Editor's note: The Value Stock-Picking Training Program is a series of four weekly assignments. (To start with Week 1,
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
- 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 Report) or Merck (MRK - Get 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.
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.)