# Valuation Model



## kac147 (Jan 12, 2018)

Do you implement any valuation models when finding companies to invest? What model would be the most powerful tool for your application?

I have created my own spreadsheet and I have the following models:
- Growth valuation using PEG
- Discounted earning valuation
- Piotroski F-Score
- Cash Flow Return on Investment and Weighed Average Cost of Capital

People suggested to read the book "Equity Valuation - Models from Leading Investment Banks" for learning some valuation models the investment banks used. Have you read this and if so, what is your comment about it?


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## Eclectic12 (Oct 20, 2010)

No offense ... but this question looks like it fits better in the Investing section as this section is for Individual Stocks/Equities.

In answer to your question ... no models used and I have not read that book.


Cheers


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## kac147 (Jan 12, 2018)

Eclectic12 said:


> No offense ... but this question looks like it fits better in the Investing section as this section is for Individual Stocks/Equities.
> 
> In answer to your question ... no models used and I have not read that book.
> 
> ...


Ya, I was thinking to put it into the Investing section too but most of the valuation models are to analysis Individual company. That's why I posted it in this section. I don't think I can move it to the Investing section now.


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## OptsyEagle (Nov 29, 2009)

None of those will help you. The first two require you to estimate future earnings for them to work and since that is where the errors are found, they simply do not work. I would like them to, but they don't. Not sure what an F-score is but I doubt it works or I would probably know what it is. The last one is useful but is just another type of info that I might want to know to help me decide what price I might want to pay for a given stock. It helps me get a feel on who is going to get the profits. Two different companies can have the same profit, but one needs it all and more to reinvest so that it can make the same amount next year and the second can pay it all out in dividends and/or buy back shares. Obviously I would pay more for the 2nd stock as opposed to the first. Not sure why anyone would ever buy the first, but many do. They are called energy stocks and commodity producing stocks. Never buy those and you will outperform most Canadian investors over your lifetime with only a few years where you will question this advice.

Going back to your list, I don't see the price of the stock being used in any of the models you listed and of course the price you pay for a stock is by far the most important component that will affect your investment results and always will be.


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## kac147 (Jan 12, 2018)

OptsyEagle said:


> None of those will help you. The first two require you to estimate future earnings for them to work and since that is where the errors are found, they simply do not work. I would like them to, but they don't. Not sure what an F-score is but I doubt it works or I would probably know what it is. The last one is useful but is just another type of info that I might want to know to help me decide what price I might want to pay for a given stock. It helps me get a feel on who is going to get the profits. Two different companies can have the same profit, but one needs it all and more to reinvest so that it can make the same amount next year and the second can pay it all out in dividends and/or buy back shares. Obviously I would pay more for the 2nd stock as opposed to the first. Not sure why anyone would ever buy the first, but many do. They are called energy stocks and commodity producing stocks. Never buy those and you will outperform most Canadian investors over your lifetime with only a few years where you will question this advice.
> 
> Going back to your list, I don't see the price of the stock being used in any of the models you listed and of course the price you pay for a stock is by far the most important component that will affect your investment results and always will be.


Thanks a lot for the comments! I use the models listed to find out the acceptable price of the company and compare it to the market price. Other than the models listed, I also have P/E, P/B, etc. which include the market prices on my spreadsheet for information. Are these ratios what you referred to on your comments or would there be any other valuation methods that the market price being utilized?


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## OptsyEagle (Nov 29, 2009)

The more numbers the better as long as you understand that future events, that are mostly unknown and completely out of your control, will continuously place hazards on just about any model you have. There is simply no model that can see into the future.

With that in mind, I do the following:

1) I do my very best to buy stocks as cheaply as possible. Here I look at PE ratios, past growth rates, size of competitors, return on capital and the need for future capital with it's resulting dilution, debt levels, etc. 

Depending on how I feel about those things, I make a determination if the current price incorporates enough of the bad stuff to give me a little margin of safety. It ends up being more of a feeling then an exact price since there are no exacts in this business. I wish there were, but there is not.

2) Buy at least 20 stocks so that the times I am right somehow magically erase the cost of the times I am wrong, because I am wrong a lot. If I only bought 3 stocks, Murphy's law would ensure that those would have been the ones that would have fallen in the "wrong" category. Remember, you can only lose 100% of your money on the stocks where you are wrong, but you can make 500%, 1000% and more on the stocks where you are right. Also, the stocks that you have made mistakes on become less significant to your portfolio (because their values have now gone down and become a smaller percentage of the portfolio) compared to the significance from the stocks that your were right on (because their values have now gone up and become a larger percentage of the portfolio). Those last two factors can somehow fix what were otherwise some pretty big mistakes. It is kind of a miracle of mathematics.


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## DavidW (May 27, 2016)

Two books from Benjamin Graham discuss valuation and investing, _Security Analysis_ and _The Intelligent Investor_. One of the more interesting things about the books are the comments on valuations from the early 1900's through the great depression to the turn of the century. He does talk about growth rates and acknowledges that they are subjective and often wrong, and also acknowledges that they are part of stock valuations going so far as to include a growth rate in the simplified formula which he used. The second book is probably the easier read, here is a paragraph for rule #4 from the chapter on The Defensive Investor and Common Stocks:



> 4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the portfolio. In particular, it would ban virtually the entire category of "growth stocks," which have for some years past been the favorites of both speculators and institutional investors. We must give our reasons for proposing so drastic an exclusion.


The Intelligent Investor-Revised Edition 2003 2006 Page 115

I try to continually work on the investment plan I have. Usually I keep the principles OptsyEagle mentioned and other principles which are very similar from the above books in mind though sometimes I'll move away from them if there is a benefit to the plan and I know why I am doing that move.


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## hboy54 (Sep 16, 2016)

OptsyEagle said:


> Not sure why anyone would ever buy the first, but many do. They are called energy stocks and commodity producing stocks. Never buy those and you will outperform most Canadian investors over your lifetime with only a few years where you will question this advice.


Oh, but the "few years" can be spectacular! Like anything, purchase price counts. 

I don't see anymore that what I do is primarily buying and selling companies. The companies are merely vectors for human emotion. I buy and sell emotion: fear and greed. When neither fear nor greed is the current status, the great mushy in between, I hold.

I don't model anything or do calculations any more beyond checking the common metrics calculated by my broker interface. It doesn't add anything to what I do. A bunch of precision applied to a matter that has no precision or certainty. If you need calculations to tell you that you should not buy TECK.B at $50 as you hinted above Optsyeagle, but should maybe give it a serious go at $10, then I have nothing for you. Or HCG is maybe interesting at under $8 or $10 as opposed to $40. Just obvious without any fancy math.

The really interesting thing with investing is how you do fear and greed. Do them well, no fancy calculations required.

hboy54


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## james4beach (Nov 15, 2012)

I'm not sure how useful these kinds of simplistic valuations are. If you're into fundamental analysis, what you really must do is crack open the company's financial statements and study the income statement, balance sheet, cashflow statement. And then read through all the notes to understand the nuances of what the company is up to.

Accounting is more of an art than a science, and it's amazing what is hiding out in the financial statements. Taking simple metrics on earnings etc just don't come anywhere close to the full picture. And these metrics you're talking about are available to everyone, anyway. You're not going to have an edge over any other trader in the market. If anything you are going to miss important factors in their valuation (the more subtle stuff hiding in the financial statements & notes) and think you've found a good buy based on a false reading.

Financial stocks in 2007 are a good example. At a superficial glance, they appeared to be cheap on valuations. Some stocks were down to book value. If you calculated simple metrics you might have thought they were great buys. But the reason people were selling the stocks was due to what was looming under the hood. The balance sheets were showing deterioration. Many assets were Level 2 and Level 3, illiquid, tough to value. Off balance sheet derivatives were showing distress, which is tough to even SEE no matter where in the financial statements you look. They had future obligations that were going to blow up on them, something that you'd only pick up in certain tables buried 100 pages deep into the "Notes" after the financial statements. My point is that looking at valuation metrics absolutely did not tell the correct story, there is so much going on. Especially in big companies, especially in financial companies.

The big money managers like Buffett go a step further than just the financial statements. They're also in direct contact with the management and executives. By talking with management and industry experts, they get even further insights into the state of companies. To be a true value investor, you need a certain amount of depth and especially personal connections. It's a reason why the rich get richer.

This may be a bit cynical of me but I don't think there's much to be gained from doing this kind of valuation work, unless you have strong experience interpreting financial statements. Or perhaps some industry-specific knowledge.


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## DavidW (May 27, 2016)

james4beach said:


> I'm not sure how useful these kinds of simplistic valuations are. If you're into fundamental analysis, what you really must do is crack open the company's financial statements and study the income statement, balance sheet, cashflow statement. And then read through all the notes to understand the nuances of what the company is up to.
> 
> Accounting is more of an art than a science, and it's amazing what is hiding out in the financial statements. Taking simple metrics on earnings etc just don't come anywhere close to the full picture. And these metrics you're talking about are available to everyone, anyway. You're not going to have an edge over any other trader in the market. If anything you are going to miss important factors in their valuation (the more subtle stuff hiding in the financial statements & notes) and think you've found a good buy based on a false reading.
> 
> ...


Fundamental analysis extends beyond the financial statements of a company to include the dynamics for the environment and industry the company is in. I agree that if you are investing for more than a short term trade you want to look at the financial statements for more than just the income statement. What I want to see in the financial statements is that management is looking after the company, and by extension shareholders. I wouldn't say I am really good at this but I keep trying to learn and improve my skills at reading how the different sections fit together to create a picture of the company's finances and how management is utilizing cash flow. The notes often seem like warning bells that don't help but they don't always turn out to be a bad thing as one recent accounting change I saw "appeared bad" but was cash neutral and studying the before after helped me understand how the company was operating better, I still hold the shares which are currently lower than what I paid.

I know I'm not a deep pocketed investor with direct access to company managements and those semi-private investment deals but I'm not trying to keep up with other traders, my investment plan's objectives are what to run out of.


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## kac147 (Jan 12, 2018)

Thanks for the comments above!

I think I didn't explain it clearly. The valuation models I used are only for quick screening and quick summary of the financial status of a company. The final decision will be made after reviewing the financial reports and doing more researches. Below steps are usually what I follow:

1. Using a stock screener to filter out the first criteria I set. Usually it will only remain 5-10 companies that meet the criteria;
2. Enter the financial statements of all the companies left into the spreadsheet and it will automatically generate the valuation models above plus other financial ratios and summary. I usually use the past 10 years of annual data and the past 5 quarter data. It will have around 3-5 companies left.
3. I will go through the financial reports of the 3-5 companies and decide which to buy.

Since I am not working in the financial sector and we have a baby to take care, I do not have too much time for reviewing the financial reports for more than 5 companies a week. I understand that it takes time and effort to find the good companies but I am trying to eliminate the screening time if most of the companies are not even close to what I am looking.

Regarding to talk with the management and executives, I understand that it is the best way to understand the company. However, I don't think they would like to talk to a small potato like me. Although most people and institution would take actions way faster than I do once they have the most current information, I don't mind to have lower return than theirs but investing on the correct trend.


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## OptsyEagle (Nov 29, 2009)

kac147 said:


> Regarding to talk with the management and executives, I understand that it is the best way to understand the company. However, I don't think they would like to talk to a small potato like me.


Just so you know, most companies record conference calls, every quarter, where the CEO and CFO and perhaps a few others at the company join in and explain the quarter and their hopes for the future. The analyst questions at the end is probably the most informative. These conference calls are usually found in the "presentations" section of the companies investor relations website.

With that said, be careful when listening to these calls. As I said the analyst questions tend to be more interesting. A CEO or CFO has to be optimistic. If they were not, they would have left or been fired a long time ago. A high share price makes their jobs so much easier because it not only gives them better access to capital but makes the ability to make a positive return on that capital so much easier if the capital is cheap (high stock price). Whether they mislead knowingly or by their strong biases, doesn't really matter, these calls and the powerpoint presentations they also put on their websites, can be very one sided. They can kind of get you to want to pay for future growth that not only has not happened yet but probably never will. It certainly will never materialize like they expect.

They are best used to get a feel for what the business actually does and then if you were me, you would never look/listen to them again...unless you need a refresher.

All that and the other stuff I wrote is just my opinion.


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## Nerd Investor (Nov 3, 2015)

I detailed the screens I use in the Money Diary section. 
I will say, my absolute favourite metric for generating a list of stocks is EV/EBIT. The main drawback is it's useless for Financials and to a certain extent Utilities because of their unique capital structures. 

At the end of the day, stock prices are based on what people/the market think about future cash flows/earnings. 

If you think about a stock price as Earnings x Valuation, then for the price to go up either Earnings has to go up or the Valuation has to go up, or both. It's really hard to predict what earnings will do in the future, so if you start with a cheap valuation, at least you're increasing your change at success (or possibly cushioning the failure), at least in the long term.


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## Pluto (Sep 12, 2013)

Nope, don't have such models. 
I want an above average return on equity on all my holdings, not just a snapshot in time, but a history of it. 
Tend to avoid boom and bust cyclicals. 
Tend to avoid capital intensive companies. 
Gravitate to history of growing earnings and dividends with good prospects for same in future. 
I don't look ofr deep value in average companies. perfer paying premium if necessary for quality companies. 

Price/book history is useful in bear markets. That ratio helps to gage a good deal and probably recovery.


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## Jimmy (May 19, 2017)

Just a general note. Companies are big black boxes. Cash goes in and it is hard to see where it goes after that. Warren Buffet's model just looks at 2 items. The book value and the dividends per share and their growth rates. That is the cash actually making its way back to share holders.

He projects them both out for 10 yrs based in part on past performance. He assumes a terminal growth rate for dividends too. Then discounts back ( using a required rate of return for the stock) the cash from the annual dividends and FV of the book value to get a PV total for the share price.

Lots of variables still to play with that can effect the valuation but you make your assumptions and go w them.


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