Friday, September 12, 2008

Value Investing Today: Chp 5: Narrowing Your Focus

Brandes provides some practical methods for finding undervalued stocks. He comments that Ben Graham translated his own methods into quantitative formulas that allowed a speedy way of determining most of the stocks worth investing in. Brandes references some of Graham's rules for finding undervalued stocks and then provides his own generalizations of those methods.

Graham's most recognized method of stock valuation was to calculate the "net-net current assets" value of a company by subtracting a company's liabilities from its current assets. If a stock's price was less than two thirds the value of net-net current assets and the company was currently generating profits, it was a buy.

Another well-known method Graham used was by looking at earnings yields, dividends yield and balance sheet debt. In this test, the earnings yield (the inverse of the P/E ratio) of a stock should be double the value of the yield on a long term AAA bond. Similarly, the dividend yield on a stock should be at least two thirds or more the value of the yield on a long term AAA bond. The last part of this method required there to be at least as much equity as debt on the balance sheet. If all three tests were met, Graham would consider the stock trading at a bargain price.

Brandes lists another Graham valuation technique called the five tests for value and five tests for safety. These tests of value and safety are the basis from which Brandes has developed his own four step test. Brandes' four step test is as follows:

1) no company losses over the past 5 years
2) debt is less than 100% of tangible equity
3) share price is trading at less than book value
4) earnings yield is at least two times the yield on a long term AAA bond.

Ideally all the conditions should be met and although there is some flexibility, Brandes warns to proceed cautiously if even one step of this method is not being met.

Brandes references Buffett's definition of the value of a business, its so called intrinsic value, as "the discounted value of cash that can be taken out of a business during its remaining life". Brandes recognizes that judgment is used in calculating an intrinsic value and for this reason recommends thinking of intrinsic value as a range rather than a single value. Even though intrinsic value doesn't have a definitive method used for its calculation, at its core, evaluating the intrinsic value for a business depends on an evaluation of the earnings strength and the financial strength of a company.

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