Decode Investing | Part 3 | How to calculate the true value of a business

As value investors, we buy a business because of the cash surplus it will generate over the time we own it. As the business generates more cash surplus every year, the equity or book value of the business also increases. Remember that equity is what is left for the business owners if the business were to cease operation today, pay off its debt, and liquidate its physical assets (this also includes cash surplus held by the business). It is important to recognize that a stock is a value-producing asset. We don’t buy a stock because we hope someone else will be willing to buy it from us at a higher price in the future; we buy a stock because we believe it will grow in value by producing ample cash surplus in the future. In other words, the stock will be worth more when we sell it because the underlying business has grown its book value. In contrast, a collector’s item such as a rare stamp, gold bar, or a rare coin doesn’t produce anything; we buy such items in hopes that someone else will be willing to pay more than what we paid for it in the future.

The stock price or market value of a stock is usually a multiple of the company’s book value. If the stock price is the below book value, it either means that the business is in big trouble and heading towards bankruptcy with investors bailing out of the stock, or the company is significantly undervalued and a great buying opportunity if it is a wonderful business. It is rare for a stock to trade below its book value; most of the time, stocks actually trade at a multiple of their book value.

The Growth Rate Number

To calculate the true value of a business, also known as its intrinsic value, we need to first determine the growth rate of the business for the next 10 years. Established businesses often follow a historical pattern of growth and looking at these historical growth rate numbers gives us an idea of the growth we can expect in the future. This is especially true if the business is wonderful, predictable and has a very strong competitive advantage. When you look up a stock on our site here, you can scroll down to find its historical growth rate numbers, also known as the Big 4 growth numbers.

The default number to use for the growth rate of the business is the 10-year equity growth rate (CAGR) number. This is the rate at which the business has grown its earnings and cash surplus for the last 10 years. This will be the most accurate growth rate number, particularly if the business has a very strong competitive advantage. On our website, this number is available on every stock page, and our stock valuation tool also automatically uses it for calculating the true value of a business. Here is an example calculation of Amazon’s valuation using the default values.

An alternative number to use is the analysts’ consensus five-year EPS growth estimate for the business, which provides a second opinion from professional analysts on whether the business has a promising future outlook. The analyst growth rate estimate is available on Zacks.com.

To play it safe, you can choose the smaller number between the 10-year equity growth rate and the analysts’ consensus growth rate estimate.

Next, use your knowledge of the business, its industry and its competition to decide if it’s reasonable for this business to grow at this rate for the next 10 years. We don’t have to be extremely accurate here; we just need to buy the stock at a low enough price that if the business doesn’t grow at the expected rate, we will still make money. And if we happen to be completely wrong about this business, we still won’t lose money since we bought it at a nice discount.

Future PE of the Stock

The current stock price is always a multiple of the company’s current earnings per share (EPS). A stock doesn’t sell at its current EPS, as this would be too cheap. For example, at a PE ratio of 1, if a business is earning $5 per share each year then it wouldn’t make sense to sell its stock for $5, since the owner can just hold on to the business and make $5 earnings that year. The owner would only sell the stock at some multiple of the EPS. This multiple is called the PE ratio. The higher the PE ratio, the higher the market predicts the business’s future prospects to be. Stock price is generally equal to EPS ⨉ PE, so if a business has an EPS of $5 and a PE of 10, then its stock price will be around $50. If the PE was 1000, then the stock price would be $5000 (this is extremely high, and it means the market is factoring a ton of growth into the stock price).

To calculate the true value of the business, we need an estimate of the stock’s future PE ratio in 10 years. Usually, a stock’s PE is approximately double its current EPS, though this number could be higher for some growth stocks and lower for others. If we don’t have any other numbers we use the double of the growth rate number that we calculated in the previous section as the future PE. This is the default value we use for Future PE in the valuation calculator on our site.

We can also look up the stock’s historical PE values to determine a reasonable future PE. The market views some companies as growth stocks and is willing to price them at higher PE ratios, while others are priced lower, sometimes because of the market sentiment surrounding their industry. We don’t need to be super accurate in estimating the Future PE; we just need a ballpark number. When analyzing multiple different numbers, the safest approach is to pick the most conservative numbers. To view the historical PE numbers of different companies, visit Wolfram Alpha.

Current EPS

Next, we need to find the current EPS (TTM) of the stock, specifically for the last 12 consecutive months. This value is available on every financial site, and we also fill it in by default in our valuation tool.

Calculate the Future EPS

To calculate the future EPS in 10 years, we simply grow the current EPS by the previously determined growth rate number of the business for 10 years.

The formula is:

current_eps ⨉ (1 + (growth_rate/100) ** 10)

You can also follow this formula: https://www.wikihow.com/Calculate-Growth-Rate#/Image:Calculate-Growth-Rate-Step-5-Version-4.jpg

Calculate the Future Stock Price

To calculate the future price of the stock in 10 years, we simply multiply the future EPS by the future PE.

This is the formula:

future_eps ⨉ future_pe

Calculate Current Fair Value or Sticker Price of the Stock Today

As value investors, we want to make a minimum of a 15% return on our investment per year, so we need to buy the stock at a low enough price to achieve this. To make a 15% return each year, the stock price will need to double four times in 10 years. We need to buy the stock at a price that can grow at this rate to make the future stock price. Using the rule of 72, we can simply divide the future stock price by 4 to get this number.

The formula is:

future_stock_price / 4

The number we get from this calculation is the fair value or sticker price of the stock today. This is the correct price to pay for the stock to make a 15% return per year or more.

Calculate the Margin-of-Safety Price

As value investors, we don’t just want to buy companies at their fair value or sticker price; we also want to buy them at a huge discount of 50% or more from their fair value. We buy them when they are undervalued to guarantee that we don’t lose money on our investment, even if we are wrong about the company’s future prospects. Of course, we only want to buy companies that we understand so we can sell them if we think their future prospects or underlying fundamentals have changed.

To calculate the margin of safety price, simply divide the fair value by 2. The formula is:

fair_value / 2

Buying a stock at a huge margin of safety price is how value investors are able to make phenomenal returns on their investments every year. We target a 15%, return but some value investors consistently see 25 -50% returns annually for many years. However, 15% is already a great return that we are more than happy with; anything higher is an added bonus. The reason we target 15% is so we don’t make irrational decisions to try to increase our returns.

We Already Do This for You

You don’t have to calculate the true value of a stock by hand, because our website already does it for you automatically. When you look up a company on our site, you can determine its fair value and margin-of-safety price using our valuation tool.

When to Buy a Stock

As value investors, we look for wonderful businesses that we understand, and ideally that we also love. We then add them to our watchlist and patiently wait for them to go on sale. When the stock price falls down to our margin-of-safety price or below, we start buying. If the price drops even further, we buy more. We want to own as much of this wonderful business as possible, and a lower stock price allows us to buy more shares.

All businesses go on sale from time to time due to events that don’t affect the fundamentals of the business. An example of this is during the 2020 coronavirus pandemic, when the Fed dropped interest rates to near 0, causing a huge sell-off of financial stocks. The market decided that financial stocks would do poorly because interest rates were too low, so some financial stocks with great fundamentals started trading below their book value. A few months later, as the economy started improving a bit, the market feared that there could be inflation due to all the stimulus and quantitative easing by the government and the Fed, so the market started pricing in anticipation of the Fed raising interest rates to respond to rising inflation. This caused the same financial stocks that were trading below book value a few months earlier to suddenly skyrocket to all-time high prices.

The market misprices stocks all the time. This is why value investors are able to make such high returns in a safe and predictable way.

If the market was a person, it would be someone who is unstable and unable to make concrete decisions, someone who changes their mind on important matters every few weeks, or even every few seconds. Value investors call this fictional person Mr(s) Market, a manic-depressive individual.

The reason why stocks swing up and down so randomly is because Mr(s) Market controls all the prices. We never try to guess what Mr(s) Market will do next, and we never try to time the market. We just wait patiently for Mr(s) Market to start pricing the wonderful business on our watchlist at or below our margin-of-safety price. When this happens, we go in and buy as much as possible.

How to Discover Wonderful Businesses

We are building an auto-discovery feature into our website for discovering wonderful businesses that could make a great investment. Remember, there are many wonderful businesses out there; the key thing is finding the ones you understand (and ideally love) and waiting for the right time to buy them on sale at a good margin-of-safety price.

We also recommend checking out existing tools like Phil Town’s Rule One Toolbox, and GuruFocus. Make sure to also check back on our site, as we are launching more features soon!

Additional Reading and Resources

For more comprehensive reading on value investing, I recommend the following books:

• Rule One Investing by Phil Town
• Payback Time by Phil Town
• The Education of a Value Investor by Guy Spier
• Check out Warren Buffet and Charlie Munger’s annual Berkshire Hathaway meeting sessions on YouTube
• Check out Phil Town’s YouTube channel