How to Pick Winning Stocks

The prospect of calculating the present value per share of all future earnings sounds daunting or even impossible. The calculation is actually quite easy (that is, for those who are familiar with time value of money calculations) and while it is subject to error useful approximations can be made, at least for some stocks. Essentially, the process consists of forecasting the earnings level and growth for the next ten years. After ten years it is assumed that the stock will be sold at a conservative Price / Earnings (“P/E”) ratio such as 12 or 15. Cutting the analysis off at ten years nicely eliminates the impossible task of predicting earnings into the infinite future. Using this method, the present value of the stock is then the present value of the calculated amount that that the stock will be sold for in ten years plus the present value of any dividends that will be received.

For example, if a stock presently earns $2.00 per share and earnings are expected to grow at an average of 15% per year then in ten years time the earnings are expected to be $2.00 times (1.15)¹⁰ . This equals $2.00 x 4.0456 = $8.09. So the company is expected to be earning $8.09 per share in ten years time. If we assume that we can sell the stock at a conservative P/E ratio of say 15 in ten years, then we will receive 15 x $8.09 = $121.35 for the share at that time.

Using a 10% required rate of return, $121.35 to be received in 10 years is worth $121.35 / (1.10)¹⁰= $121.35 / 2.594 = $46.78. That is, if you pay $46.78 for the share today and sell it for $121.35 in ten years, you will have earned 10% compounded annually on your money.

So, if you expect that the earnings will grow at 15% then you now know the stock is worth about $47, If the stock is selling in the market at substantially less than $47 then you would expect to earn more than 10% by investing at that lower price. Conversely, if the stock were trading in the market at more than $47 than you would conclude that the stock was not a good investment since you would expect to earn less than a 10% annual return.

If the above stock pays a dividend then you add the present value of the dividend stream to the $46.78. For example, if the prior year’s dividend was $1.00 per share and the dividend is expected to grow at 15% per year then the present value of that amount can be calculated as $1.15/1.10 + ($1.00×1.15²)/(1.10)² + ($1.00×1.15³)/(1.10)³ …  + (1.00×1.15¹⁰)/(1.10)¹⁰ = $12.87. In that case the calculated present or intrinsic value of the share is $12.87 + $46.78 = $59.65.

To account for the fact that some companies are riskier than others, investors can assume a lower growth rate (to be on the safe side) or can use a higher discount (required return) rate in the present value calculation. I believe that investors rarely make these kind of calculations. Furthermore, most advisors and brokers do not make these kinds of calculations. Therefore those investors who are capable of and willing to make such calculations should gain an advantage over the majority of investors who are not making or relying on those calculations.

The intrinsic value calculation requires just 4 basic inputs. 1. The initial earnings and dividend per share; 2.The expected earnings per share growth rate; 3. The required return or “discount” interest rate; 4. The P/E ratio at which the stock is assumed to be sold after ten years. More information on setting each of the four inputs is provided below.

The initial earnings per share is simply the current adjusted earnings divided by the diluted weighted average number of shares outstanding. Average diluted shares are higher than the actual average number of shares outstanding to account for the net dilution from stock options and convertible bonds. The diluted average number of shares can be determined from information provided on the income statement. The calculation should be based on adjusted earnings, rather than actual earnings, as discussed in the other box.

Calculating an expected growth rate for earnings is very challenging. But, an investor can consider the nature of the business and the competitive environment of each industry to make a more informed judgment regarding earnings growth.

In predicting the earnings growth it is very useful to calculate and graph past earnings growth rates. Since earnings can often be impacted by a variety of one-time gains and losses you should also graph the adjusted or normalized earnings per share to reveal the under-lying growth trend.

If the historic earnings and sales graph shows a very erratic pattern, as is often the case, then it may not be possible to forecast future earnings. (In which case you really can’t apply this intrinsic value method to judge the true value of that stock.) If however, the company has shown a reasonably consistent pattern of earnings then an initial assumption might be that the historic growth rate will continue. However, it is advisable to also consider the environment in which the company operates in order to attempt to discover if it is likely that the company’s past trend is no longer applicable. The current state of the economy is also a factor, although we should remember that this is a ten year projection and we should not be overly influenced by the current state of the economy, since that will change.

The return on equity can provide an estimate of the sustainable growth rate. In theory, the sustainable growth rate is equal the return on equity rate multiplied by the percentage of earnings that are retained (not paid out as dividends). In this case, it is important to use the adjusted or normalized earnings to calculate the return on equity and to consider whether or not the return on equity level is sustainable for the next ten years.

In some cases management provides an outlook for the longer term growth in earnings per share.

Since the growth rate over the next ten years is inherently uncertain, the calculation should be done twice, once with a relatively conservative growth rate and once with a more optimistic growth rate. It is important to avoid the use of a wildly optimistic growth rate since doing so would result in a calculated intrinsic value per share that assumes that the wildly optimistic growth will occur. If you paid a price that assumed all that wildly optimistic growth would occur, you would essentially have a stock that had little or no up-side left and plenty of down-side risk.

The required rate of return can be set at a standard level. It consists of the return available from risk free bonds plus some risk premium. In theory the risk premium could change with every company. In practice I estimate the return on bonds as about 6% and add 4% for a risk premium to arrive at a 10% required return or discount rate. I then adjust for risk by being more or less conservative in my growth assumptions in step 2 above.

Finally, estimate the P/E ratio at which the stock can be sold after the ten year holding period. Today’s high growth, high P/E stock cannot be assumed to grow rapidly forever. To be conservative, assume that ten years out the growth rate will have slowed to a more normal level and that therefore the stock will be selling at a relatively normal P/E between 12 and 25. In most cases you should assume a P/E of about 12 for a conservative calculation. Repeat the calculation with a P/E of about 15 for a more optimistic scenario. In unusual cases you could assume a P/E as low as about 8 or as high as 20. If you assume a P/E that is too high, you leave yourself with little up-side risk and plenty of down-side risk.

So after all of that, for the more predictable companies, you will have arrived at a conservative and a more optimistic calculation of the present or intrinsic value per share. If the earnings do not seem sufficiently predictable then it is appropriate to decide not to make the calculation or alternatively to assume a very conservative growth rate.

A variation of the above method is to use an assumed 5 year holding period rather than 10 years.

Net income is the most important consideration in valuing a stock. There is often a tendency to trust and use the reported net income as is. In reality you usually have to correct for any unusual gains and losses that distorted the net income. The following are items that often may distort net income.One-time gains and losses – A company may have a substantial gain or loss on the sale of land or equipment. Or a company may take a one-time charge for restructuring or some very unusual item such as a strike or other disruption. These items should be reversed in attempting to calculate the future income since they are not expected to recur.

Unusual income tax rate – Some companies pay very little in income tax expenses due to past tax losses. This is a temporary phenomenon and should be adjusted for. Calculate the effective tax rate of each company and then investigate the reasons if the tax rate is much different than the expected statutory rate (about 45%) for large companies.

Capitalized exploration expenses – Mining and oil exploration companies are allowed to capitalize exploration costs even for “dry holes”. For this reason, it may be appropriate to be very skeptical of the net income of such companies. In fact such companies typically do not lend themselves to this type of analysis since their earnings are often inherently unpredictable.

R & D expense – Under U.S. GAAP all R & D costs are expensed while in Canada all research costs are expensed while development costs are capitalized. In either case the result of this conservative accounting can be an “artificial” lowering of net income. If it is believed that the research will create future value then it seems appropriate to add back at least a portion of the expensed R&D or recalculate income as if R&D were amortized over say 5 years.

Depreciation – Consideration should be given to the level of the depreciation expense versus the likely true deterioration (or possibly appreciation) in value of the fixed assets or the cost to eventually replace an asset due to its usage or the passage of time. In rare cases such as with a portfolio of newer buildings, it may be appropriate to add back a portion of the depreciation expense on the basis that the actual replacement of the building will occur many many years in the future and the cash outlay at that time (even with inflation) has a present value that is less than the depreciation expense. And it is appropriate to add back amortization of goodwill since goodwill is not usually an asset that is used up over time and it often appreciates in value.

Deferred Income Taxes – These have to be paid eventually only after some years. The present value of this future outlay is less than the non-cash expense deducted under GAAP. Therefore, it is appropriate to add back some portion of this expense. I would be conservative with this and add back say 20% of the deferred tax expense.

Preferred Share dividends – Technically net income is properly reported prior to any preferred share dividends. But most companies also show the deduction to arrive at net income applicable to common shares. For those companies that do not show the deduction, you must make that deduction.

In summary every income statement has to be taken with a grain or two of salt. With some digging, you can make an informed adjustment to the published net income to calculate a normalized or adjusted net income.

Conveniently, some managements provide an adjusted earnings figure. This goes beyond a disclosure of extraordinary items, which is required by GAAP, and includes a variety of unusual items. You should focus on that number when it is provided. But also check for any unusual items that management did not highlight.