A reader sent me this email:
I have an investment idea at the moment, but am very new to actually valuing businesses so it may take some time to learn how to do it properly.
The basic approach to valuing a business is very simple.
Try to start without looking at the stock price. Instead value the entire business. You want to start by using some written in stone valuation ratios without letting concerns about quality, future prospects, etc. cloud your initial judgment. That comes later.
When appraising a business, you want to use the real estate appraisal principle known as "highest and best use".
You can easily rank a non-financial company's possible uses from lowest to highest:
- Liquidation Value
- Net Current Asset Value
- Tangible Book Value
- Earning Power Value
In almost all cases, liquidation value is not the highest use for a business, because even very bad businesses are usually worth more than they can be immediately liquidated for. So normally you skip a liquidation analysis completely and go straight to analyzing the net current asset value, tangible book value, and earning power value.
A business is almost always worth its net current asset value (Net Current Asset Value = Current Assets - Total Liabilities). A business is worth its tangible book value if it earns a return on capital equal to or greater than the future return expected in the stock market. So, if you think the stock market will return 7% a year from now on, any business that earns an 11% pre-tax return on invested tangible capital should be worth its tangible book value or higher since 11% pre-tax is greater than 7% after-tax (assuming a 35% tax rate). Businesses that can't earn 10%+ on capital may actually not be worth tangible book value. It depends.
The highest and best use for many stocks is #4: Earning Power. Two good rules of thumb here are that a business is normally worth about 10 times EBIT (Earnings Before Interest and Taxes) and 15 times free cash flow. These are just round numbers. It's not an exact science. I use 10-year average real EBIT and free cash flow. Don't worry about adjusting for inflation right now. But always make sure you use long-term averages for EBIT and free cash flow (unless we're talking about super fast growers – which I’m a total dunce at valuing anyway).
I like to use enterprise value instead of market cap to value a stock both in terms of EBIT and free cash flow.
Also, unlike a lot of folks, I always split cash and debt off from the operating business. Cash and debt are just the financial scaffolding around the business. They’re not inherent to the business itself. And they're not permanent. Just a choice made by the current owner. So, I value cash at 100% and separate it from the invested tangible book value.
That means I appraise a stock’s earning power value as being worth (Cash - Debt) + (10 * EBIT) or (Cash - Debt) + (15 * Free Cash Flow).
Of course, valuing a business and picking a stock are two different things. Even though I say a business is worth 10 times EBIT and 15 times free cash flow, I don't like to pay more than 8 times EBIT or 10 times free cash flow. Usually, a lot less. That's my margin of safety.
Whenever you see a stock, start by ignoring the stock price and just try to value the business. Only look at the stock price after you've calculated your appraised value. This is just psychology 101.
Here's my advice for how to really learn to value a stock. Start with a stock that's pretty easy to value and completely unknown to you. Don't look at the stock price! Just try to value the whole company.
Ideally, you should be able to black out the company name, business description, and stock price on a Value Line page and still be able to come up with an approximate appraised value for the business within 10 minutes.
Ben Graham could.