The inculcation begins early and is repeated often: Future cash flows, discounted to the present at a risk-adjusted rate, are the theoretically correct method for valuing investments. This concept of bringing the future back to the present at a hefty discount gained academic traction on the heels of John Burr Williams' 1938 book, The Theory of Investment Value. It then gained near-universal acceptance after the flood of Warren Buffett exegesis, which revealed in great detail how the Great One applied the concept to his analysis.

Discounting future cash flows is an enticingly precise exercise, even though it leaves the door wide open for an infinite number of interpretations: First, what do you discount? Total cash flow, operating cash flow, free cash flow, dividends, maybe earnings? Second, what is the appropriate risk-adjusted rate for the discount? The 30-year Treasury yield plus an equity premium (and what is the premium?), weighted average cost of capital, the long-term rate of the S&P 500, or the cost of equity? Third, how far into the future should you estimate the future cash flows, and at what rate (rates) should you estimate the growth?

Garbage in, garbage out
Using Pfizer (NYSE:PFE) as an example, we can see how estimates fluctuate. Pfizer's trailing-12-month EPS is $1.12. (I'll focus on discounting EPS for simplicity's sake.) Last week, my analysis suggested that Pfizer could grow EPS at 6% for the next five years, and 5% thereafter (excluding the Wyeth purchase from the analysis). I also thought Pfizer was less risky than the market, based on it's 0.73 beta, so I used its cost of equity:

 risk-free rate + (beta coefficient X equity risk premium) 

... as a discount factor. The plug-ins are the 10-year Treasury bond yield of 3.44% as a risk-free proxy, the 0.73 beta, and a 5% equity premium, to arrive at the discount factor. Based on these inputs, Pfizer's intrinsic value was $58.89 a share, which left plenty of room to move north from Pfizer's current price of $16 and change.

Today, I'm less sure. I'm thinking that Lipitor's loss of patent protection could be more damaging to future earnings than I originally thought, so I've changed my assumptions: Pfizer will grow EPS at only 4% annually for the next five years, and 3% thereafter. I also think that the reduced earnings power makes Pfizer as risky as the market. The S&P 500 has averaged just less than 10% growth annually for the past 25 years, so I'll go with that discount rate. Based on my new inputs, Pfizer is worth $17.20, much closer to today's price.

So is Pfizer's intrinsic value $58.89, $17.20, $16 and change, or something else? I'm unsure, at least based on net present value alone, because the odds are my intrinsic-value calculations are wrong. Perhaps wildly wrong. 

Research suggests that we are horrible forecasters, and net-present-value calculations are no exception. What's more, the research shows that the smarter we think we are, and the more information at our disposal, the more likely we are to be wrong. I think I'm smart, and I have access to a plethora of information; therefore, I have little faith in the accuracy of my forecasts.

Grounded in ratios
Because I'm a lousy forecaster, and because I'm value-oriented, I prefer to seek intrinsic value in ratios (a la Ben Graham). In other words, I let the numbers in front of me lead me. My bias favors:

  • Debt-equity ratios of 1 or less (signifying low financial risk).
  • A dividend yield of at least 3%, with steady growth in the dividend.
  • A current return on equity of at least 15%.
  • Discounted share price -- a stock trading within the lower 50% of its 52-week range.

Pfizer didn't make the cut, but the following group of five diverse stocks -- since I'm often wrong, I don't want to overweight one sector -- did:

Stock

Current Yield

5-Year Dividend Growth Rate

Return on Equity (5-Year Average)

Long Term Debt-to-Equity

SYSCO (NYSE:SYY)

3.8%

13.5%

32.1%

0.7

Procter & Gamble (NYSE:PG)

3.1%

12%

19.1%

0.3

American Ecology (NASDAQ:ECOL)

4%

N/A

28.1%

0.0

Westwood Holdings (NYSE:WHG)

3.4%

0.3%

24.1%

N/A

Sunoco (NYSE:SUN)

4.3%

18.1%

40.4%

0.7

Source: Thomson Reuters.

Of course, the figures are meaningless in isolation. We need their relative industries as a point of reference. In this case, the five stocks compare relatively well to their industries, and to a previous price benchmark -- the 52-week high.

I can't be sure whether any of these stocks will breach that high again. But based on these ratio valuations and respective businesses, I suspect they will. I just lack a concrete price target to shoot for. Then again, I would lack a concrete price target if I had estimated intrinsic value based on discounted cash flows. This way, at least, I know that.  

Fool contributor Stephen Mauzy, CFA, holds no positions in the stocks mentioned. He's the author of the upcoming book The Wealth Portfolio, available this fall. Sysco is a Motley Fool Inside Value selection. Procter & Gamble and Sysco are Motley Fool Income Investor picks. The Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.