Before We Start
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A quick method you can use to find potential opportunities quickly is the Owner Earnings Valuation method. It takes about 5 minutes. You should still do the NAV/EVP after.
Tip:
Before you do this valuation, do not look at the market cap of the company you are valuing. Warren Buffett always did his valuations first, then looked at the stock price after, so as not to be influenced by it.
The Formula Is:
Free Cash Flows / Discount Rate
Note: This formula doesn’t forecast in any future growth. We only look at the cashflows as if they are to continue at a constant rate into the future at today’s value.
How To Find Free Cashflows: Cash Generated By Operations minus (-) Capital Expenditures (Take them both from the most recent year)
Definitions
Cash Generated By Operations = Operating Cashflow
Capital Expenditures = PPE (Property, Plant And Equipment)
Free Cashflows = Operating Cashflows (-) PPE
Where To Get The Data
- Go to https://finance.yahoo.com and find the company you’re looking at
2. Click “Financials” -> Then click “Cashflow”
Operating Cash Flow is one input used, which is $80,008,000
Net PPE Purchase And Sale is the other input used, which is -$8,302,000
Recall earlier that Free Cashflows = Operating Cashflows (-) PPE
So, Free Cashflows = 80.0B — 8.3B = 71.7B
We now have part 1 of the formula completed.
Discount Rates
To complete part 2 of the formula, we need a discount rate.
Use a range of discount rates:
Rate 1:
The 10 year government bond rate (today it is so low, you won’t get a realistic valuation) — Currently it is 1.7% (round it up to 2%).
Rate 2:
6% (or use the WACC)
Rate 3:
10%
Once you have the discount rates, apply the formula to all 3 discount rates:
2% Discount Rate: 71.7 / .02 = $3.6T
6% Discount Rate: 71.7 / .06 = $1.2T
10% Discount Rate: 71.7 / .1 = $717B
WACC (8.5%): 71.7 / .085 = $843B
Note: I googled the WACC. I wouldn’t normally, but to save time, I found 3 calculated WACC’s online for Apple and took the average.
Is The Stock Overpriced Or Is It A Bargain, Worth Buying?
Rate 1:
If it is trading at this rate, with today’s current interest rates, it is likely overvalued. If you buy Apple at a 2% discount rate, for $3.6T, it’s the same thing as saying you are okay with a 2% return on your money.
Rate 2:
If it is trading at this rate (near the WACC), it is likely trading near fair value). If you buy Apple at a 6% discount rate, for $1.2T, this is the same thing as saying you are okay with a 6% return on your money.
Rate 3:
If it is trading at this rate (10%), the company could be undervalued and it is worth doing a deep dive.
Note:
Of course, the rates at which the stock is expensive or a bargain can also be affected by interest rates, however Joel Greenblatt stated that you should use 5 or 6% as the absolute lowest interest rate to buy, as in the long term, that is what the average interest rate will be. This is the same as saying, do not pay for stocks at 2% interest rates or you are likely to lose money.
Summary For Apple
We found that Operating Cash Flows is 80B and Net PP is -8.3B. Therefore Free Cashflows were 71.7B.
When we divided the 71.7B by 6%, we got $1.2T.
When we divided 71.7B by 8.5%, we got $843B.
So we know fair value range for Apple is $843B to $1.2T.
If we pay more than $1.2T, we are likely overpaying.
If we pay less than $834B, it is worth doing a NAV/EPV.
What Would Warren Buffett Do?
When you read his annual letters, especially from the early partnership years, it’s clear that Buffett had high standards. He would look at the return from buying the company at it’s current market price and ask “is that the best I can do?”.
He compares the investment with every other opportunity in the universe. He is looking for the highest return, with the greatest margin of safety, that is also in a durable, competitive advantage, with lots of history, at a very low price (high implied rate of return) with the opportunity for internal compounding.
You can think of the discount rate as the earnings yield you would earn from buying the stock.
If you come up with a 2% price, say for Apple of $3.6T, you can ask yourself if you are really okay with a 2% return on your money.
The Final Step
Now, we look at the market cap of Apple. It is trading today, March 22, 2021 at $2.07T.
Here, we can find the implied return for buying it at this price
2070/71.7= 28.9
1/28.9 = 3.46%
(We can check our math 71.7 / .0346 = 2.07)
The implied return for buying Apple at $2.07T is 3.46%.
We then compare that return with every other investment opportunity and pick the best one.
Is Apple Overpriced?
Apple is currently trading at between it’s 6% discount rate and it’s 2% rate.
This is in the lower-end of it’s range. This means, it’s certainly not a bargain and the market perceives the value of growth to be high.
Note, this is only a rule of thumb and there are other factors to look at. One is that Apple likely has a sustainable competitive advantage where growth does have value, so it should be valued using a NAV/EPV and also the Growth Franchise valuation.
