Poking around the Internet a little while ago, 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 (DCF) 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 and conservative 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). I simply used the default settings to see what I might learn from one perspective about the market's current state.
The big guys
First, I wondered, "What's up with the biggest, best-known stocks? 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 Time Warner, ExxonMobil, General Electric, and Citigroup. (Though these latter companies aren't included in the table, I've incorporated them into the total average at the bottom.)
|Company||Price Per Share 8/29||Estimated Value||Non-Risk-Adjusted Appreciation Potential||Risk-Adjusted Value Incorporating Beta||Risk-Adjusted Appreciation Potential||Number of Analyst Estimates Used||Assumed Growth Rate|
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 their rough-cut valuations. A difference of 13% for such a rough tool is little more than a rounding error, really.
Second, it is obvious that the market as a whole is not discounting the "tech" 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. Applied Materials and Hewlett-Packard are the most obvious examples, 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 does -- 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, more like 5%), though most of that history involves companies paying out higher dividends than we see now. 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) in particular.
Is everything fairly valued 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 roughly fairly valued or overvalued, depending on your thoughts (and the market's) about risk.
While the Hidden Gems newsletter picks are up 31% versus the S&P's 9% since inception of the newsletter, so what? All that those numbers really tell us is what their stock 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 an entirely 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:
|Company||Price Per Share 8/29||Estimated Value||Non-Risk-Adjusted Appreciation Potential||Risk-Adjusted Value||Risk-Adjusted Appreciation Potential||Number of Analysts||Assumed Growth Rate|
|Total Average for all Hidden Gems recommendations||n/a||n/a||39.69%||n/a||36.73%||3||n/a|
The total average in the table accounts for the 28 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 published growth rate to input into the calculator.
While these are positive numbers, by no means should they be taken at face value without doing further independent research. Knowing something about the companies, for instance, will make you immediately aware that projecting a "true value" estimate of Deckers of $63 per share is complete 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. Furthermore, I think you can argue that there should be a higher discount rate applied to all companies than 10%, and for small caps perhaps in particular.
That's a healthy margin for error. And that margin is one of the reasons why Fool co-founder Tom Gardner started Motley Fool Hidden Gems as a small-cap investment newsletter. His hypothesis was that because small caps are ignored by most funds and other Wall Street pros (evidenced by the fact that an average of three analysts covered our Hidden Gems, while an average of 11 analysts covered the big guys), they would offer better values and greater growth opportunities. His 30% returns to date have borne out this hypothesis, so the non-risk-adjusted column is not that much of a surprise. But the fact that the companies turn out to be more valuable on a risk-adjusted basis was definitely surprising.
I did a control test of the largest holdings of the Vanguard Small-Cap Index Fund to see whether there was a small-cap bias with the calculator 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.
DCF calculators are definitely not one-size-fits-all solutions to picking undervalued stocks. They are, however, helpful tools for determining 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. If you'd like to take a look at those holdings for free, consider a 30-day trial. You'll have access to everything we've ever written with no obligation to subscribe. Click here to learn more.
This article was originally published as "Where the Values Are Right Now" on July 1, 2005. It has been updated.