Valuation basically means estimating a company's true value (intrinsic value) independent of the market price of the stock. It would be nice to have a simple formula for it, but valuation is not only based on financial figures, but also on subjective judgement of non-financial parameters such as company management, prospects, market position, research and development, and so on.
Discounted Cash Flow / Net Present Value models
Value can be estimated by estimating the company's future annual earnings or cash flow (based on past performance), and discounting that by an appropriate factor representing the cost of capital. More about this method in the next section.
1. Strong financial condition. Current assets should be at least 2x current liabilities. Long term debt should not exceed net current assets.
2. Uninterrupted dividend payments.
3. Consistent earnings.
4. Some earnings growth (3-4 % annually, averaged over 10 years).
5. Moderate P/E ratio
Additional things to check:
Warren Buffett uses "owner earnings". Owner earnings = net income plus amortization and depreciation, minus normal capital expenditures (sometimes called structural free cash flow). One could also subtract costs of granting stock options,'nonrecurring' charges, 'income' from the company's pension fund. Annual growth in owner earnings of 6-7 % over the past 10 years can be considered good.
Balance sheet: debt <50% of total capital. Look for, or determine yourself, the ratio of earnings to fixed charges.
There are numerous ways to make low earnings and losses look good. Here are a few tricks you should watch for when reading an annual report.
1. Losses can be listed under "special charges".
2. Earnings can be made to look better by switching from an accelerated to a straight depreciation schedule. Straight line depreciation is less burdensome on earnings. Also, there is the choice between "first in first out", and "last in first out" - methods of valuing inventories.
3. Some reports give "pro forma" earnings, These are earnings the company could have had, if only they had done better. Of course, this is not informative.
4. Unrealistic expectations about the return on company's pension funds can be used to make the financial situation look better than it is.
5. Some companies have special purpose entities (affiliate firms that buy risky assets or liabilities, to remove them from the balance sheet of the main company)
6. The use of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). EBITDA does not say anything about cash flow, and leaves out the cash required to fund working capital and the replacement of old equipment.
7. Treating the exchange of assets as sales.
8. Treating expected profits as realized profits.
9. Treating normal operating expenses as capital expenditures (expenses made to acquire or upgrade physical assets such as buildings and machinery), increasing the company's total assets while it was actually a decrease in net income.
10. Listing items as nonrecurrent, when they actually occur very often.
Use earnings averaged over the past 7-10 years. This evens out the ups and downs of the business cycle, but also solves the problem of what to do about special charges and credits. Just include special charges in the average earnings.
- Read the annual reports backwards (bad news is usually hidden in the back).
- Read footnotes. Watch for words like 'capitalized', 'deferred','restructuring' plus indications that accounting practices have changed. Compare with a firm that is a close competitor to get an idea about how aggressive the accountants are.
- "Johnny-One-Note": company relying on only one big customer.
- "Serial acquirer": More than two acquisitions/year. Too many of these and then having to sell at big losses (e.g. Lucent, Mattel, Quaker Oats).
- "Other People's Money": Too much borrowing or too much selling stocks to raise money, usually under "cash from financing activities" (under cash flows), only to make it look as if underlying business is generating cash (e.g. Global Crossing).
- Repeatedly splitting shares and hype them in press releases: Bad sign. Managers should manage, not merely promote the shares. By good management they prevent the price from going too low OR too high.
- Buying back stock: companies should buy back stock only when the stocks are cheap.
- A huge salary for managers is only right if the managers are really good. Repricing stock options for insiders? Stay away. Read footnote about stock options in annual report. When stock options are converted into stocks, the flood of new shares will dilute your earnings per share. If senior executives repeatedly sell, it is a bad sign.
- Competitive advantage: brand identity, monopoly, the ability to sell huge amounts of goods cheaply (eg. Gilette), a unique intangible asset (eg. Coca-Cola's secret formula), resistance to substitution (eg. electricity is not easily replaced by something else).
- Sow AND reap (i.e. importance of research and development). Average spent on research and development varies per industry, but company should not spend too much, nor too little.
- Managers should say what they will do, then do what they said. They should admit and take responsibility for failures, without blaming "the economy" or "weak demand", because those are too general. Find all this in previous annual reports. Also, the tone and content of chairman's letter should be steady, and not vary with whatever is hip on Wall Street.
Further reading, on interpreting financial statements:
Fridson & Alvarez- "Financial statement analysis";
Mulford & Comiskey - "The financial numbers game";
Schilit - "Financial Shenanigans";
Graham - "The interpretation of financial statements".