| Level 1
Templates Let's do an analysis on Johnson
& Johnson, the health care product company. After having
done some research on the company (its products, competitors,
and so on), you are ready to crunch some numbers. This is
where the Valuesoft Investment System comes in. We will look
at three different templates each using a single function
from Valuesoft:
- Stock Return using STRETD
- Stability using STAEGR
- Intrinsic Value using DCF2S
(For an example of an Australian company,
click here. For Level 2 templates, click here.)
1. Stock Return using STRETD
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Suppose you are interested in estimating
the percentage return on buying JNJ now and holding
it for 5 years. You will need some data which
you can get get free from most of the major investment
sites such as
Money Central or Yahoo
Finance. When you use these sites, you may have
to go to different pages to collect all the information
that you need.
For Yahoo Finance all the data we
need is on the Summary page and the Analyst Estimates
page for each company. The URL for these pages for
Johnson and Johnson are: |
You might find it easiest to print these pages
before you start. The following is the list of the required
data and the page where you can find it. (More details of
these terms can be found in our glossary: click
here. For the financial glossary at Yahoo, click
here.)
Current price:
this is the last price at which the stock was sold (Profile
page)
Earnings per share trailing
12 months (EPSttm): the total earnings of the company
over the previous 12 months (four quarters) divided by the
number of shares outstanding (profile page). Think of this
as the amount of money that the company is earning on your
behalf for each share that you own (Profile page).
Projected price to earnings
ratio (P/E ratio): as an estimate of the future P/E
ratio we will use the current P/E ratio which is the current
price divided by the EPSttm(Profile page).
Projected growth rate of earnings:
this is a forecast of the average growth rate of earnings.
Use the figure in the column "Next 5 Years" on
the Analysts Estimates page even though you may have a longer
time frame in mind. If you are not given a figure (perhaps
because no analysts are following the company), enter the
average percentage growth rate for the past 5 years. If
this is also missing, then beware of investing in this company.
With less than five years of data, it is very difficult
to make any forecasts. (In the Level
2 Templates you will see how to avoid having to rely
on analyst forecasts.) In the example of JNJ, I am just
going to use the historical growth rate of earnings instead
of relying on analyst forecasts.
Years: the time frame
of your investment. Generally this will be 5 years or more.
Payout rate: this is
the percentage of earnings that the company pays out in
dividends. You can get this figure at the Key Statistics
page, under the 'Dividends & Splits' table. You can
also calculate it by dividing Dividend by Earnings per Share.
For things like the P/E ratio and the projected
growth rate, don't worry too much about decimal places. It
is likely that you will change them to more conservative figures
when you have everything all set up. As first estimates just
start with historical levels.
The last two requirements are:
Tax rate on
dividends: this is your marginal rate of tax.
Tax rate on capital gains:
for simplicity I will set these at 0% in the following examples.
Now enter this data into an Excel page to get
something like shown in the following figure:
I have formatted some of the cells as percentages.
Otherwise you can leave them as decimals.
In the cell I3 type =STRETD(A4,B4,C4,D4,E4,F4,G4,H4)
and press return. (You don't need to use uppercase letters.
And if you are more familiar with Excel, you can get the same
result by using the function button and going to the function
STRETD, which stands for STock RETurn with Dividends reinvested.)
When you have done this you will get:
In this case I have formatted the cell I3 as
a percentage. If you did not do this you would get a decimal
number. In this case I have put the cursor back into cell
I3. Notice that =STRETD(A4,B4,C4,D4,E4,F4,G4,H4) has appeared
in a box at the top of the page.
The number in the cell I3 is an estimate of
the before-tax annual return by purchasing JNJ at the current
price and holding it for 5 years.
The huge advantage of Valuesoft is that you
can put in your own estimates of the growth rate and P/E ratio
so that you can see exactly the effect on the final result.
We will demonstrate this below.
Of course, the above only works when you have
purchased and loaded Valuesoft. Without Valuesoft, you will
get the result #NAME?
Margin of Safety
Remember, none of the inputs can be totally accurate.
It is up to you to adjust them to allow for a margin of safety
and other outcomes of your investigations. (In the Level
2 Templates we show how Valuesoft has built-in functions
for calculating a level of safety as a staring point for your
own margin of safety.)
In the 1999 annual report of Berkshire Hathaway,
Warren Buffett said that he employs "a range of values,
rather than some pseudo-precise figure." With Valuesoft
this is a snap since each time you enter a new number and
press return, the answer is automatically recalculated.
For this simple case, we will just make an
estimate of a reasonable margin of safety for the P/E ratio
and the projected growth rate. The data and results are shown
in the next figure.
This time the estimated after-tax return in
Cell I1 is much lower. What this means is that under a margin
of safety you will make at least this rate per year over the
next 5 years. At the same time it leaves the upside open so
that the final return could be much higher.
With more experience, you can do the above in
a few minutes. Once you have set it up for a company, it is
a simple matter to update that data as new information becomes
available. We are looking for companies that give us a reasonable
rate of return with a high level of confidence. Then, in practice,
the actual return is frequently much higher.
STRETD is only one of the 30 functions in Valuesoft.
One of my other favorite functions is TARGD. This calculates
the price that you would need to pay to achieve your desired
return. When you do this, you set yourself up to wait until
there is a dip in the price. At that moment you can buy the
stock you want at your price to get your
return.
2. Stability using
STAEGR
The importance of focusing on companies with
high stability in the growth of earnings and sales is described
in Chapter 13 of The Conscious Investor. This is
done via a proprietary function called STAEGR. (It is pronounced
stay-ger and comes from the expression "stability of
earnings growth.")
 Staegr
measures the stability or consistency of the growth of historical
earnings per share from year to year, expressed as a percentage
in the range 0 to 100 percent. When applied to data over any
number of years, high STAEGR corresponds to high stability
and low STAEGR corresponds to low stability. STAEGR of 100
percent signifies complete stability, meaning that the data
is changing by exactly the same percentage each year.12 The
function has the feature of adjusting for data that could
overly distort the result, such as one-off extreme data points,
negative data, and data near zero. It also puts more emphasis
on recent data.
The important result for us is that large-scale
studies in the USA and Australia show that stocks with a high
level of STAEGR are likely to have earnings that continue
to grow in the future at the same rate as they grew in the
past.
We particularly look for stocks that have STAEGRs
of 80 percent or more for both their earnings and their sales.
If a company does not satisfy this criterion, I usually just
pass it by. After all, if there was little stability in sales
and earnings in the past, then it becomes virtually impossible
to make confident forecasts for the future.
The previous image shows how it can be used.
The entry in cell C13 is calculated as "=STAEGR(C8:C12)"
and calculates the stability of earnings per share over the
5 years.
Similarly the entry in cell C14 is calculated
as "=STAEGR(C8:C12)" and calculates the stability
of earnings per share over the 10 years.
3. Intrinsic Value using DCF2S
Calculating intrinsic value is a basic method
used by many analysts. Usually it is based on the assumption
that free cash flow will grow at a constant rate over a specified
period (called the initial growth period) followed by a second
constant rate over the remaining life of the business (called
the terminal growth rate). These cash flows are then discounted
back to present time. The sum of these discounted values is
called intrinsic value and the method is called the discounted
cash flow (or DCF) method. This method is discussed in detail
in Chapter 7 of The Conscious Investor along with its strengths
and weaknesses. The most serious weaknesses are based on the
fact that the method requires forecasts to be made over infinite
periods.
In Valuesoft the function DCF2S is a function
that calculates intrinsic value using a two-stage approach.
The following table is a simple example. The data is placed
in cells A21 to E2. Cell F2 contains the entry "=DCF2S"
and calculates the intrinsic value. Instead of free cash flow
in cell A2, dividends, or any other financial measure can
be used.
According to these calculations,
the company is undervalued.
Note: Earlier versions of Valuesoft
contained the function PRESVAL which combined a two-stage
discount formula and a version of a three-stage discount formula.
This has now been replaced by DCF2S for two-stage discounted
cash flow calculations and DCF3S for three-stage discounted
cash flow calculations.
Level
2 Templates Click here
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