Value Stock Investing: CarMax, Overstock.com

How much is CarMax stock worth? I think it's worth $33 a share currently and $42 or $43 in two years' time. It recently traded at $20 [mid-May]. My calculation of value is based on 75% of revenue, not on current earnings.

It's a fair question: Why base valuation on a multiple of revenue instead of earnings? It's because current operating metrics understate the earnings power of CarMax. If you can figure out a base case for how the operating structure will look, you can back into a valuation using a revenue multiple. For example, in the mid-'90s, if you figured out that Dell (DELL Quote) had sufficient margin leverage to take net margins from 2% to 6%, you could have participated in a historic multi-bagger. If you recognized the margin leverage in the Dell model, you would have known that the stock was worth at least 1 times sales (based on 6% net margins) plus a healthy premium for its sales growth.

Here is another example: My analysis indicates that Amazon's current net margins of 2.5% to 3% understate its earnings power. I think the company can generate at least 5% net margins in the not-too-distant future. This is worth at least 1.25 times sales (more than Dell in the mid-'90s) because the model generates a ton of free cash. Implicit in the current market quote of 1.5 times sales is a 20% premium for sales growth. That seems a bit low, given the company's category dominance and record of robust sales growth.

For investors interested in identifying the next Dell or Amazon, take the time to study the evolution of their operating models. You'll see that massive multi-baggers like these require both sales leverage (usually recognized but underestimated) and margin leverage (almost always unrecognized).

I should note that my estimate of normalized net profitability (3.5%) for CarMax is a base case, a minimum. Since CarMax dominates its category and has at least eight to 10 years of healthy growth in front of it, my valuation of 0.75 times sales is probably too conservative.