How to Get Rich in the Stock Market:
There is a simple way to get rich in the stock market. “All” you have to do is buy stocks that are bargains and avoid or sell stocks that are over-priced.
The approach used in our analysis is to attempt to determine whether the “true” value of a share is above or below the current market price. The “true” value of a share based on its current and projected balance sheet and earnings can be estimated using two main approaches:
- Based on the liquidation value of the assets.
- Based on the present value of future cash flows to the investor.
The first approach is applicable only when there is a reasonable possibility that the company might soon be “wound down” and its assets liquidated. It is the second approach that we focus on in most cases.
Calculating the present value of future cash flows
“All” that is required is to forecast all of the future cash flows to the investor and then calculate the present value of those future cash flows. At first glance this is an impossible task. How can anyone predict the future cash flows of any company over its entire future?
In many cases the task is impossible. However, there are some approximations that we can use to model the cash flows of some companies. Some companies have a history of a steady growth in earnings. For some of these companies it is reasonable to assume that the earnings will continue to grow at the historic rate. If we combine this assumed growth rate with an assumption that the investor will sell the share after 10 years at given price earnings ratio, then we can model the present value of the future cash flows.
In our method, the value of a share consists of two components.
- The present value of the expected dividends to be received during a 10 year holding period.This is based on the initial dividend and a forecast dividend growth rate.
- The present value of the proceeds of selling the share after the ten year holding period. This
share price in ten years is estimated by starting with the initial normalized earnings per share, and then calculating the earnings in ten years by applying an expected average compounded growth rate, and then valuing the share at a conservative P/E ratio of between 10 and 20.
The ten-year period is selected because it is arguably conceivable to predict the growth rate in earnings and dividends for at least some companies for that period of time. We cut the analysis off after ten years because it becomes increasingly harder to predict the earnings that far into the future. We assume the share is sold after ten years. We suspect that a holding period of ten years is also something that makes more sense to most investors compared to an analysis based on holding a share forever. We use a conservative estimate of the P/E to determine the proceeds of the share sale at that time. The conservative P/E recognises that today’s high growth company will not continue to grow at very fast rates forever.
In application, our stock valuation model requires five separate input assumptions
- Beginning earnings per share
- Beginning dividend per share
- Growth rate in earnings and dividends over the next 10 years
- Price / Earnings ratio at which the share will be sold in ten years.
- The appropriate risk adjusted interest discount rate
There are many uncertainties and assumptions involved in setting these five input numbers for each company to be analysed.
- The beginning earnings per share should be representative. We use an adjusted earnings per share figure that removes the impact of unusual gains and losses. Many but not all companies provide data on adjusted or normalized earnings per share. Note that there is no point in attempting the analysis if the beginning earnings figure is not representative.
- Beginning dividend per share. This is the initial annual dividend per share. Dividends are the cash that an investor receives each year. This figure is readily available from the company financials.
- Earning growth rate. This can be very difficult to predict. If past earnings have grown at a steady rate then that figure could be used. The past revenue growth rate can also be used, since in the long run earnings growth and revenue growth should be similar. In general we use two figures for this, one a conservative estimate and the second being a more optimistic estimate. In many cases if the company’s past earnings and revenue growth are volatile then we can’t make any intelligent estimate and we don’t perform the analysis. The growth rate in earnings per share (“EPS”) and in the dividend is predicted by considering several methods. The historic rate of growth in sales per share and EPS are considered. Another estimate is calculated by multiplying the current ROE by the percentage of earnings that are retained. We also consider that a company that pays out 50% of its earnings as a dividend should be expected to grow EPS only about half as fast as a similar company that retains all of its earnings for reinvestment. The value of the dividends received is considered in part 1 of our calculation, and therefore dividend stocks are not being “penalized” by this lower expected growth rate. In our analysis we calculate two separate estimates of the share value; one using a conservative growth rate, and a second estimate based on a more optimistic rate of growth. The conservative growth rate is not a worse case scenario but rather is simply a conservative estimate. Similarly, the optimistic estimate is not wildly optimistic. It does not seem logical to us to value a share using more than about a 20% EPS ten year average growth rate in the most optimistic case. A 20% growth rate for ten years will result in EPS increasing by over 520%. Consider a scenario where we expect that a stock will grow at 30% and value it as such and find it is selling at a value that reflects “only” 22% growth. If we buy it and it grows at “only” 20% then we have made a poor investment despite the excellent performance of the company. Based on that logic we find it unacceptable to value a stock by predicting that it will grow EPS at more than 20% or 25% even in the most optimistic cases.
- The price / earnings ratio at which a share will sell in ten years time is difficult to predict. Higher growth companies will sell at higher price earnings ratios. Our approach has been to assume that in tens years time, growth will have slowed to a market average level. No tree grows to the sky and our approach is a conservative one. It would also make sense to use a conservative and an optimistic value for the future price earnings ratio. In general it would not be wise to assume a price earnings ratio of more than 20 or 25. A higher P/E assumes that today’s growth company will still be growing strongly in ten years.
- The interest discount rate reflects the minimum rate of return that the market should require from the company on a risk adjusted basis. We use 10% for most companies and 12% for riskier companies.
In attempting to use the above calculation method, we divide all stocks into three categories
- Stocks that have no current earnings or for which future earnings are virtually impossible for aninvestor to estimate. These stocks would include most mining exploration companies, emerging high technology stocks, those biotechnology stocks that are still primarily in the research and development stage, arguably most commodity companies, and many other smaller and newer companies. These stocks are a bit like buying a lottery ticket. They are definitely highly speculative. Stocks in this category cannot be valued based on earnings since investors cannot even roughly estimate earnings. In addition it is not possible to value these stocks based on their invested assets or book value. The asset investment may generate a return or it may turn out to be money down the drain. Successful strategies do exist for these stocks. But application of fundamentals from the balance sheet and income statement are of little or no help for these stocks. An investor in these types of stocks would likely invest in a portfolio of such stocks in order to minimize risk. Another strategy for these stocks would be to become very knowledgeable in a particular sector and to monitor industry and company developments very carefully.
- The second category is stocks for which future earnings and/or dividends can reasonably be estimated. This would include large, stable, well-established companies that have already demonstrated a stable history of growth. In the ideal scenario, these stocks are valued like bonds with earnings and dividends that are very predictable. The legendary investor, Warren Buffet has argued that there are stocks that fit this mould. He has used this type of approach to justify very large investments in Coke, Disney, McDonalds’s and a small number of other stocks. He calculated that these stocks were trading at a large discount to their intrinsic value based on their future earnings, which he felt were reasonably predictable.
- The third category would include all of the other stocks in the middle that seem predictable enough to exclude from category 1 but which are not stable enough to qualify for category 2. investment-pick.com believes that valuation methods can be used to identify opportunities in category two and to a lesser extent in category three but not for category one.
If the share can be purchased below our more conservative valuation then we think it is very likely to be a good investment. Stocks which are below the more optimistic valuation that we calculate may also be good investments. Stocks which are trading above our more optimistic valuation will have to grow at very high rates to turn out to be good investments and therefore we would not normally invest at those levels.
Pitfalls of this method:
The valuation arrived at by this process is extremely dependent on both the starting earnings per share and the expected growth rate. We deal with this by only applying the method to the latest fiscal earnings adjusted for unusual items. In addition we exclude companies that did not earn at least 5% on equity. And we exclude companies if the earnings and / or sales are too volatile. In addition we will not forecast a growth rate of more than 20 or 25% in the most optimistic cases.
Our valuation method will give a reasonable result as long as the company continues approximately along its current earnings trend. The strength of this method is in quantifying exactly how an expected growth rate in earnings per share should translate into a reasonable share price range.
However, the method certainly will not prove to be even reasonably accurate in every case. If the company fortunes take a sudden very sharp turn for the better or for the worse (despite a stable past) then our method will fail.
The following example illustrates how we calculated a present value for each share of Nortel.
Nortel Example:
Next 10 years expected earnings and dividend growth rate | 30% |
Dividend as percent of earnings | 25.9% |
Assumed P/E when share is sold after 10 years | 15 |
Risk free real return required | 4% |
Expected inflation rate | 2% |
Risk premium required | 4% |
Total discount interest rate required | 10% |
Prior year earnings per share, adjusted for unusual items | $ 1.009 |
Earnings per share | Dividend per share | Proceeds share on sale | Total Cash flow | |
Year 1 | $ 1.31 | $0.340 | $0.340 | |
Year 2 | 1.71 | 0.442 | 0.442 | |
Year 3 | 2.22 | 0.574 | 0.574 | |
Year 4 | 2.88 | 0.746 | 0.746 | |
Year 5 | 3.75 | 0.970 | 0.970 | |
Year 6 | 4.87 | 1.261 | 1.261 | |
Year 7 | 6.33 | 1.640 | 1.640 | |
Year 8 | 8.23 | 2.132 | 2.132 | |
Year 9 | 10.70 | 2.771 | 2.771 | |
Year 10 | 13.91 | 3.603 | $ 208.65 | 212.251 |
Present value of projected cash flow stream of each share | $87.79 |
In the Nortel example the dividends and earnings increase at a quite optimistic average of 30% per year. After ten years the earnings have grown to $13.91 per share. The share is assumed to be sold at the end of ten years at a conservative P/E of 15 for proceeds of $13.91 times 15 = $212.25. In order to earn a 10% compounded rate of return an investor must purchase the shares for $87.79 today.
If an investor believes that the growth scenario is realistic then he would find Nortel attractive at prices below $87.79, but would not want to purchase above that price. Many shares like Nortel trade at prices that reflect an expectation of very high growth. Value investors tend to be leery of these stocks. The reason is that if the growth of Nortel turns out to be “only” 20%, then the investment will not provide a reasonable return.
In purchasing a stock like Nortel, we think it is useful to calculate the kind of growth or future P/E that would be required to earn a compounded 10% return on the share. Our share value calculation tool can be used for that purpose.
Note that the present value that we calculate is not a prediction of where the market price will go, particularly in the short term. We do believe though that purchasing shares that are trading below a conservative estimate of the present value will on average be a good strategy.
Efficient Market Hypothesis
Some people believe that it is complete folly to think that it is possible tp calculate which stocks are being under-valued in the market. The problem is that if the stock market is efficient, it will be impossible to consistently pick out the winners.
An entire industry has developed that centres on the belief that the market is not fully efficient and that in fact it is possible to consistently pick out the winners. Most mutual fund managers, pension fund managers and investment advisors believe that they are quite capable of outperforming the market consistently.
The efficient market theory holds that the fair value of a share is equal to the market price at all times. If the market is totally efficient then the market price of all shares immediately adjust to take account of all possible information about each company and its industry. At any given time the market price is the consensus valuation of each share. Under this efficient market hypothesis it is not possible to consistently predict which shares will outperform the average share on a risk adjusted return basis. In reality some stocks will in fact outperform. But in this view it is simply not possible to reliably pick those winners.
A review of the evidence would indicate that the market for large capitalization stocks is somewhat efficient but is not perfectly efficient. We believe that there are enough inefficiencies to justify not relying blindly on the efficient market hypothesis. We believe that the market for smaller capitalization stocks, which are not generally followed by analysts, must be rather inefficient. At the same time though we recognize that acting on an analysis that suggests that the market price is wrong is always a risky proposition.
Some trading strategies do not rely on determining the “true” value of any given share. This includes the efficient market hypothesis, which would suggest an index investment or a random portfolio approach. Another strategy that has proven successful in recent times is a momentum strategy of investing in “hot” stocks and “hot” sectors.
END
Shawn Allen
May 12, 2001