Streetwise for Friday, December 22, 2017

As we approach the start of a new year, now is an excellent time to re-evaluate your current investment holdings and perhaps consider some new potential candidates. Therefore, let me again address the process of how to initially vet candidates. While bookstore shelves sag under the weight of mighty tomes that attempt to answer the selection question, it is usually with little success.

Although describing all the necessary vetting criteria in detail is too complex for a newspaper column (see my nest class offering at the end of this column), let’s slice the proverbial Gordian knot of valuation and couch the answer in terms of intrinsic value. Simply put, intrinsic value is the present value of a specific cash flow that a company could potentially generate into perpetuity.

Yes, perpetuity is an awfully long time. However, there are mathematical shortcuts that address the issue. More importantly, an integral part of present value is the discount rate used. This is the rate of return you require of your investments. Regular readers know that I suggest a minimum 8 to 10 percent return before dividends. Finally, there is the question of which cash flows to utilize. Three of my favorites are free cash flow to the firm, earnings, and dividends.

The intrinsic value calculation is nothing more than projecting forward in time a specific flow of cash and then determining what the present value of that cash flow is today. For example, the dividend discount model projects dividends going forward, at a specific rate of increase into perpetuity, and then calculates the present value of that dividend flow. Among those companies that have been raising dividends for more than 10-years, the dividend growth rate is about 7 to 10 percent.

I know what you are thinking; you have not seen the inside of a mathematics text book for many years and you would like to keep it that way. Not a problem. There are numerous Internet web sites, such as where you enter a stock symbol and in turn receive an intrinsic value.

In the case of ValuePro, the methodology utilized is free cash flow to the firm. For the other two models, I have a small Excel program that calculates the intrinsic value using an earnings model and a two-stage dividend growth model. Designed for use by my students (see below), readers are welcome to request a copy. There is a disclaimer attached.

As a rule of thumb, the intrinsic value should be a minimum of 10 to 15 percent higher than the current share price. If the intrinsic value is less than the current share price, move on. Your objective is to find 15 to 20 candidates to investigate further. Do yourself a favor and pick the low hanging fruit, i.e., well known and easily researched companies with a track record of annual dividend increases.

Before sending me all the other possible permutations and combinations of investment criteria you feel should be considered, keep in mind that intrinsic value is merely the first hurdle in the stock selection process, but a critical one.

Let’s look at an example. The intrinsic value of Praxair (PX) using the model gives an initial number of $95.37. However, some modification is in order due ValuePro’s data not always being fully up to date.

For example, I would reduce the 10-year treasury rate to three percent. I would also update shares outstanding and operating profit. The result is an intrinsic value of $187.94, an intrinsic value that is 22.4 percent higher than a recent share price of $153.58.

Note to Readers: I will be teaching one course, Advanced Investment Analysis, beginning on Monday, January 8, for the Ringling College’s Lifelong Learning Academy. Call 941-309-5111 for registration and information.

My 9th annual talk sponsored by the non-profit American Association of Individual Investors (AAII), titled: Wall Street 2018 – Where Do We Go Now?”, will be on Thursday, January 18, at the Hyatt Regency, 1000 Blvd. of the Arts. Registration/Social/Refreshments 3:00 P.M., Program 4:00 to 5:30. Please call 941-706-3449 to register. $10 per person at the door.