Editor's note: The Value Stock-Picking Training Program is a series of four weekly assignments. (To start with Week 1, click here.) Each assignment is based on one of James Altucher's strategies in his book Trade Like Warren Buffett. To get a copy of the book, click here.
This assignment was written by Stockpickr member Ira Krakow.
Trade Like Warren Buffett
James Altucher quotes Benjamin Graham, the founder of
Graham notes that when a company is trading below its market value, one of two things should happen (note the word "should"): 1. The market will once again value the company on the basis of its liquidating value or higher. 2. The company's management, if they can't turn the business around, will liquidate the business and return the proceeds to investors.
This raises two questions:
1. How do we calculate a company's real value? 2. When, if ever, will the market price of the company's stock rise to that value?
One way to realize value, as we saw
last week, is for the company to be
acquired. But at what price? In
Week 2, we saw how to use the
price-to-book ratio to discover value. However, this is only one
valuation method. In this final week of value stock-picking, we will explore other ways to spot value.
Large-Scale Value Plays
How would a company like
price Facebook (see
"Microsoft Takes Stake in Facebook")? What's the right price for a biotech company, such as
? What about a bank? When you read about a how a stock is priced, you will often see phrases such as "12 times
EBITDA" or "2 times
growth rate" or "5 times
However, not all deals are priced the same way.
Here are five distinct approaches to pricing a big takeover deal:
- Pricing based on the price-to-book ratio: According to Jim Cramer, if (for example) a bank's price-to-book ratio is 2 or less, it is a possible takeover candidate (see the Wall Street Confidential video, "Cramer: Spain to Conquer Southern U.S. Banks").
- Pricing the deal based on earnings: Companies looking for bargains are basing their calculation on forward earnings (what they think the potential takeover company's earnings will be), as opposed to historical earnings (what the earnings were in the past). If the potential acquirer wants to buy a company for its growth as well, management will then often look at the target company's PEG ratio. Typically, management will look at companies with a PEG of 2 or less, more commonly referred to as "2 times growth." However, these future earnings are estimates, not guaranteed numbers.
- Refining the earnings picture, using enterprise value and EBITDA: Altucher has created a Takeover Targets Trading System on Stockpickr that uses both enterprise value and EBITDA. By his calculation, a company is a takeover target if the multiple of enterprise value divided by EBITDA is less than 5.
- Basing the value on free cash flow: If a company is profitable, another valuation method is to look at the price-to- free cash flow ratio (also, see price-to-cash flow). In other words, how much cash the company generates. Earnings can be manipulated in many ways. As examples, a big order can be "booked" earlier (to increase earnings) or be postponed to the next quarter (to decrease earnings), payments to suppliers can be delayed or accelerated, and so on. Cash can't be manipulated in that way, and so it is considered a more reliable barometer of a company's profitability and overall health. To see how to use this method to find stock bargains, check out the Top Free Cash Flow Stocks portfolio on Stockpickr.
- Estimating discounted cash flows: Suppose a potential acquisition has no earnings, no products on the market and is worth only the cash in its bank account and perhaps the test tubes in the lab? A biotech company like Dendreon, which is developing a drug that may or may not get FDA approval, falls into such a category. When pricing a company like this, none of the valuation methods discussed above will produce a meaningful price. So what does a potential acquirer do? In Dendreon's case, a potential acquiring company, such as a major drug company like Pfizer (PFE) - Get Pfizer Inc. Report or Merck (MRK) - Get Merck & Co., Inc. (MRK) Report will estimate the future revenues if Dendreon's drug passes muster. How? A discounted cash flow (DCF) analysis. There's a lot of guesswork involved in future revenue estimates, but the DCF analysis is usually done by people with deep industry knowledge.
Your Week 4 Assignment
It's role play time. Let's pretend you run a Canadian or Spanish bank and you're looking for the best U.S. bank to acquire. Your fourth and final assignment in this value stock-picking program is to find and price the next bank takeover deal, by looking for both the potential bank to be bought out and the acquiring bank to do it.
Although this assignment focuses on banks, you can use the primary approach and strategies to find potential value plays in almost any sector.
To help you get started, I created
a Stockpickr portfolio of possible U.S bank takeover targets, and Canadian and Spanish banks that might be interested in acquiring them (based on Cramer's earlier video).
Stockpickr, create a portfolio called "Bank Takeover Target Analysis:
Your Stockpickr Username." (To create a portfolio on Stockpickr, you'll need to first log in to the
Stockpickr Web site. If you're currently not a Stockpickr member, you can register at
Turn the "Portfolio Tracking" feature on, so you can monitor stock prices over time.
Add the companies in the
Bank Takeover Candidates portfolio to the portfolio you just created.
In the "Reason for picking" box of each stock, enter the
forward P/E, PEG ratio, price-to-book ratio and enterprise value-to-EBITDA ratio. You can find these measurements on Yahoo! Finance.
To find this data on Yahoo! Finance, do the following:
1. Enter the ticker symbol and click the "Get Quotes" button, to get the current quote. 2. On the left-hand side, click the "Key Statistics" link. On this page, you will find a "Valuation Measures" section that will display the numbers that we covered earlier.
(Notice the other value metrics, such as "Price/Sales" and "Enterprise Value/Revenue." Even though we have discussed five different ways to value a company, we have by no means exhausted the topic.)
Read the news about each bank by searching for articles and videos on
and other sources. What you're looking for are reasons why one bank might want to be taken over and why another bank might be on the hunt for an acquisition.
For the potential acquiring bank, the deal has to "fit" their business model. For example, perhaps
( STD) is interested in reaching the Hispanic market in the United States. Or
Bank of Nova Scotia
might want to expand its market into a nearby geographic area, such as New England. Which U.S. bank would be the best fit for one of those scenarios? Take notes in the "Reason for picking" box for each stock.
Identify one likely bank buyout and determine the most reasonable takeover price, Make sure to include the pricing method you used. Then identify one likely acquiring bank, by creating a "pick list" of the banks that present the best acquisition opportunity, given the bank's business objectives.
Follow the news for each bank for the next three weeks, adjusting your numbers and notes if you see any relevant developments. And, if you see other possible takeover targets (or buyers), add them to your portfolio and repeat the analyses in Steps 3 and 4.
Whether you're a corporate M&A player or an individual investor, the search for value is more or less the same. As we have seen in this four-week program, when it comes to value investing, what you look for is the right combination of income, growth, margin of safety and long-term outlook.
Stockpickr is a wholly owned subsidiary of TheStreet.com.