Yesterday, I received the following comment and question regarding my watch list. I thought I would answer the question in a blog post in case others had the same question and to better explain the methodology of my watch list.
Great site, thanks very much for all of your ideas.
I’ve looked at your watch list every time you’ve posted it, but I’m finding it very unintuitive.
I think I understand your concept of Expected Return expressed as a %, but why not have an implied valuation and Margin of Safety columns as well so you can quickly see the variance from current price and best opportunity to research?
If I understand correctly, you could just rank opportunities from greatest yield to least, but the metric feels very unfamiliar.
I’m interested in your thoughts,
First, I want to thank Aron for the question. I would start by saying that there is not a perfect way to value a company. All valuations are based on future assumptions that are inherently suspect. There are two basic approaches to this reality: 1) limit future projections to companies with exceptional economics and a long track record (Buffett) or 2) don’t make projections and look for things that are cheap based on current assets and earnings power.
The idea behind the watch list is to focus on those companies that have exceptional economics as evidenced by ten years of exceptional returns on equity without undue leverage. These are the companies where an investor has at least a fighting chance of projecting long-term future earnings and growth.
In order to prioritize the list and highlight areas of opportunity, I wanted to include a valuation metric. I chose to express this as an expected return, which is the sum of the earnings yield and the expected growth rate. This is the approach used by Glenn Greenberg. (Greenberg also seems to suggest that Buffett approaches valuation in a similar way.) The benefit is that it is simple and gets you to focus on two central questions:
- Is it cheap today? (earnings yield)
- How fast can intrinsic value grow? (growth rate)
It is also easy to calculate.
Aron asks why I don’t rank opportunities from greatest yield to least. The answer is that I wanted to include growth in the valuation since growth is such an important part of a company’s intrinsic value. As Buffett pointed out in his 1991 letter to shareholders, a business with “bob-around” no growth earnings is worth 10 times after tax earnings using a discount rate of 10%. A good business that can grow earnings at 6% is worth a “whopping” 25 times after-tax earnings.
The expected return approach I take is simply another form of a discounted cash flow (DCF). There are three components to a DCF: 1) the discount rate (or expected return), 2) the projected stream of cash, and 3) the present value (PV) of those cash flows.
For a growing stream of cash flows we can use the following calculation:
PV = current earnings x 1/(discount rate) – (growth rate)
Assume I find a stock on the watch list with an earnings yield of 10% ($50 stock price and an EPS of $5) and an expected growth rate of 5%. I would calculate that stock to have an expected return of 15%.
Using the formula above, here’s the math:
$50 = $5 x 1/(15% – 5%)
We can say that the $50 stock price is discounting a 15% future return, assuming a growth rate of 5%.
Often DCF’s are done by first setting the discount rate – or alternatively, the hurdle rate – and calculating the present value of the stock. (I believe this is the approach that Aron is looking for.) If this value is greater than the current stock price, we can look at the difference between the PV and the current stock price and judge whether it provides a sufficient margin of safety, typically expressed as a percentage derived by dividing the discount by the PV of the stock
For example, let’s use a discount rate of 10%. 10% is often used as a proxy for an expected return on an equity investment. (Alternatively, we could follow Buffett and use the yield on long-term government bonds.)
In that case, the present value is far greater because of the reduction in the discount rate from 15% to 10%:
$100 = $5 x 1/(10% – 5%)
We could then say that the stock is selling at a 50% discount to present value.
What I intended to show is that the approach I take in the watch list and the approach of expressing the PV using a fixed discount rate are essentially two sides of the same coin.
Aron also asks about having a margin of safety value so it could be easily compared with that of other stocks on the list. First, I think some caution should be used in expressing the margin of safety as a single percentage in that it can give the impression that the figure is precise. Intrinsic value is better understood, I believe, as a range of values. (Of course, in fairness, the same critique could be made of expressing the expected return as a precise figure, which is why I stress that this is a starting point, nothing more.)
Having said that, the expected return does imply a margin of safety. An asset with a true expected return of 15% is worth far more than an asset with an expected return of 8%. Think of it this way: many things could go wrong with the former asset and it could still outperform or equal the latter asset paying only 8%.
I hope this answers the question. If not, please let me know. Also, I welcome all comments and questions on this most important investing topic of valuation.