The MoneyGeek Method of Valuing Stocks

Last update on Jan. 30, 2017.

Image Credit: Sira Anamwong / Shutterstock.com

 

How much is a stock really worth? The question had haunted me since I became passionate about investing many years ago.

Most of the successful investors I admired seemed to follow the value investing strategy. These investors made a distinction between ‘value’, which they deemed to be the true worth of a stock, and ‘price’, which is what they could pay to buy it in the stock market. As the saying goes, price is what you pay, and value is what you get.

Value investors attempted to assess the value of each stock, and only bought those whose prices were significantly below their values. In other words, these investors tried to buy a dollar for fifty cents.

Value investing doesn’t resonate with everyone, but it resonated with me. I wanted to learn how to value a stock, so I tried to read many prominent books on the subject. However, I ran into some problems.

The books I read offered different methods on how to value stocks and the value derived from these methods often disagreed with each other by wide margins. Not only did this conflict with my belief that each stock has just one true value, but it presented a practical difficulty as well. What if a stock looked undervalued according to one method, but not the other? Should I trust one method over another? Or should I only buy a stock when it looked undervalued according to every method?

Perhaps more importantly, I couldn’t make any sense as to why a company’s valuation should matter. So what if I bought a company that was undervalued? Was there any guarantee that the stock price would catch up to the company’s true value?

It took me years, but I finally think I have the answers. The big breakthrough came a few years ago, when I read an anecdote about how Warren Buffett valued companies. Warren Buffett, if you don’t know, is often considered the greatest investor of all time. When I reflected on his method for valuing stocks, I finally began to understand how companies should be valued, and why such valuation mattered.

In this article, I will outline my own method (which I’ll call the MoneyGeek method) for valuing stocks, which is heavily inspired by the way that Buffett analyzed some companies.

 

Liquidation Value

The MoneyGeek method rests on three main pillars: liquidation value, future earnings and the time value of money. Let me explain each of these pillars in turn.

Liquidation value refers to the amount of money shareholders (i.e. those who own stock) would receive if the company ceased operations today, sold all its assets, and distributed the money to shareholders.

We can generally get a good sense of a company’s liquidation value by examining a company’s financial statements. Such statements show the financial conditions of a company, and every public company must publish these statements regularly. Most Canadian and U.S. stocks publish the statements every quarter (i.e. 3 months), but some very small companies publish them every six months.

There are three different types of financial statements: balance sheet, income statement and the statement of cash flows. The balance sheet shows what each company owns (i.e. assets) and owes (i.e. liabilities). The income statement shows how much money the company has made and spent in recent months, and the cash flow statement shows the company’s cash transactions during the same period. Of these types of financial statements, the balance sheet generally serves as a great starting point for evaluating a company’s liquidation value.

Since the balance sheet lists all the company’s assets and liabilities, you might be tempted to estimate the liquidation value of a stock as simply its assets minus its liabilities. This residual value of a company’s assets is reported as “Shareholder’s equity”, and is also called “book value”. Unfortunately, the value of assets and liabilities are measured using accounting convention, and so book value may have little relation to liquidation value.

One common example of this is the treatment of inventories. Inventories refer to raw materials and finished products that a company owns, but hasn’t sold yet. For car manufacturers, inventories will consist of car parts and assembled cars not yet shipped to dealers. For clothing retailers, it will consist of clothes stacked on store shelves.

Accounting rules state that companies must value inventories at either A) the cost to produce the inventory, or B) the at price at which they think they can sell the inventory, whichever price is lower. Usually, unless the company is expected to go bankrupt, it will price its inventory using method A.

However, if a company decides to liquidate its inventories, it will often get less money for its inventories than it cost the company to produce them. Think about the time you walked by a store that was offering a liquidation sale. Those stores usually have to mark everything down by huge margins in order to clear out their inventory. When they offer such huge discounts, they are often selling them below cost.

If we want to properly estimate a company’s liquidation value, we would therefore have to adjust the value of assets and liabilities shown on the balance sheet. Let me show you how this works using lululemon athletica’s financial statements.

As of Oct 30, 2016

As Reported ($millions)

Liquidation Value ($millions)

Inventories

365

240

Other assets

1,114

1,114

Total assets

1,479

1,354

Total liabilities

274

274

Book value/Liquidation value

1,204

1,080

The table above shows a very simplified version of lululemon’s balance sheet. As of Oct 30, 2016, lululemon had $1,479 million in assets and $274 million in liabilities, giving it a book value of roughly $1,479 - $274 = $1,204 million.

Of its assets, about $365 million consisted of inventories. If we estimate that lululemon’s inventories will fetch $240 million in a liquidation, then its total asset value would go down to $1,354 million. Then, if we don’t adjust any other items on the balance sheet, we would arrive at a liquidation value of $1,354 - $274 = $1,080 million.

Of course, in reality, we would adjust more items besides inventories to arrive at the proper liquidation value for lululemon. I won’t go into these other adjustments because that’s beyond the scope of this article. Rather, I hope that this example clarifies what I mean by ‘liquidation value’, and how I would calculate for them.

 

Future Earnings

The second pillar of my valuation method involves estimating a company’s future earnings (i.e. profit). In particular, let me define what I mean by ‘earnings’.

Conceptually, earnings is the amount by which a company’s value has risen over a period of time. For example, if a home builder pays $200,000 to build a house and sells it for $300,000, the company’s cash balance goes up by $100,000. Since the asset value of the company has increased by $100,000 with no corresponding increase in liabilities, it’s said to have earned $100,000.

Earnings don’t necessarily have to involve cash transactions. If a company buys $1 million worth of gold bullions and if the price of those bullions goes up by $0.5 million, then we say that it earned $0.5 million.

Following this logic, I define ‘earnings’ to mean the increase in a company’s liquidation value. For example, I would say that a company earned $3 million if its liquidation value went up by $3 million.

My definition of earnings often differs from officially reported earnings, generally found in a company’s income statement under the item ‘Net income’. This is because reported earnings show the increase in the company’s book value, rather than the company’s liquidation value.

In order to calculate my definition of earnings, I generally use a company’s income statement as a starting point, and then make adjustments to it. Let me use the previous example from lululemon to show how this works.

In the lululemon example, I estimated the value of lululemon’s inventories to be somewhat lower than their reported amount. This same assumption will cause us to adjust the value of lululemon’s earnings as the following shows.

Net income

266

Increase in inventories

83

Net income excluding effect of inventories

183

Liquidation value of new inventories

55

Adjusted earnings

238

The table above shows some numbers from lululemon’s 2015 financial statements. All numbers are in millions. As you can see, the company reported $266 million in earnings for the year,  but the company reached this number in part because the reported value of its inventories went up by $83 million. If we exclude the effect of the change in inventories, net income would become 266 - 83 = $183 million.

Now, let’s assume that this extra inventory does have liquidation value estimated at $55 million. If so, we can add this liquidation value to the $183 million number to get an adjusted earnings of $238 million. This adjusted earnings more accurately reflects the change in the company’s liquidation value.

If we wanted to get a full picture of lululemon’s adjusted earnings, we would need to adjust more entries other than inventories. I won’t show such adjustments here because, again, that’s beyond the scope of this article. Rather, I hope that my explanation makes clear what I mean by ‘earnings’.

 

Time Value of Money

The last pillar of my valuation method is the time value of money. Let me explain this by using a related concept called ‘opportunity cost’.

Let’s suppose that a friend came to you and asked to borrow $1,000. The friend promised to pay back the money in a year, and since he’s your friend, you agreed not to charge any interest on that money. A year later, the friend pays you back as promised. So here’s the question: Did you lose any money by doing this? The answer is yes.

If you hadn’t lent out the $1,000, you would have been able to invest that money. Let’s suppose you’re confident that you would have generated a 5% return on investments. Then, if you hadn’t lent out the $1,000, you would have turned it into $1,050 in a year. However, since you only got $1,000 back from your friend, you missed out on $50 worth of gains. This $50 is the opportunity cost of money. As an aside, the rate of return used (5% in this case) is called the ‘Discount rate’.

When we analyze the value of a company, we account for opportunity cost in two areas - the company’s liquidation value and its future earnings. Let’s talk about each of these areas.

Let’s say that a company whose stock we own has a liquidation value of $20 per share. Note that to calculate the per share value, we simply divide the company’s total liquidation value by the number of existing shares. While we then technically “own” $20 per share, we don’t have access to that money. In other words, we can’t just ring up a company and demand to receive $20 for each share.

This fact that we can’t access the money creates opportunity costs. If we think we can generate a 5% per year rate of return on investments elsewhere (i.e. 5% discount rate), we are forfeiting gains of $1 per share (i.e. 5% of $20) each year. Our valuation model needs to reflect this cost.

The other area in which we apply opportunity cost is on future earnings. Let’s say that the company whose shares we own is set to earn $200 million next year. Now, if the company didn’t have to wait a year to receive this money and could receive it today instead, it would then be able to invest this money to generate more profit in the future. For example, if it received $200 million in profits today, it may be able to reinvest that money so that the profit next year goes up to $220 million.

To compensate for having to wait, we ‘discount’ future earnings. For example, we say that $200 million in profits a year from now is worth $182 million today when discounted at 10% per year. We would make this assumption if we’re confident that the company can turn $182 million today into $200 million next year.

In summary, because of opportunity cost, we say that money due to arrive in the future is worth less than money in the bank today. This is what I mean by the ‘time value of money’, which forms the third and last pillar of my valuation methodology.

 

Completing The Picture

Now that I’ve explained all three pillars, let me now show how every pillar ties in together to yield a company’s value.

Suppose there’s a company today that has a liquidation value of $300 million. Let’s say that we expect this company to generate $30 million of earnings in year 1, $35 million in year 2, and $40 million in year 3. At the end of year 3, let’s say that the company chooses to sell everything it owns, and return the money to shareholders. The following table shows how we can value such a company.

($millions)

Today

Year 1

Year 2

Year 3

Earnings

 

30

35

40

Liquidation value

300

330

365

405

Opportunity cost of liquidation value

 

30

33

36.5

Residual income

 

0

2

3.5

Discounted residual income

 

0

1.7

2.6

Value of company

304.3

     

Note: I applied a discount rate of 10% per year.

Let me explain the table. I hope that by now, you understand the concepts behind ‘Earnings’ and ‘Liquidation value’.

The ‘Opportunity cost of liquidation value’ represents the loss of investment gains arising from the lack of access to money tied up in the company.

‘Residual income’ is earnings minus the opportunity cost - in other words, it’s how much value the company added by not deciding to liquidate its assets in each of the years.

‘Discounted residual income’ is today’s value of future residual income, after taking the time value of money into account through discounting.

Finally, we calculate the value of the company by adding up the liquidation value and the discounted residual incomes of each year.

Now, let’s examine why this valuation makes sense. You’ll probably agree with me that the company’s value should equal its liquidation value if the company decided to liquidate today.

But what if it waited a year? Then, we should account for the earnings that the company generates, but we should also factor in the loss of investment gains we could get from other opportunities.  We should also penalize the company for our having to wait for our money. If the company decides to delay the liquidation event further, we should keep applying this reasoning until such time that the company actually does liquidate.

We can confirm that this valuation method makes sense because it matches the cash flow that shareholders will eventually see. In the example shown in the table, shareholders of the company will receive no money until year 3, when they’ll receive $405 million. If we take the time value of money into account, $405 million in year 3 translates to $304.3 million today, which is the value of the company we arrive at with the MoneyGeek method.

Now, forecasting a company’s earnings each year is tough and tedious. To get around this, I normally use a shortcut. Instead of predicting earnings each year, I usually select a baseline residual earnings for a company (what I think they’ll earn next year), and assume that the residual income grows at a constant rate forever. If we make this simplifying assumption, we can reduce the value of a company down to the following formula.

Value of a company = Liquidation value + (Residual income next year)/(Discount rate - Growth rate of residual income)

For example, if a company had a liquidation value of $500 million, next year’s residual income of $50 million, a growth rate of that residual income of 5% per year and a discount rate of 10% per year, we would then arrive at a value of 500 + 50/(0.1-0.05) = $1.5 billion. Since I chose a discount rate of 10% per year, this means that shareholders of this company should receive a rate of return of 10% on their company’s stock when the whole company is valued at $1.5 billion.

So there you have it. I hope that you now understand the MoneyGeek method of valuing a stock. I tried to make this article as simple as possible, but I’m sure some of you will have questions. If you do, please ask away in the Q&A forum.

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