size of its factories or the quantity of its inventory. (Location 2548)
The easiest way to use a P/E ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, or the same company at a different point in time. Each of these approaches has some value, as long as you know the limitations. A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the P/E ratio. All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less debt, and has lower capital reinvestment needs. (Location 2580)
Relative P/Es have one huge drawback: A P/E of 12, for example, is neither good nor bad in a vacuum. Using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you’re using. (Location 2596)
When you’re using the P/E ratio, remember that firms with an abundance of free cash flow are likely to have low reinvestment needs, which means that a reasonable P/E ratio will be somewhat higher than for a run-ofthe-mill company. The same goes for firms with higher growth rates, as long as that growth isn’t being generated using too much risk. (Location 2611)
A few other things can distort a P/E ratio. Keep these questions in the back of your mind when looking at P/E ratios, and you’ll be less likely to misuse them. (Location 2613)
Has the Firm Sold a Business or an Asset Recently? (Location 2615)
Has the Firm Taken a Big Charge Recently? (Location 2621)
Is the Firm Cyclical? (Location 2623)
Does the Firm Capitalize or Expense Its Cash Flow-Generating Assets? (Location 2628)
Is the E Real or Imagined? (Location 2633)
If a stock sells for $20 per share and has $1 in earnings, it has a P/E of 20 but an earnings yield of 5 percent (Location 2652)
The best yield-based valuation measure is a relatively little-known metric called cash return. In many ways, it’s actually a more useful tool than the P/E. To calculate a cash return, divide free cash flow by enterprise value. (Enterprise value is simply a stock’s market capitalization plus its long-term debt minus its cash.) The goal of the cash return is to measure how efficiently the business is using its capital—both equity and debt—to generate free cash flow. (Location 2661)
Be picky about valuation. You’ll do well over the long haul by buying companies that are undervalued relative to their earnings potential. • Don’t rely on any single valuation metric because no individual ratio tells the whole story. Apply a number of different valuation tools when you’re assessing a stock. • If the firm is cyclical or has a spotty earnings history, use the price-to-sales ratio. Companies with P/S ratios lower than their historical average can sometimes be bargains. • The price-to-book ratio is most useful for financial firms and firms with numerous tangible assets, and it’s least useful for service-oriented firms. In addition, firms with higher ROEs will typically be worth a higher P/B ratio. • You can compare a company’s P/E with the market, with a similar firm, or with the company’s historical P/E. In each case, you’ll want the company’s P/E to be lower than the benchmark, but make sure you’re aware of any differences in risk or growth rates between the company you’re valuing and the benchmark. The most reliable benchmark is likely to be the company’s own historical valuations, assuming the company hasn’t changed very much over time. • Use the PEG with caution because fast-growing firms also tend to be riskier. Don’t overpay for expected growth that may never materialize. • The lowest P/E isn’t always the best. Firms with high growth, low risk, and low capital reinvestment needs should have higher P/E ratios. You’ll likely be better off in the long run paying more for a low-risk firm that’s generating large amounts of cash than paying less for a cyclical company that’s very capital intensive. • Check the earnings yield and cash return, and compare them with the rates available on bonds. An earnings yield or cash return above current bond rates can indicate an undervalued stock. (Location 2682)
THE BIG DRAWBACK of the ratios we discussed in the previous chapter is that they’re all based on price—they compare what investors are currently paying for one stock to what they’re paying for another stock. Ratios do not, however, tell you anything about value, which is what a stock is actually worth. (Location 2700)
At Morningstar, we’re firm believers that stocks should be purchased because they’re trading at some discount to their intrinsic value, not simply because they’re priced at a higher or lower point than similar companies. (Location 2703)
Having an intrinsic value estimate keeps you focused on the value of the business, rather than the price of the stock—and that’s what you want because, as an investor, you’re buying a small piece of a business. (Location 2707)
The value of a stock is equal to the present value of its future cash flows. No more and no less. (Location 2721)
Remember, we care about free cash flow because that’s the amount of money that could be taken out of the business each year without harming its operations. (Location 2725)
Add the government bond rate to the risk premium, and you have what’s known as a discount rate. (Location 2738)
Now you can start to see why stocks with stable, predictable earnings often have such high valuations—investors discount their future cash flows at a lower rate, (Location 2751)
You can see why a rational investor should be willing to pay more for a company that’s profitable now relative to one that promises profitability only at some point in the future. Not only does the latter carry higher risk (and thus a higher discount rate), but the promised cash flows won’t arrive until some years in the future, diminishing their value still further. (Location 2755)
However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about $2,700 less than StableCorp. That’s because StableCorp is more predictable, which means that investors’ discount rate isn’t as high. CycliCorp’s cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they’re valuing its shares. As a result, the present value of the discounted cash flows is lower. (Location 2764)
Value is determined by the amount, timing, and riskiness of a firm’s future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock. That’s all it really boils down to. (Location 2772)
How do we know whether to use 7 percent or 10 percent? From our previous example of the delayed vacation, we know that opportunity cost—or time value—is one factor and that the other big determinant of our discount rate is risk. Unfortunately, there is no precise way to calculate the exact discount rate that you should use in a discounted cash flow (DCF) model, (Location 2790)
Here’s what you need to know for practical purposes: As interest rates increase, so will discount rates. As a firm’s risk level increases, so will its discount rate. Let’s put these two together. For interest rates, you can use a long-term average of Treasury rates as a reasonable proxy. (Location 2795)
In mid-2003, the average yield of the 10-year bond over the past decade was about 5.5 percent, so we’ll use that. Because this isn’t an exact science, you may want to use 5 percent or 6 percent. Now for risk, which is an even less exact factor to measure. According to standard finance theorists, risk is the same thing as volatility, and the risk level of a company can be estimated simply by looking at how much its shares have bounced around relative to how much the market has bounced around. Thus, if a firm’s shares suddenly drop from $30 to $20, this theory holds that the stock has (Location 2798)
just become much riskier. (Location 2802)
We think it’s better to assess risk by looking at the company, rather than by looking at the stock, and that a firm’s riskiness is determined by the likelihood that it will or won’t generate the cash flows that we’re forecasting. Why? Because what the share price has done in the past may have little bearing on what cash flows the company generates in the future. We think it makes more sense to define risk as the chance of permanent capital impairment—in other words, the likelihood that our investment will be worth much less when we go to sell it than it is today. (Location 2805)
Smaller firms are generally riskier than larger firms because they’re more vulnerable to adverse events. (Location 2811)
Firms with more debt are generally riskier than firms with less debt because they have a higher proportion of fixed expenses (debt payments) relative to other expenses. (Location 2813)
Look at a firm’s debt-to-equity ratio, interest coverage, and a few other factors to determine the degree of a company’s risk from financial leverage. (Location 2816)
Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases. (Location 2819)
How much do you trust the folks running the shop? Although it’s rarely black or white, firms with promotional managers, managers who draw egregious salaries, or who exhibit any of the other red flags covered in Chapter 7 are definitely riskier than companies with managers who don’t display these traits. (Location 2821)
Does the firm have a wide moat, a narrow moat, or no economic moat? (Location 2824)
How should you incorporate all of these risk factors into a discount rate? As I said earlier, there’s no right answer. At Morningstar, we use 10.5 percent as the discount rate for an average company based on the factors in the preceding list, and we create a distribution of discount rates based on whether firms are riskier or less risky than the average. As of mid-2003, firms such as Johnson & Johnson, Colgate, and Wal-Mart fall at the bottom of the range, at around 9 percent, whereas riskier firms—such as Micron Technology, JetBlue Airways, and E*Trade—top out at 13 percent to 15 percent. The key is to pick a discount rate you’re comfortable with. Don’t worry about being exact—just think about whether the company you’re evaluating is riskier or less risky than the average firm, along with how much riskier or less risky it is, and you’ll be fine. (Location 2831)
We’re almost there—we have cash flow estimates, and we have a discount rate. We need only one more element, called a perpetuity value, and we’re ready to put the whole thing together. (Location 2840)
The most common way to calculate a perpetuity is to take the last cash flow (CF) that you estimate, increase it by the rate at which you expect cash flows to grow over the very long term (g), and divide the result by the discount rate (R) minus the expected long-term growth rate. In formula terms, this equals: (Location 2843)
The result of this calculation then must be discounted back to the present, using the method I discussed previously. Let’s run through an example to show you what I mean. (Location 2846)
and its cash flows will grow at a steady 3 percent annual rate after that. (Three percent is generally a good number to use as your long-run growth rate because it’s roughly the average rate of U.S. gross domestic product [GDP] growth. If you’re valuing a firm in a declining industry, you might use 2 percent.) (Location 2849)
Estimate free cash flows for the next four quarters. This amount will depend on all of the factors we discussed earlier in the book—how fast the company is growing, the strength of its competitors, its capital needs, and so on. (We get into more detail on estimating cash flows in the next chapter when we analyze and value two firms top to bottom.) For Clorox, our first step is to see how fast free cash flow has grown over the past decade, which turns out to be about 9 percent when you do the math. We could just increase the $600 million in free cash flow that Clorox generated in 2003 by 9 percent, but that would assume that the future will be as rosy as the past. During the 1990s, the rise of mega-retailers like Wal-Mart—which now accounts for almost a quarter of Clorox’s sales—has hurt the bargaining power of consumer-products firms. So, let’s be conservative and assume free cash flow increases by only 5 percent over last year, which would work out to $630 million. (Location 2867)
A step-by-step discounted cash flow model for calculating the equity value of a company. Source: Morningstar, Inc. Simple 10-Year Valuation Model Step 1 Forecast free cash flow (FCF) for the next 10 years. Step 2 Discount these FCFs to reflect the present value: ▶ Discounted FCF = FCF for that year ÷ (1 + R)N (where R = discount rate and N = year being discounted) Step 3 Calculate the perpetuity value and discount it to the present: ▶ Perpetuity Value = FCF 10 × (1 + g) ÷ (R - g) ▶ Discounted Perpetuity Value = Perpetuity Value ÷ (1 + R) 10 Step 4 Calculate total equity value by adding the discounted perpetuity value to the sum of the 10 discounted cash flows (calculated in step 2): ▶ Total Equity Value = Discounted Perpetuity Value + 10 Discounted Cash Flows Step 5 Calculate per share value by dividing total equity value by shares outstanding: ▶ Per Share Value = Total Equity Value ÷ Shares Outstanding (Location 2875)
Estimate how fast you think free cash flow will grow over the next 5 to 10 years. Remember, only firms with very strong competitive advantages and low capital needs are able to sustain above-average growth rates for very long. If the firm is cyclical, don’t forget to throw in some bad years. (Location 2893)
Estimate a discount rate. Financially, Clorox is rock-solid, with little debt, tons of free cash flow, and a noncyclical business. So, we’ll use 9 percent for our discount rate, which is meaningfully lower than the 10.5 percent average we discussed earlier. Clorox is a pretty predictable company, after all. 4. Estimate a long-run growth rate. Because I think people will still need bleach and trash bags in the future, and it’s a good bet that Clorox will continue to get a piece of that market, I use the long-run GDP average of 3 percent. (Location 2901)
This is a very simple DCF model—the one we use at Morningstar has about a dozen Excel tabs, adjusts for complicated items such as pensions and operating leases, and explicitly models competitive advantage periods, among many other things. (Location 2907)
We’ve analyzed a company, we’ve valued it—now we need to know when to buy it. If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. (Location 2920)
If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valuation and any analysis is subject to error, and we can minimize the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the margin of safety, a term first popularized by investing great Benjamin Graham. (Location 2920)
This discount is called the margin of safety, a term first popularized by investing great Benjamin Graham. (Location 2922)
Having a margin of safety is like an insurance policy that helps prevent us from overpaying—it mitigates the damage caused by overoptimistic estimates. If, for example, we’d required a margin of safety of 20 percent before buying Clorox, we wouldn’t have purchased the stock until it fell to $43. In that case, even if our initial analysis had been wrong and the fair value had really been $40, the damage to our portfolio wouldn’t have been as severe. (Location 2930)
If, for example, we’d required a margin of safety of 20 percent before buying Clorox, we wouldn’t have purchased the stock until it fell to $43. In that case, even if our initial analysis had been wrong and the fair value had really been $40, the damage to our portfolio wouldn’t have been as severe. Because all stocks aren’t created equal, not all margins of safety should be the same. It’s much easier to forecast the cash flows of, for example, Anheuser-Busch over the next five years than the cash flows of Boeing. (Location 2931)
Because I’m less confident about my forecasts for Boeing, I’ll want a larger margin of safety before I buy the shares. (Location 2936)
Paying more for better businesses makes sense, within reason. The price you pay for a stock should be closely tied to the quality of the company, and great businesses are worth buying at smaller discounts to fair value. Why? Because high-quality businesses—those that have wide economic moats—are more likely to increase in value over time, and it’s better to pay a fair price for a great business than a great price for a fair business. How large should your margin of safety be? At Morningstar, it ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. On average, we require a 30 percent to 40 percent margin of safety for most firms. (Location 2938)
How large should your margin of safety be? At Morningstar, it ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. On average, we require a 30 percent to 40 percent margin of safety for most firms. (Location 2942)
Although we acknowledge that some high-potential companies are worth a leap of faith and a high valuation, on balance, we think it’s better to miss a solid investment because you’re too cautious in your initial valuation than it is to buy stocks at prices that turn out to be too high. (Location 2956)
Estimating an intrinsic value keeps you focused on the value of the business, rather than on the price of the stock. • Stocks are worth the present value of their future cash flows, and that value is determined by the amount, timing, and riskiness of the cash flows. • A discount rate is equal to the time value of money plus a risk premium. • The risk premium is tied to factors like the size, financial health, cyclicality, and competitive position of the firm you’re evaluating. • To calculate an intrinsic value, follow these five steps: Estimate cash flows for the next year, forecast a growth rate, estimate a discount rate, (Location 2962)
estimate a long-run growth rate, and add the discounted cash flows to the perpetuity value. (Location 2968)
First, look for evidence of an economic moat. (Location 2985)
we can do this by examining how profitable AMD has been in the past by analyzing free cash flow, margins, return on equity, and return on assets (Location 2985)
However, some rapidly growing firms spend years plowing all of their money back into capital spending, which means their free cash flow is negative because they’re still building their economic moat. (Starbucks was a great example of this during the 1990s.) Even these kinds of firms should have solid profits, however, (Location 2990)
Biomet’s earnings yield and cash return of 3.0 percent and 2.1 percent, respectively, didn’t exactly scream “undervalued.” We could get better returns in risk-free treasuries, and given Biomet’s higher risk than a T-bond, we should demand a higher cash return and earnings yield from its shares. (Location 3237)
Biomet’s free cash flow has increased pretty steadily over the past several years, so let’s use $180 million as our estimated amount for 2004. (Biomet’s historical free cash flows are shown in Figure 11.8.) (Location 3242)
(I used a relatively low discount rate of 9 percent—versus a market average of 10.5 percent—because Biomet is a very financially stable company.) Add (Location 3246)
Therefore, let’s try another scenario. We’ll assume Biomet can grow faster starting in year six, and we’ll push our forecast horizon out to 15 years, at which time we assume that Biomet’s growth rate declines to a steady state of 3 percent (Location 3253)
field. Apply the following tests to any stock that you think might be a worthwhile investment, and you should be able to decide in 10 minutes whether it warrants much of your time. (Location 3283)
Read the most recent 10-K filing (Location 3363)
front to back. Pay special attention to the sections that describe the company and its industry, the sections about risks and competition, any mention of legal issues (sometimes labeled “commitments and contingencies”), and the “management’s discussion and analysis” section. (Location 3363)
Read the two most recent proxies (form DEF-14A, in the SEC’s jargon). Look for reasonable compensation that varies with corporate financial performance and a reasonable options-granting policy. (Location 3370)
Read the most recent annual report, as well as the past two years’ reports, if possible, to get a feel for the company. (Location 3372)
Look at the two most recent quarterly earnings reports and 10-Q filings to see whether anything has changed recently. Look for signs that business is getting better—or worse—as (Location 3376)
Start valuing the stock. Look at the stock’s valuation multiples relative to the market, the industry, and the stock’s historical valuation ranges. If the firm has low reinvestment needs, low risk, high returns on capital, or a high growth rate, be prepared to accept a higher price-to-earnings ratio. (Location 3380)
Of all these areas, we think drug companies and medical devices firms are usually the most promising because they (Location 3456)
typically have the widest economic moats. (Location 3457)
there are also several large independent pipeline companies in existence, such as Kinder Morgan. (Location 5857)
ExxonMobil, which has some of the largest reserves in the ground, is also the largest refiner in the industry. (Location 5862)
In addition, the health of the industry tends to be extremely cyclical, with short-term demand for drilling services and equipment highly volatile and dependent on commodity oil and gas prices. When oil prices are high—as they were in 2000—Baker Hughes’ phones are ringing off the hook with oil producers scrambling to drill more wells so they can get more oil to market while profits are high. But when oil prices tank to near $10 a barrel—as they did in 1998—demand can quickly evaporate and come to a grinding halt. Budgets for new drilling are often the first to be cut when oil companies are operating with lean cash flow. This makes the stocks volatile (Location 5881)
in the short term as the markets try to guess the next cyclical movement, while long-term investors are hampered by the red ink typically created in the cyclical lows. (Location 5886)
Although there will inevitably be some bumps along the road when oil prices are low, we expect modest long-term sales growth for the overall oil services field. (Location 5890)
Hallmarks of Success for Energy Companies (Location 5950)
Investor’s Checklist: Energy (Location 5989)