Investing 201: Value Investing Framework
This is the fourth post in a series of posts I am going to write about investing. Each post will make most sense if you have read the ones before in sequence.
Part 2: Conventional Investing
Part 3: Investment Strategies and Hedging Tools
Value investing is hard. It requires time to do the research and analysis to form a more objective opinion on whether a stock is undervalued. In a frothy market, it becomes increasingly hard to find value stocks, since most stocks will come across as overvalued — at least when seen from traditional value investing standards. Nonetheless, I want to go over a specific stock (I picked Valero Energy Corporation) to walk you through how I might go about evaluating a stock. Note this is still a high level analysis, but should get you familiar with certain fundamental concepts and a basic framework.
Intrinsic value of a stock is nothing but future cash flows discounted by the cost of capital. For simplicity sake, we will take ten years as the time frame and use 10-year federal note’s interest rate as the discount rate¹. We could theoretically go beyond ten years but the additional value gets smaller as you go farther into the future.
One way to estimate the future cash flows is by adding up the future book value of the company to dividend payouts (both, ten years from now). Book value of a company is what you will essentially get if the company shuts down today: Company assets minus its liabilities.
Note that a company can decide not to give any dividends and reinvest all its earnings (if it has any) into future growth of the company. This is especially true for early stage companies and more generally for growth stocks. There are a few exceptions, of course — for example, Microsoft and Apple both issue dividends to its shareholders, and continue to show amazing growth rates on almost all important metrics, including their stock values. Value stocks typically preclude ones that do not offer dividends — these dividends can come in handy as you try to buy other undervalued stocks or if you just want to have some passive income.
Back to estimating the future cash flows. In a simple equation, it’d look like:
Future Cash Flows = Dividend Payments + Book Value in Ten years
In order to calculate the book value, let’s look at historical book value growth. Fortunately, you can find a lot of relevant data on the internet.
The average book value growth for the last eight ears (that we have data for) is roughly 7%. If you project the same average over the next 10 years, the Book Value in Ten years is $101. The average yearly dividend over the last ten years is $1.67. Now you have got all the numbers you need to plug in a formula to give you the intrinsic value of a share. Put in the values as shown in the picture below, and voila you have the number you need: $106. What this means is that value of the stock today should be $106 (while it is trading at around $65 as we speak). On the surface, it looks like it is an undervalued stock, and you should buy it. But there are several other factors you should look at before making the final decision: Let’s go through a few important ones, one by one.
From one of my earlier blogs, a few metrics to look for are as follows (also refer to Figure 3 below).
Look for stocks that issue dividends — ideally 3% or greater. With depressed stock price, we are comfortably above 3%.
Look for companies that have a Debt/Equity ratio below 0.50. We are below 0.5 all the way through 2019, but trended upwards in 2020.
Current ratio should be above 1.0. Current ratio, which essentially is short term liabilities divided by short term assets, is higher than 1.0.
P/BV should be less than 1.5. As we speak, the P/BV is 1.41.
P/E should be less than 15. Valero did not earn profits in the trailing 12 months, so this figure is actually undefined.
Look for ROE > 5%. Return on Equity is well above 5% for the last several years.
In addition to the above metrics, you can spot a trend looking at Figure 3 — which is an obvious one, that while the company has been growing quite steadily over the last ten years and has performed quite well on the metrics, the last 12 months have been trending downwards. This is primarily due to low demand in Covid times.
We started with projecting book value growth based on historical patterns — which is in fact just one of the inputs to your model. You may want to do a sensitivity analysis there — take worst-case, base-case, and best-case scenarios. The other inputs to the model are more qualitative²: For example how soon the economy will recover, what the general trend towards renewable energies vs oil is, and how oil prices are going to behave in the next few months and years.
Setting macro factors aside, Valero seems to have shown strong growth in the years leading up to pandemic, has a comfortable cash cushion, and is in a strong competitive position. I believe as the economy starts to normalize, Valero will be in the right position to take the most advantage.
A sneak peak into what’s coming next in the series.
Part 5: Alternative investments. This is a huge universe, and each of the asset classes can warrant a post — but we will touch upon a few important asset classes and themes.
Part 6: Real-estate. Some classify it in conventional and others in alternate investing. It is big and important enough of an asset class to warrant a separate post. While I arguably know the least about real-estate (compared with most other popular asset classes), I hope to talk about a few interesting aspects.
Part 7: Private equity. This one is perhaps closest to home. I will discuss angel investing, venture capital (note though that in all my posts I am wearing hat of an individual rather than an institutional investor), and pre IPOs — but not the traditional private equity (which largely entails a PE firm taking a public company private — doing financial engineering, reorganization, and other fine tuning, and selling it off at huge gains).
I will conclude by summing up, but also shed light on overall portfolio management.
¹ When you make an investment, you have to make sure that its expected returns are higher than that of a federal note, which is considered virtually risk-free.
² Value stocks are not risk immune of course. The biggest unknown in any stock’s future is its projected earnings. They are just projected earnings after all. The whole market may behave differently, the industry may not grow as expected, a pandemic could happen (which gave a huge boost especially to technology stocks, as we saw), or the company may fail to deliver. At the end of the day you have to make some judgment calls, there is no way around that.
