I have fond memories of staying home from school as a kid with some dubious ailment, piling up in bed with chicken soup and ginger ale, and watching The Price Is Right. When it came down to going to school or watching the world's greatest game show, it was an easy call.
As it happens, all that time spent "convalescing" eventually proved to be quite educational -- Bob Barker taught me a valuable lesson about the dangers implicit in overbidding.
Under is better than over
The premise of The Price Is Right is to reward players who have a keen sense of value, particularly when it comes to pricing everyday household products.
The goal is to win your way out of contestants' row to compete onstage for bigger and better prizes. To do that, players must "guesstimate" a price that comes closest to a chosen item's actual retail price -- without going over. Underestimating by a mile is fine, but overbid by so much as a penny and you'll be lucky to walk home with anything.
Before you roll your eyes at me, I admit that determining the fair value of a stock is trickier. Nevertheless, we'd be wise to apply a similar philosophy in our portfolios.
Come on down!
Let's play a quick game. Using the following hints, tell me what this mystery stock might be worth:
This company is one of the world's leading fast-food chains, operating more than 30,000 restaurants in 100 different countries. Last year, it generated around $2.7 billion in free cash flow (FCF) on more than $20 billion in revenues. Over the next five years, analysts are forecasting annual earnings growth of approximately 8.5%. As of last quarter, the company had 1.23 billion shares outstanding. So how much is each one worth?
With that sparse amount of information, it is difficult to come up with anything more than a ballpark estimate. Yet, in many cases, this is all it takes to determine whether a stock deserves further scrutiny.
In dealing with stocks, bonds, real estate, etc., the value of an asset is simply based on the cash flows it produces. By taking the sum of this company's future cash flows and then discounting back to the present using a rate that compensates for the risk taken (I've used 10%), we come up with an intrinsic value of $53.2 billion.
That figure, dividing by the 1.23 billion shares outstanding, works out to a fair value of around $43 per share.
The company, incidentally, happens to be McDonald's
Expect the unexpected
However, there is always the risk that my assumptions are off. What if McDonald's brisk international sales slip, snapping the firm's 36-month streak of same-store sales gains? What if rising food and labor costs chip away at margins and take a bigger bite out of the bottom line?
If we run the same calculations as before but trim the growth projections from 8.5% to 5%, our fair-value estimate dips to $36. Suddenly, the stock that seemed like a decent buy is actually overvalued.
A few missteps here and there, and those who bought McDonald's at $38 may discover that they overbid slightly -- eliminating the opportunity to pocket the big bucks.
Playing to win
Same scenario, different business:
Our second company is a beverage distributor whose iconic brands control roughly half of the domestic market share. Over the past 12 months, the firm has posted FCF of almost $1.9 billion on revenues of around $15 billion. Analysts are expecting annual earnings growth of 8.5%. With 769 million shares outstanding, what price tag would you place on the stock?
Using a discount rate of 9%, the numbers yield a fair value estimate of $59 per share.
What's the stock? Motley Fool Inside Value recommendation Anheuser-Busch
Although that discount to fair value is steep, like nearly any other company, Anheuser-Busch is not without potential threats; growth in China may not materialize as expected, wine and spirits could continue stealing market share, and so forth.
However, even after paring back our growth estimate to 5%, we arrive at a fair value that is still within a few pennies of the current price. To be sure, that spells out less risk than before, but conservative investors might want to demand an even larger margin of safety.
There isn't an overabundance of stocks trading at extreme discounts of 25% or more -- but they can be found. After free-falling more than 40% year to date, eBay
The showcase showdown
That's the beauty of not overbidding. If the company overshoots your estimates, no harm done -- you might rake in even more than expected. And even if it comes up short, you stand a better-than-average shot of avoiding losses and walking away with a decent profit.
That simple but powerful approach is what guides our Inside Value newsletter. By carefully hand-picking undervalued stocks with limited downside risk and significant upside potential, Philip Durell's team has produced an average gain of 17.9% -- outperforming the S&P 500 by six percentage points. We don't have a big wheel to spin, but we do have a valuable bundle of prizes: the Inside Value lineup of stock recommendations, as well as the handy discounted cash flow (DCF) calculator (which I used throughout this article). You can check out the service for free with a 30-day trial.
Fool contributor Nathan Slaughter would like to remind everyone to have their pet spayed or neutered. He owns none of the companies mentioned. eBay is a Stock Advisor recommendation. The Fool has a disclosure policy.