Where the Values Are Right Now

Poking around the Internet the other day, I came across the online valuation calculator at SmartMoney.com. I decided to type in a couple of stock tickers to see what I'd learn.

The calculator uses a discounted cash flow analysis like many other online calculators, but this one has the nifty feature of automatically inputting five-year assumed growth rates taken from the consensus for published analyst reports. It assumes a consistent 2% growth rate after the initial five-year period. The discount rate for future cash flows is 10%, the earnings base is the trailing 12-month period, and you can adjust the discount factor for risk by incorporating the company's beta (or not). You can change the variables as you please, but for the purposes of this exercise I used the default settings to see what I might learn about the market's current state and some specific sectors. If you're not familiar with doing a discounted cash flow analysis to value your stocks, you should learn how -- and the online calculator is one tool you can use in that education.

The big guys
First, I wondered, "What's up with the biggest, best-known, most eagerly followed stocks around? Are they overvalued today, as many seem to be saying?" I examined the usual suspects in the table below and also took a look at Nokia, General Electric, Yahoo!, and Intel. (Though these latter companies aren't included in the table, I've incorporated them into the total average at the bottom.)

A couple of things strike me about these numbers. Focusing on the non-risk-adjusted estimated appreciation potential column, we see that the current market values pretty closely reflect this default rough-cut valuation model for a random selection of heavily followed stocks that are often assumed to be overpriced. A difference of 4% for such a rough tool is a rounding error, really.

Second, it is obvious that the market as a whole is not discounting these stocks (today at least) based upon their betas. That may or may not mean much to you. Using beta as a multiplier for a discount rate can give you some pretty monstrous discount rates. Cisco is the most obvious example, but I could have selected stocks that show an even greater divergence between their risk- and non-risk-adjusted appreciation potentials.

Third, shareholders of any of the above stocks -- particularly those who think they have a better grasp on the valuation of their holdings than a stupid calculator -- will focus their differences on the perpetual growth rate of 2% (after the initial growth period) to make themselves feel better. While I agree that a perpetual growth rate of 2% is low, it is not all that much lower than history indicates you should assume. Real earnings growth for companies over time is in the neighborhood of about 2% (including inflation, about 5%), though most of that history involves companies paying out higher dividends than we see now, and higher particularly than every company above except ExxonMobil. I know there are people out there who think some of these companies will grow earnings from now until the end of time at 10%, 15%, 20%, whatever. Anybody who assumes that ought to consider history in the long sweep, and the recent past (2000 to 2003) as well.

Is everything fairly or overvalued?
What I wanted to see next is what this little device thinks about our recommendations in the Motley Fool Hidden Gems newsletter. It seems to value the best-known companies at either fairly valued or significantly overvalued, depending on your thoughts (and the market's) about risk.

While the Hidden Gems picks are up 33% vs. the S&P's 7% since inception, so what? All those raw numbers really tell us is what their prices used to be, and what they are today. Not what their values are or might be. I'm not going to pretend that this online calculator is the final or best arbiter of value, but at least we can say that it's a neutral one. So let's turn the question over to the SmartMoney.com calculator to get an answer. My expectations before running the numbers were that our picks would be judged no better in terms of potential value appreciation than the better-known companies above, and because of their small size would exhibit significantly higher risk.

But that's not what I found:

The total average in the table accounts for the 20 Hidden Gems recommendations for which the calculator has an estimated value. The additional picks of the newsletter produce no estimated value from the calculator because they do not currently have positive earnings or because there are no analysts following the companies and therefore no growth rate to input into the calculator.

Caveats
While these are obviously very positive numbers, by no means should they be taken at face value. Knowing something about the companies, for instance, will make you immediately aware that projecting a "true value" estimate of Deckers of $60 per share is madness. Deckers is going through too many problems at the moment, and to say that its five-year growth rate could be 20.8% seems to ignore the fact that it isn't growing at all this year. And, frankly, I'm not comfortable with the growth projections that the analysts are putting forward.

But still.

That's a lot of margin for error. And the fact that the companies turn out to be more valuable on a risk-adjusted basis was definitely a surprise.

When these companies were recommended in Hidden Gems, it certainly wasn't on the basis of, or with any knowledge of, this particular calculator. Yes, discounted cash flow analyses were incorporated into all the selections to provide a margin of safety, and that discounted cash flow analysis incorporated growth rates and discounts (though no explicit beta), but we're not using assumptions nearly as aggressive as the analysts following the companies seem to be.

The Hidden Gems companies listed in the above table are fairly representative of the larger group of recommendations in the newsletter. I excluded the names of most of the companies with the largest price appreciation potential from this article because it wasn't necessary to further the point. According to the calculator, there are a few that are selling for less than half their intrinsic value, but I'd want to be significantly more cautious in my estimates than that.

I did a control test of the largest holdings of the Vanguard Small-Cap Index Fund to see if there was a small-cap bias here. There was no bias in that respect -- those companies were deemed fairly to slightly overvalued by the market, similar to the better-known companies in the top table.

Calculators like the one offered on SmartMoney.com are not one-size-fits-all solutions to picking undervalued stocks. They are, however, helpful tools for determining what numbers are assumed by the market (in terms of growth rates) and how your assumptions match up with analysts -- and what a company must achieve in the future to justify its current stock price.

Having gone through this process, we're happy with our holdings, and hope you are with yours.

Presumably, you'll always be looking for stocks that sell for less than their intrinsic value. According to SmartMoney.com's calculator, we've found at least 20, and you can have access to all of their names and the analysis that we've run on them for free during a 30-day risk-free trial. Whether you take the trial or not, we'll continue to monitor them to see whether they are as attractive in the future as they are today. Click here to learn more.

Bill Barker does not hold shares of any of the companies mentioned in this article. eBay and Amazon.com are Motley Fool Stock Advisor recommendations. The Motley Fool has adisclosure policy.