Junk or Treasure?
The TV series Antiques Roadshow is exciting to watch. People from around the country bring in dirty, dusty old relics to be appraised by antiques experts. My whole family tunes in, anxiously trying to guess the prices of the items being showcased. The one thing that amazes me is how much some of that “junk” goes for—a pink porcelain pig fetching five big ones, a musty old carpet full of mites appraised at twenty g’s, and a seemingly pointless faded photo estimated in the thousands. An item that is seemingly worthless may be identified as in fact having great potential value.
Some of the most successful investors of all time have one thing in common: They know a good value when they see it. Graham, Dodd, Buffett, Munger, Templeton, Greenblatt, Lampert, and other legendary value gurus perfected the art and science of finding undervalued stocks with future growth potential.
The last twelve months on Wall Street have been a bumpy ride: up, down, up, down. If a company’s share price soars is it worth that price? If a stock tanks should the price be that low? For example take a look at one of our favorite companies from our Dueling Duo Portfolios Bed, Bath, & beyond (NASDAQ: BBBY). The stock has been as low as $48 and as high as $75 over the past 12 months (as of 6-19-12). What is the company really worth?
It’s all about Price!
With stock investing, it’s all about price. When the markets were falling, think investors like Warren Buffett are buying or selling? He has made quite the successful career buying stocks and waiting for a turnaround to begin. John Templeton, a legendary investor also became famous for buying up stocks when they are beaten down. He was buying in the wake of the horrendous stock market crash of 1929.
As I’ve said before, “Wall Street knows the price of everything and the value of nothing.” During a sharp downturn, countless high-quality companies are often unjustly trashed, and trade at extremely low valuations. A keen investor who knows the difference between just another piece of “junk” and a “priceless antique” can make out like a king.
The big question then is, what is the stock I am interested in worth? Is it really a value or a value-trap? Is it a precious antique or piece of junk? Using simple valuation metrics like: price-to- earnings (P/E), price-to-book (P/B), and price- to-cash-flow ratios can be helpful for getting a quick read on a company’s attractiveness. Realistically, though, these measures give you only a glance at a specific point in time (e.g., trailing twelve months or most recent quarter), and cannot tell you what the future holds.
One quarterly miss and in an instant, a once low P/E stock can become a high P/E stock. Another common problem is that a low P/E stock may be low compared to their competitors but high compared to the overall market, and if the sec- tor loses favor so can the stock, regardless of its P/E. Many stocks within the retail sector are currently falling prey to this effect. Sometimes cheap is cheap for a reason!
Most seasoned analysts dig deeper into a firm’s true value by looking at free-cash flows (FCF) and more rigorous measures like discounted cash flows (DCF). FCF is simply the amount of cash flowing through a company during a quarter or year after all cash expenses have been paid. FCF is important because it represents the actual amount of cash left over, which can be used to increase shareholder value by re- purchasing shares, paying dividends, developing new products, etc. Increasing FCF is highly attractive, especially if the company’s future growth still looks promising.
The DCF model is used to predict the value of a company today by looking at the sum of its future cash flows and then discounting back to he present. While DCF valuations are extremely helpful, accurate calculations require analysts to predict future sales growth, profit margins, FCF, discount rates and risks, interest rates, and other key elements. In these models if you inaccurately estimate any of these variables, your DCF valuation for the company will be off.
We routinely employ FCF forecasts, DCF calculations, and various other statistical measures at Faith-Based Investor to gauge the value of the companies we recommend. By gaining a better understanding of a company’s current value and what its future holds you can often get a pretty clear picture on whether a company’s share price is over or undervalued. If it’s overvalued, are you willing to pay the price? Over pay and it may take a long time to make money. That it is why it is so important to buy companies at a discount as you have much better odds of making a profit.
Warren Buffett is highly successful, not only because he finds highly valuable companies, but, in my opinion, probably more so because he has a knack for successfully predicting a company’s future growth potential. A key to finding tomorrow’s treasures is your ability to successfully predict a company’s future today. If a company’s future looks bright, more often than not, so will its stock price in the future! Knowing the future value can be priceless!
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