COVID-19 is running amuck through the global economy. You can say the fear is overblown and it’s “just the flu bro”, but regardless of how you feel about the way our government and the global economy are reacting to this virus, it’s happening.
We haven’t seen this kind of volatility since the 2008 financial crisis when greedy bankers took a dookie all over the hard-working people of America. The VIX index a.k.a the “fear index”, is a measure of the volatility of the market.
These crazy big swings in the market strike fear into investors and as people panic, they sell out of their positions. Imagine It’s times like these that really make you learn what type of investor you are and how you are able to handle volatility. As long term investors, we shouldn’t worry about what the market is doing in the short term. On the contrary, we should try to keep a level head and refrain from doing anything stupid. If you panic everytime stocks drop, you are going to lose money. DO NOT PANIC!
There are two main types of long term investors. The first is value investing and the second is growth investing. Value investing has been around forever and has been made popular by the greatest investor of all time, Warren Buffet. We’ll touch on growth investing in later posts, but these are exciting times to be a long term value investor.
Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. The intrinsic value of a stock is the amount that the stock is actually worth, and may be higher or lower than what the stock is actually trading for. Learning how to determine the intrinsic value of a company is probably the most important skill you can learn. You know that lady at the supermarket with 9000 coupons who is stoked because she saved 35 cents on veggie patties? That’s going to be us but with stocks.
Think about it this way… How do you know if something is a good deal or not when you go to a store? Let’s say you go to a shoe store looking for a new pair of sneakers. If you saw a pair of Nike running shoes for $500, would you buy them? You obviously know how much a normal pair of shoes cost, so seeing that price tag would make you not buy them or at the very least, would make you have some questions as to why they cost so much. Unless you are one of those weirdo sneakerheads who will spend their life savings on Yeezys or whatever the kids are buying these days…
You go back a week later and now the shoes are $2,500 dollars. You really want the shoes but this is such a ridiculous price to pay. They are damn running shoes, not a computer. Also, how is it that the price went up $2000 dollars? Did the value of the shoes change? Or are people just willing to pay that much? You wait a month and now the shoes are on the clearance rack for $75. The shoes themselves didn’t change. They are not less valuable than they were a month ago, they just cost less. Obviously these crazy price swings don’t happen in retail stores but they CAN happen in the stock market.
The Market is Irrational
This is something you need to accept. I’m not saying there no reason for stocks to be dropping right now because, at this point, the Coronavirus will without a doubt affect the short term earnings forecast for the vast majority of public and private companies alike.
However, fear is very powerful and can make investors make really stupid decisions. Think about it this way, every time you buy a stock, there is a person on the other end of that trade that is selling the shares to you. As an investor, you want to be on the winning end of that transaction. In a market like this, people will start giving away great companies at ridiculously low prices. As a buyer, you can set yourself up for success by taking advantage of these fearful and panicked sellers by buying shares at 50% off.
Let’s take a little trip down memory lane to the 2008 financial crisis. Stocks got absolutely WRECKED from 2007-2008. People didn’t want to touch publicly traded companies with a 10 foot pole. If you sat on the sidelines with $10,000 and bought shares of SPY (ETF which tracks the S&P 500) at the bottom of the recession, you would now have over $36,000 (369% return). At the bottom of the recession, you can basically throw darts at a wall with the top companies and make money.
It seems so simple, buy low and sell high. The issue is that no one is going to tell you when it is time to buy. Just because stocks have dropped to what seems like a lot in the past month, that doesn’t necessarily mean that they are cheap. We want to buy when they are cheap not just when they drop. This is a super important distinction and takes a tremendous amount of patience and discipline.
How do I figure out intrinsic value?
The best method I’ve found for calculating the intrinsic value of a company is the Discounted Cash Flow equation (DCF). I’ll be completely honest, I thought about trying to type this out but I’m going to steal Investopedia’s youtube video instead.
Super simple right? Definitely didn’t make you want to jump off a tall building right?
The point is, people a lot smarter than you or I came up with this stuff and let’s just roll with it. The DCF method runs off the assumption that a dollar today is worth more than a dollar tomorrow. I’m going to be giving out a free Excel sheet with the DCF model which will allow you to plug in some numbers and let the formula do its work. Let’s take a look at an example. I’m going to walk you through calculating the intrinsic value of Nike (NKE).
EPS Growth Rate
The first step to calculating the intrinsic value of Nike is to determine the EPS growth rate per year, for the next 5 years.
EPS stands for Earnings per Share. This is the amount of earnings retained by the company divided by the total number of shares. If you see a negative EPS, that means that the company is losing money. You don’t have to worry about calculating EPS because this is always calculated for you. Nike earned $2.26 per share for the last twelve months.
You’ll hear people talk about EPS a lot because this tells you how much money company is making per share. A good company is able to consistently grow the amount they earn over time. Earnings are reported once per quarter and usually the stock will make a big move if they beat or missed the analyst estimates.
As investors we want to invest looking forward, not looking back. Let’s see what the analysts are projecting the EPS growth rate to be per year, for the next 5 years – I use Yahoo Finance so that’s where we’ll be getting all of the data to plug into our formula.
You can see that the formula has reduced the growth rate down to 15%. Throughout this process, you’ll see that everything will be reduced to give us a more conservative estimate of the value. The worst-case scenario is the company exceeds expectations and we could have bought it earlier but its always better to be safe. In this case, the analysts are predicting growth to increase compared to the last 5 years. This is also an area where you can use your own judgment. If you wanted to be even more conservative, you can cut the projected growth rate in half but for the purpose of this example, we will leave it as is.
Price Earnings Ratio
Often referred to as a P/E ratio, this is a quick easy way to see how much people are willing to pay for a stock. This ratio tells us how much people are willing to pay for each dollar of earnings. If a stock is trading at 100 dollars and has an EPS of $2.00, the P/E ration would be 50. This means that people are willing to pay $50 dollars for every dollar the company earns. The P/E ratio can give insight into how expensive a stock really is. Just keep in mind that the P/E ratio doesn’t tell the whole story and P/E ratios can vary widely depending on the industry.
You need to get it out of your head that the stock price tells you how expensive a company is. A $10 a share stock can easily be more expensive than a $1,000 stock.
AutoZone (AZO) is currently trading at $1,012 a share. I know so many new investors and look at that and say, “holy shit that’s expensive, I’m going to find a cheaper company because that one is clearly overvalued”. They go and sift through companies at random based on the current stock price and find Under Armour (UA) which is currently trading at $9.48 a share. “WOW it’s only $9 a share they are practically giving shares away for the price of a burger. I AM THE WOLF OF WALLSTREET. I WILL MAKE MILLIONS.” Then they buy a shitload of shares and spend the rest of their time thinking about what color Lamborghini they are going to buy with their profit.
AutoZone has an EPS of $65.55 and a P/E ratio of 15.45. This means that investors only are paying $15 for each $1 of earnings. Under Armour on the other hand only earns $0.20 a share and has a P/E ratio of 46.70. This tells us that from a valuation standpoint Under Armour is 3 times more expensive than AutoZone. Without even diving into the number, I can already tell you that AutoZone would be a better value play than Under Armour.
Lets get back to the Nike example. Complete the P/E ratio section by using the projected forward P/E ratio found on Yahoo finance.
You can see that the P/E ratio was further reduced by 15%. This is a conservative measure to assume a discounted price on the stock in the future. If you want to be even safer, take the current P/E ratio and cut it in half. This is basically saying that you think people will only be willing to pay half as much for shares as they are right now.
Beta, VIX, and TYX
This section will discount the price further based on the current volatility of the market, how the volatility of the individual stock relates to the market, and the return you would get on a 30-year treasury bond.
The beta of the stock is a measure of its volatility in relation to the overall market. The S&P 500 has a beta of 1. Anything that is more volatile than the market will have a beta greater than 1 and anything less volatile will be below 1. For our purposes, the formula will place a higher discount for stocks with high betas and a lower discount for those with low betas. You can find the beta value of any particular stock on the summary tab in yahoo finance. If you buy a stock with a super high beta, that means that if everyone else gets boned by a market collapse, you will get boned twice as hard. Most people don’t invest with the intention of getting boned in the butt and I try not to either.
As mentioned before, VIX is the ticker symbol of the Volatility Index which tracks the volatility of the market as a whole. The higher VIX is, the higher the volatility is at that time. The formula will discount the stock price more if VIX is high at that moment. This is assuming that being in the market when VIX is high comes with more risk than being in the market when the VIX is low. This is also known as the Market Risk Premium. If the VIX is high that means the market is having a temper tantrum and your risk of having money invested is high.
To find the current VIX value, simply type “^VIX” into yahoo finance, and enter the value into our formula.
This is the yield for a 30-year treasury note. Bonds are considered risk free so when yields are higher on bonds, that means you would need higher expected returns on stocks to make them worth it. When the bond yield is low, it would make more sense to accept some extra risk on stocks with the hope of getting a higher return. This is also known as the Risk-Free Rate. If you are under 40, don’t buy bonds. I mean come on, I want to be safe as much as the next guy but you have time on your side. If you made a mistake on a purchase, usually you can just wait it out and eventually the stock will go back up (assuming you bought a good company).
To find the TYX value, type “^TYX” into yahoo finance and enter the value into the formula.
Current Stock Info
Okay, we are at the home stretch here – I know I’ve been going on forever but stay with me. The last box is where you will enter the current stock price, the current earnings per share (EPS), and the years of projected growth. The stock price and the EPS can be found on the summary tab in Yahoo Finance for the particular stock. As you can see, I was lazy and took two weeks to write this, so the stock price already dipped well below the previous screenshots.
We used 5 years of expected growth when we calculated the EPS growth rate, so we will use 5 years for projected growth at the bottom of the formula. Here’s everything filled into the formula for Nike (NKE).
Margin of Saftey
You’ll often here value investors talk about what’s called “Margin of Safety”. A margin of safety is an important principle of investing where you only purchase stocks when their current price is below their intrinsic value. This helps to minimize the downside risk of an investment. The bigger the margin of safety is, the less risk the investment theoretically has. We are assuming that eventually, the market will price this stock accordingly and closer to its intrinsic value. It’s the same concept of only buying clothes on sale. If you are the type of person that always shops in the clearance rack and loves searching for good deals, you will be a great value investor.
Everyone has different rules for how much margin of safety they require before purchasing a stock. My personal rule is 25%. In this case, I wouldn’t buy Nike just yet because it doesn’t meet my requirements. The formula is showing that Nike is truly worth $88.06 per share and is trading at $67.45, which truly is a good deal but not good enough for me. But hey, you do you.
Art vs. Science
When I first learned about all this I got way too hung up on plugging number thinking that they tell the whole story. It’s super important to know all of this to be a great value investor but don’t just mindlessly plug in these number for random companies and think its a good investment because its cheap.
Use your head here. If you are obsessed with cars lets say, you already have insight on different auto manufacturers and brands. I know jack shit about cars, so you and I could look at the same company and you already have an edge over me. Start using your own skills to gain insight over other investors. Start thinking about where you think the world will be in 10 years. This will help you make intelligent investing decisions that go past what you see in the numbers.
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