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Often, investors seem to be wearing blinders when making investment decisions. They get caught up in the “story” of a stock or focus too much on short term performance. What is frequently forgotten is that when buying a stock, investors are paying for a set of expectations that are being implied at a given price. If investors want to improve their stock selection process, they must first answer this one simple question “What am I paying for in today’s price?”
Over 20 years ago, The Applied Finance Group (AFG) developed a research application called Value Expectations that has been helping clients answer the core of that very question and removing emotional biases from the equation. The engine behind Value Expectations translates AFG’s proprietary Economic Margin framework, which converts GAAP accounting data into a set of economic cashflow metrics, to a DCF model.
Value Expectations reverse engineers the DCF model to understand the embedded sales growth expectations a stock must deliver to justify its current price. This helps investors leverage their time by avoiding stocks with high expectations and improves performance by focusing on stocks with low expectations which may merit further due diligence.
For example, below is the Value Expectations interface with Coca-Cola (KO), which is telling us that the expectations are very rich. Assuming historical median EBITDA Margins and Asset Turns, KO needs to achieve over 22% sales growth each year for the next five years to justify its current price of $43.48. These expectations are much higher than anything they can realistically achieve.
We can also apply this process to gain insights on any universe of stocks like the S&P 500. The chart below highlights current and historical implied sales growth expectations embedded in the market price for the S&P 500 index compared to the sales growth these stocks have delivered over the past five years.
When the index approaches abnormal ranges (+/- 1.5 std dev.) it signals that the index is extremely under or overvalued. The two biggest extremes in expectations was in 2000 at the height of the euphoria around tech when your doctor was giving you stock tips and in the doom and gloom of 2008 which represented a generational wealth creating opportunity for investors. As of July 31st, 2016 the implied expectations for the S&P 500 are a bit high compared to historical norms, but we don’t perceive any major concerns that should cause any change in allocations in the large cap space. The real opportunities in today’s market, lie within the universe of mis-priced stocks with unrealistic expectations priced in.
Under the Hood – Corporate Performance
To value a company, you must first understand it’s corporate performance. Earnings is a very poor proxy for profitability as traditional accounting-based metrics provide an incomplete view of a company’s performance by ignoring the investment needed to generate the earnings and the cost of capital associated with the investment.
To address these issues, AFG’s proprietary Economic Margin (EM) was developed to evaluate corporate performance from an economic cash flow perspective. Effectively linking the income statement and balance sheet to capture differences in Capital Structure, Asset Age, Asset Life, Asset Mix, Off Balance Sheet Assets and liabilities, Investment Needed to Generate Earnings and Cost of Capital.
The chart below is a bird’s eye view of the EM calculation. The numerator states the economic profit which is then divided by an inflation adjusted invested capital to make it easier to compare against other companies and over time.
Calculating Intrinsic Value and understanding the Value Expectations for stocks
Now that we have created an effective framework to measure corporate performance we can begin calculating intrinsic value. As mentioned at the beginning, when buying a stock, you are essentially paying for its future expected performance. We calculate intrinsic value by forecasting Economic Margins, then discounting those cash flows. Unlike traditional DCF models that lock into perpetuities, assuming nothing in the market will change, we take into account real market forces by incorporating a competitive advantage period (CAP) – the time frame that competition will compete away economic profits. In other words, a better investment decision can be made because the framework provides clarity and structure in understanding a company’s economic profitability, management quality, growth prospects, and competitive advantage period to translate into a valuation target.
With the DCF engine in place, rather than starting by forecasting cashflows, investors can use historical median EBITDA Margins and Asset Turns, to solve for the implied sales growth to justify its current price, as illustrated on the chart below. By beginning your research with insights on what the market is implying, you can leverage your time significantly by focusing your efforts on analyzing those stocks where the expectations significantly deviate from their own historical performance, their peers or your own insights. Once you have identified a short list of stocks with low expectations, you can be much more explicit in calibrating each value driver, or as many other inputs as your time allows, to calculate an intrinsic value based on your forecast.
In conclusion, the market is always speaking loudly to investors and providing guidance with very clear expectations you can leverage. To improve your selection process, before you begin forecasting cashflows, you need to remove the noise and remember to answer “What am I paying for in today’s price?” Alternatively, you run the risk wasting your most precious asset, time.