Reverse the Thumbnail

"It's a poor sort of memory that only works backwards."
-- The Red Queen in Lewis Carroll's Alice's Adventures in Wonderland

I have a confession to make: I love valuation. It doesn't matter if it's discounted cash flow valuation, projected future valuation, or relative valuation against a firm's own history or against its competitors. I love 'em all. I've worn out a mouse pad or two perusing NYU Stern School Professor Aswath Damodaran's excellent website. Heck, a few years ago, when I learned how to apply the Black-Scholes option pricing model to value employee stock options, I was giddy for hours.

Weep for my family.

First comes caution
There are pitfalls to valuation. You can get caught up in numbers and actually ignore the underlying business. You can make one or two systematic errors in your model, which, in turn, can give an erroneous buy or sell signal. Finally, valuation is largely dependent on future, unknown numbers that have varying degrees of uncertainty. The future may not reflect the past, but then again, past records are all we have (unless the Red Queen is your financial advisor).

Still, I'm firmly in the valuation camp for the simple reason that it can help you avoid losing money foolishly (lowercase "f"). You might miss a few highfliers like Google (NASDAQ:GOOG) and Sirius (NASDAQ:SIRI) or a perpetually "overvalued" company such as Microsoft (NASDAQ:MSFT), but you'll also avoid a lot of risky duds. My rigid valuation methodology kept me out of KrispyKreme (NYSE:KKD), for example, which at the close of its January 2002 fiscal year was trading for nearly $40 per stub. Back then, even after adjusting for growth-related capital spending (without which free cash flow was actually negative), I couldn't justify a share price much beyond the teens. The stock is down 85% since that time.

One valuation tool
One of the lesser-touted and more valuable services of Motley Fool Hidden Gems is the monthly "investing lesson." (It's not by accident that the first two words of the Fool's mission are "to educate.") Subscribers (or anyone who signs up for a 30-day free trial) should take a look at the September 2004 issue to learn about thumbnail valuations. This quick and easy exercise allows investors to estimate and compare projected annual returns from several investment opportunities in hopes of identifying the very best. (And they work pretty well. Tom and his team of analysts are using them to identify stocks that are collectively beating the market by 20 percentage points.)

Yet while thumbnail valuations can be useful for projecting prospective annual returns, I contend that there is another hidden use. If we turn the process around into what I call a "reverse thumbnail," we can predict the percentage a company must grow it's free cash flow (FCF) to justify a target return.

When to buy? When to sell?
The reverse thumbnail can also help investors determine good times to buy shares of a company -- and this is particularly helpful when analyzing small caps because they tend to be more volatile than the broader market. Buy decisions are even more difficult to make when a stock has been beaten down, even if we intellectually know that's precisely when we should be buying.

So, I'd like to show you how the reverse thumbnail can help in these decisions by taking recently beaten-down Hidden Gems recommendation CryptoLogic (NASDAQ:CRYP) as my example.

Those are the vitals today. Now we can use the reverse thumbnail to determine how much CryptoLogic will have to grow FCF to justify various potential annualized returns:

To gain a 15% annual return and double our money in just less than five years, CryptoLogic will need to grow free cash flow by a little more than 15% annually. Since free cash flow has been compounding at a 36% annual clip since 2002, I have some hope that this is possible, despite the recent loss of Betfair, one of CryptoLogic's largest clients.

Now let's go back to May 2005, when the stock was flying high.

At the end of May, investors needed CryptoLogic to grow free cash flows by nearly 25% to achieve the same 15% annual return that we can get today on the back of more modest 15% growth. Put another way: CryptoLogic looks like a bargain to me now.

The Foolish bottom line
The problem with calculating a reverse thumbnail is that it requires an iterative calculation to determine the required FCF growth that corresponds with a target return. Just by writing "iterative calculation," I've likely caused more than a few eyes to glaze over. No problem! Here's a spreadsheet that automates the reverse thumbnail process. (Be sure to enable macros when opening.) Just input the numbers under the "Input" heading, and press the "Reverse Thumbnail" button. The spreadsheet will do the calculation for you.

Getting into the habit of doing a reverse thumbnail can simplify buy or sell decisions and help you determine which stocks in your portfolio are best for new money now. Remember Peter Lynch's words: "The best stock to buy may be the one you already own." But if your desired 15% annual return can only be accomplished through 30% or greater annual FCF growth, you should probably wait for a better price.

Nevertheless, it's always worthwhile to revisit your investments and their valuations. And you're in luck, because that's exactly what Fool co-founder Tom Gardner and his analysts just did at Motley Fool Hidden Gems. Yesterday, the Hidden Gems team released an update on every company recommended (the portfolio is currently beating the market by 20 percentage points) as well as picks most worthy of new money. You can access the issue by clicking here for a free, no-obligation 30-day trial.

Jim Gillies owns shares of CryptoLogic, but no other companies mentioned in this article. He probably spends more time than is healthy playing with Microsoft Excel. Send Jim feedback! Krispy Kreme is a Motley Fool Stock Advisor recommendation. The Fool has a disclosure policy.