Is Your Stock Worth Owning Today?

The two toughest questions any investor has to answer are:

• Is this stock worth buying? And,
• Is this stock worth selling?

Get those two questions right and everything else pretty much just falls into place.

The trouble is that it's not entirely straightforward to figure that out. The problem starts with the fact that investing is all about predicting a company's future earnings and then backing up those earnings to what they're worth today. In theory, that sort of discounted cash flow analysis should tell you exactly what the company's shares should fetch today.

How's that prognostication working out for you?
The catch, of course, is that the future isn't entirely knowable. The economy changes. The market changes. Competition changes. Innovations change the way we work, play, and interact. All of them can radically affect our investments in previously unfathomable ways. And frankly, my crystal ball broke years ago, and it never really did work right in the first place.

As investors, all we can really do is follow a four-step process:

• Make our best projection of what that future will bring,
• use that projection to estimate what a company is truly worth,
• compare that estimate to where the market is pricing it today, and
• incorporate a "margin of safety" to make our buy and sell decisions.

Ben Graham would be proud
That simple four-step process serves as the heart and soul of value investing, the strategy that Ben Graham first codified and that made his more successful pupils like Warren Buffett into billionaires. It's such a time-tested approach that has performed so well for so long that even those that believe in efficient markets have carved out a "value anomaly" to acknowledge its success.

At value investing's core is that "margin of safety," which is nothing more than a fudge factor added to your analysis to acknowledge that you can't possibly perfectly predict the future. So you take that best estimate of the company's value, adjust it downward, and only buy if the stock is trading below that adjusted level. You can use that strategy on the flip side to sell, as well, looking to offload your shares only if the stock trades above your value estimate plus a fudge-factor margin of peril.

That way, you've given yourself room to be wrong and still make money. And isn't that what investing is all about?

The downsides
Of course, even following the value strategy doesn't guarantee that every investment will work out. Things change, businesses fall apart, and your projections can still wind up far enough away from the mark to wind up losing money. That's why it's still important to diversify within the value strategy -- a process Graham himself likened to being a casino running a roulette wheel.

On top of that, while that market doesn't always get it exactly right, it does a pretty good job of pricing companies pretty close to the mark, most of the time. As a result, you've got to be prepared to be patient while waiting for companies to drop below your buy level or rise above your sell level.

As Buffett has said: "I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." That's the sort of patience that you'll need to incorporate in all of your buy and sell decisions.

So what about the stocks?
Take those Graham-inspired principles, and the following assumptions:

• The company will grow at its analyst consensus long-term growth rate for five years,
• it will then grow at half that consensus rate for the next five years and 2% forever beyond that,
• you require a 12% annual return rate for the risks you're taking, and
• the company's recent free cash flow fairly represents its typical business.

With those assumptions, you can get a first-cut estimate on approximately what a company would be worth if it exactly lives up to expectations. For instance, if you believe the analysts, the companies below would be worth what you see in the "Implied Fair Value" column:

Sources: S&P Capital IQ and author's calculations.

If those estimates were correct, choosing whether or not to invest would become simple. All you'd have to do would be to compare that implied fair value with the stocks' recent market capitalization, add in the fudge factor, and make your buy or sell decisions accordingly. The table below shows the comparison for those same stocks, and the decision you'd make if the valuation number were correct, assuming you had a 20% margin of safety for your fudge factor:

Sources: S&P Capital IQ and author's calculations.

When you assume...
Of course, the big question is how accurate your assumptions are. The more aggressive those assumptions, the tougher it will be for the company involved to meet them. Take Apple, for instance. To maintain a 20% annual growth rate for the next five years, it will need to maintain all its current business and generate enough new business to add more than $50 billion in additional annual free cash flow by the end of that fifth year. Even for a rapid innovator like Apple, that's a tough challenge, indeed.

On the flip side, Wal-Mart's apparent overvalued status is due in large part to the troubles it has been having over the past few years. While its enormous size does limit its long-run growth potential, it does stand to benefit from a one-time boost as it turns its massive ship around.

Whenever you use a discounted cash flow model to value a stock, the assumptions matter a great deal in determining the usefulness of the value it suggests. Get those right, and the rest is textbook Graham.