How to value stocks? Three rule of thumbs

From overthinking to simple rules? Should the calculator be ignored?

I am trying to find simplicity when valuing stocks. I have moved from a sophisticated but diffuse style to a more simple approach with rule of thumbs. I’ll just start with two “lenses” or end goals that should be mentioned from the start:

• Significant undervalued right now - deep value

• Significant long term potential, if you look ahead - GAvRP

Often companies are somewhere in-between, but these are the two broad lines for the companies that passes the quality filter (in the earlier post) and the valuation filter (in this post).

Quality, valuation & momentum - a background

This is were I come from. A undefined but rule based world of red, yellow and green for all types of cases. In theory it goes like this: Once the basic requirements are met and the company is of interest, it is a matter of deciding the company’s quality, valuation and business momentum. A buy/hold/sell decision depends on that. And it is business momentum, not momentum in the share price.

Note: This is a clear blink to Grandeur Peak, it’s their model that I have tried to learn. I have made some changes, not shown here, that there is a price limit for everything, even for exceptional businesses with the strong momentum.

The obvious risk is that you could justify “buy at any price” especially for top quality and top momentum. I don’t agree with that. But the graphs shows in a pedagogic way that if you go for higher quality, you will get fewer decisions. Quality is usually consistent, while valuation and business momentum vary more over time. It’s also a very good framework for reasons to sell: a drop in quality, business momentum or worse price.

I still like this, but even more as a background idea. Since I have tendency for overthinking and being slightly colorblind when it really matters, I decided to try something easier for me. That’s rule of thumbs.

Rule of thumb 1: Double and still cheap?

For my deep value names, I have more and more moved to this simple question, where I don’t really need any calculator:

Could this company double and still be cheap? If you can answer yes without doubt I think you could have a deep value stock that could be worth owning. And if it passed my quality checklist, it should be safe enough. Price is most important, but the company should be of good or high quality, cheapness alone isn’t enough.

Often it is that simple, could it double and still be cheap right now? But there are sometimes near time growth that’s safe enough to account for. I could stretch things and think double and still be cheap within 12 months, including that growth. That’s ok to do, but it’s often not needed. Simplicity is best.

This is a lot of emphasis on valuation rather than quality and business momentum (growth). This is deep value and how I think about the bulk of my portfolio and a yes implies both big upside and downside protection. For deciding cheapness, I look at P/E, EV/EBITDA, FCF-yield and P/B among other metrics, in combination.

Rule of thumb 2: Exceptions for exceptional stocks

If there is significant long term potential, I could use GAvRP. For growth names (+15% REV/EPS), I think like this: Is this Growth At a Very Reasonable Price or not? I “estimate” a long term CAGR and compare that number with the valuation. The difference is that I here dare to look a few years ahead and then must be sure enough about future growth.

How sure am I that on revenue and EPS growth the coming 3-5 years? How much do I pay for this growth? This decides the multiple contraction risk. Is this such an exceptional and predictable stock that it is worth making exceptions? The real danger is that growth stalls and multiples falls.

For example: I think Karooooo will grow revenue and EPS 15-25% for 5+ years. That’s both in line with history, and a quite realistic future. It’s trading at P/E 25 and I don’t think it should be traded at anything lower than P/E 25. And compared to others, a P/E of 50 isn’t unreasonable at all. I don’t like relative valuation, but the point is that there shouldn’t be a big multiple contraction risk, as long as they perform. I guess this is my new way of capturing exceptional quality stocks with good business momentum and then accepting a higher price (the graph to the far right earlier above).

At the moment, Karooooo is the only one where I am comfortable looking a few years out, and the only really growthy stock I own. It’s a rule-breaker, it would have been easier if I “just” owned the 8 other stocks. But this is something I must own. And I might add stocks in this category. For the deep value names, there is on the contrary no “demands from the future”, they are more here and now. It is more dangerous with growth, since P/E 25 implies looking 25 years ahead (who can do that?). But there is also value in growth, but you must be certain that you must make an exception.

Rule of thumb 3: Think like buying your nearest café!

I have presented two models, for two different company types. Let me present a third way. If you would buy a real company, how would you do that? I think price and dividend capacity is very important then.

If you buy the nearest café I think most people would be sensible with their own money. How much is the price, how many times earnings? What amounts of dividends would I get? Could I get an extra dividend from cash reserves? Is there large needs for investments? That affects the price I pay. Will I get 12% a year or 2% a year in regular cash distributions in the foreseeable future?

This is real world calculations, leaning towards low P/E and high FCF-yield and the opportunities for extra dividend payouts etc. It’s simply Buffett’s buying the whole company with a twist: Try, in theory and just for fun (remember, this is not financial advice), buying your nearest café, and think the same about the stock you are nearest to buy. If only 2% FCF yield, you need a very strong growth plan - and even then, I’d remain skeptical. But a 10%+ FCF yield is often attractive (7 of my 9 companies have that right now). This simple example shows why I’m mostly a deep value investor.

And about dividends, I think it’s extremely important not to look at dividends per se, but total dividend capacity (FCF yield). What is produced, not distributed. Things like debt and capex cannot be ignored.

My hurdle is 10% CAGR in each investment

It’s really simple. Every investment should be able to return at least 10-15% annually (ideally 15%) without big risks. The company and valuation must support this, and I should see a clear path to double digit returns. This could come in different forms, growth, dividends, FCF-yield, even some revaluation (but that’s not reliable to count on ). Even low P/B (book value) and a growing B could work. It’s a combination.

Cheapness is good. Extreme cheapness is best: No-analyst stocks, but no-brainers if you just care to look at P/E, EV/EBITDA, FCF-yield and their large cash piles. No trigger or catalyst is needed if the valuation is more than right. A CAGR of 12–15% from each holding should be possible; a stable 5–10% might be nice, but it’s often not good enough.

If I think like this, companies that meet the criteria are harder to find. But it’s easier to hold if you really find them and you might get conviction that they really are unique. But you have to lookout for confirmation bias.

Hidden value? Not to be forgotten

Note! It’s not THAT easy. Sometimes you find a company returning let’s say 8% a year going forward, but having great hidden values. I e property, investments or other things that, if realized could give a 50-100% return. That could be very important. This is not only downside protection, it’s also potential.

You can also find companies that in theory could be liquidated and returning more than the market value today. This is like if the cafeteria above would have some inventory (that don’t grow old) or could rent out or sell off an unused part of the building. I deal with this by accepting i e 8%-cases with big potential upside, lumpy upside, by adding i e 3-5% for these possibilities if they are so real that they could happen within 5 years.

Other ways to “skin the cat”? Opinions?

How do you do this? Do you look at IRR, Share price potential (DCF:s) etc? And do you have different valuation methods for different types of names? The subject is a bit hard and somtimes confusing, I thought of naming this post: Price is what I pay, value is what I can’t get :)

But I am on the hunt for improvements and simple rules. One could be that never pay more than i e P/E 15 (TTM) for a “value” name and P/E 30 (TTM) for any “growth” stock. That could work. Or at least never pay more than x times sales, how good a company ever might be. I prefer classic valuation metrics and a combination of them. I think it’s dangerous to look only at cashflow, sales, EV/EBITDA etc, since every number shows one truth and tells one story. In the end you always must make an overall assessment if the price is fair. For calculations, this is a good guesstimator.

Perhaps I should use more excel, and present simple formulas. But I don’t think that suits me and I am more into Greek stocks than Greek letters. My simple, not so unique, point is that you shouldn’t need a calculator if you find something you really want to own. You know it when you see it. My conviction isn’t just in the numbers. I own the stocks I simply must own, looking at risks, quality and valuation combined.

Best regards, and all input is…valuable!

Gustav